STO vs VC: liquidity & control

Evercity continues the series of articles that analyse the pressing issues of traditional fundraising landscape and the way security tokenization can help to tackle them.

In the second part we took a look at how STO offers a more efficient alternative to ICOs — one of the newest (and most notorious) fundraising methods. But security tokenization also steps in to disrupt fundraising giant from the previous century: traditional venture capital system.

It is true that venture capital funds have stood behind many mind-blowing success stories and major disruptions of our age. However, the system itself has barely changed for the past 60 years, and right now venture funds represent rather rigid institutions. The whole venture industry is an elite limited-access club ecosystem that sets strict rules and limits to both investors and startups. These limits become harder and harder to deal with as the world moves on in its digital paradigm, starting to outweigh the benefits.

Still, VC remains a financial industry which powers humanity’s tech progress. To what extent STO can change — or maybe even replace? — this strategically important sector of the fundraising industry, we are just about to see.

VC problem №1: low investor liquidity

“Every VC will tell you that its biggest limitation when raising funds is illiquidity”.

If you consider investing your money into venture capital, you have to be fully prepared to lock your funds in for a (very) long term. 7–12 years in average, to be clear.In this context, thousands of people lining up to give their money to yet another ICO project do not seem too surprising.

Venture capital has many advantages over initial coin offerings, legal protection and investor safety not being the least. But liquidity is certainly not on the list.

If something changes on the way, an early exit from a VC fund inevitably leads to heavy losses and cannot be executed without approval of management.

STO solution:

While issuance of your own security tokens via ICO can be legit an alternative to VC for startups, it can also bring liquidity to traditional venture capital in the form of tokenized funds.
In this case, issued tokens represent traditional ownership and revenue rights, while they also provide investors with opportunity to trade these tokens (see: a share in a fund) on secondary markets at any time. This model is currently being implemented, for example, by SPiCE VC.

Liquidity means that investor is flexible to make changes in his portfolio: decide when to exit, to trade or to hold his assets in parts.

VC problem №2: investor entry barriers

Venture capital sets high standards not only for the startups. So it does for investors.
Usually you have to bring in certain (big) sums to join an investment round.
Not everyone can afford to forget about their money for the next 7–12 years and patiently wait for the exit.

Even if you can — it doesn’t necessarily mean that you’ll be able to join the party. For example, according to Stephen McKeon: “many of Sequoia Capital venture funds have been notoriously difficult to access, even for some institutional investors”.

STO solution:

While startups can still set a minimum investment amount when doing their own STO, the method is much less demanding to investors. A startup can decide to attract funds from thousands of private investors — and they just have to be accredited.

Talking about a solution for venture capital, security tokens of a VC fund can represent such additional rights as access to certain investment rounds, as per professor McKeon. As an extra bonus, it can make them trade above the net asset value.

VC problem №3: loss of control on your startup

From a startup’s point of view, VCs are not only rainbows and butterflies either.

Many young tech startups find it extremely hard and expensive to take care of fundraising campaigns: financial structuring, legal compliance, marketing. In this scenario, venture capital becomes a source of guaranteed, fully compliant investments.

But it comes with a price: losing equity stake and control of your creation.

As Harvard Business Review put it, «most entrepreneurs want to make a lot of money and to run the show. But it’s tough to do both». Private venture capitalists and funds usually require a large equity stake in a startup they invest in. For founders it means losing the ability to make important decisions and having to put up with forced management changes.

How would you solve the «Founder’s Dilemma»?

STO solution:

In this regard, STO comes as an alternative to VC that saves startups from giving away their independence. A startup can decide what rights and what amount they are ready to tokenize and sell.
In its turn, the DAO principle is able to provide a more efficient decentralized governance model, where decision-making power is given to the community of shareholders, and not to “higher powers”.
At the same time, in comparison with ICOs, security token offering remains a fully legal fundraising method.

Ivan Podmasko, Partner @ Emery Capital VC, CEO @ Scrypta & Advisor to Evercity

Raising capital for a start-up is always: structuring the round, capitalization modeling (drafting cap table), determining classes and volumes of issued shares, forecasting the founder’s dilution, allocating option plans for employees, determining restrictions on the sale of shares and vesting schedules, and, of course, drafting package of legal documents (corporate decisions, contracts, entries into the shareholders register).
We can assume that digitalization trend, which is now gaining momentum in the capital markets (and manifesting itself in such a phenomenon as STO — Security Token Offering), will lead in the future to the creation of new mechanisms for capital management through smart contracts on distributed ledgers, simplifying and speeding up not only the process of raising capital and its circulation (thanks to a single digital carrier of information — for both money and securities — blockchain), but also the processes of its modeling and audit.
The emergence in a short time of a single transparent environment for programming and accounting of the share capital through convenient interfaces will unite founders and investors”.

Coming next: STO vs IPO

Article by: Masha Vyazemskaya, Alexey Shadrin