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Security tokens: long awaited VC markets evolution or yet another buzzword?

Illustration: Deloitte.com

Recent years have shown a major decline in VCs willing to invest in early stage ventures, leaving multiple startups with bleak chances to get funded and make their impact. Why has venture capital become incapable of fulfilling its initial purpose of driving innovation? Is tokenization truly able to make a change, or security tokens are just another buzzword and a leftover from ICOs?

VCs less willing to fund early stage startups

According to Venture Pulse research by KPMG, international VC scene has seen a sharp decline in early stage deals over the past few years.

We can now witness venture capital firms acting more cautious and private equity-ish, sticking to the “new late-stage/growth equity hybrid model that facilitates massive unicorn rounds”. The general decrease in the number of deals in 2018 reflects the pattern clearly enough.

Adding up to the trend, the number of VC-backed exits have been decreasing since 2014, making the chances of a venture-funded company for M&A or an IPO more subtle with every year, as of Pitchbook. Lengthening exit timelines, which have never been short in the first place (7–12 years on average), forces VCs to play safe and makes the industry long for alternatives.

The biggest pain of venture capital is liquidity, and time pressure of the modern world makes it less and less affordable. As we keep racing into the digital paradigm, the 60-year-old VC system seems to be struggling to fulfill its initial role of boosting early stage ventures. Current VCs want traction and proven market fit and, ironically enough, cultivate the short-term thinking by doing so. The chances for innovations to be left out are pretty high in this scenario.

Blockchain to help

Blockchain has brought the new fundraising promise. Even though it took an (arguably) wrong turn first with the ICO hysteria, it has matured in the process and has now come up with a new idea: let’s tokenize the real world assets.

Here’s why it makes sense and actually gives a hand to VCs.

Tokenization essentially means issuing “security” tokens governed by a smart contract that represent a particular asset (equity, debt, real estate, precious metals, and so on as your imagination can offer) and are fully compliant with securities legislation. While one might argue that these are the same securities, it is not quite so. Tokenization offers multiple promises such as reduced direct costs, 24/7 global markets access, automated compliance, instant settlement, fractional ownership and — ta-da-da! — increased liquidity.

Investors enjoyed the ICO idea of tokens so much, because it provided almost instant opportunity to get returns. When it comes to traditional investing, investors are unable to further allocate their funds, until the funded venture is acquired or goes public via an IPO, which might take many years.

Of course, issuing a security token does not magically provide liquidity per se. That’s what many former ICO adepts tend to forget about. However, it gives way more options and flexibility for a startup with an innovative (and sustainable) business idea.

Alexey Shadrin, Evercity CEO & Co-founder:

“If we want to live in clean sustainable future, we need to kickstart democratizing and wiping out barriers of raising capital for talented tech teams. Blockchain infrastructure can make legacy VC markets more accessible and transparent to new categories of startups and investors, globally creating an existentially needed innovations boost”.

Diversifying risk for investors and entrepreneurs

Tokenizing equity allows startups and small enterprises to expand their investor base, not relying solely on venture capital as the last resort for funds.

Traditionally, deals for private investors in early tech startups start from $20,000 and more. We already see security tokens changing that, with deals starting from several thousands or even hundreds dollars. The minimum investment amount still depends a lot on regulators: for example, this December Neufund was forced to raise the ticket for its “equity token offering” from €500 to €100,000 due to the last minute audit, but we are likely to see less of that happening in the future.

Allowing wider audience to participate in the round makes diversification and price discovery easier and gives a substantial boost to innovation. In fact, it actually gives a boost to high quality and truly disrupting (excuse my french) innovation: with no promise of immediate pump-and-dump styled returns of a crypto exchange, even non-professional investors will be forced to do their due-diligence and invest in something truly worth it.

As for small and medium VC-backed entreprises, stuck in the “purgatory” being not grown-up enough for an IPO, tokenizing their equity can help them avoid unfavorable acquisitions and let early investors exit and release the money flow for further innovations, as Vertalo CEO Dave Hendricks put it in his article. On top of that, security tokens are a way of getting a quick feedback from the industry, which can be a helpful instrument for VCs.

Additional liquidity, introduced by tokenization, mitigates the risks and makes startups a more attractive investment opportunity. In its turn, it empowers many more entrepreneurs to create innovation and achieve their dreams.

Thus, tokenization introduces a new fundraising method that is evolving into something between traditional VC investments and crowd sales.

Denis Soldatov, founder of Russian-speaking Ethereum community and DevOps in Parity Technologies:

“Blockchain itself does not solve the liquidity problem. Investors who prefer to invest in crypto assets do. They choose lower entry barriers and fast, secure and transparent asset conversion in investment portfolio. Blockchain does not have any limits or borders, except those that market participants agree on to reach consensus. For example, using DAO functionality for co-financing”.

Tokenization is already making the moves to transform the venture capital system by creating tokenized funds, that might in fact create this miraculous liquidity for investors — and make VCs more relaxed and eager to invest in early stage venture again.

We will get back to this topic in our next article, coming next week on Security Token Accelerator blog. Stay tuned!

More good reads on the topic:

Article by Alexey Shadrin and Masha Vyazemskaya



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