Fixing the $80M problem with “tokenization”
“Tokenization” is pitched as an efficient way to securitize small deals, under $80M. However, it suffers from a deep underlying problem, which is that small cap deals make bad security investments. They don’t consistently deliver profits for passive security buyers, and investors are not buying. If there is no way to package small offers for passive investors, then the current “tokenization” pitch is a dead end. Is your deal dead? In this article, we examine the size of the problem and propose some enhancements.
The traditional private investment market works well. There are a lot of private deals under $80M, in which 1–20 fairly active buyers buy stakes and hold them indefinitely. The volume of offers that are “securitized” and distributed to less committed investors is vanishingly small in comparison.
Smaller security offers do not work in any context that I looked at:
- Equity crowdfunding raises a small, disappointing amount of money. The buyers tend to be customers with other motives, not real investors.
- If we look at more actively traded markets, smaller deals have been flushed off the exchanges, penny stocks often have problems, and Reg A+ investments have been a disaster for IPO buyers.
- Portals to sell real estate investments are the largest category for the $3-$80M deal sizes. They typically end up with a small set of permanent, active investors.
- Smaller offers seemed to work in the unregulated crypto ICO market during 2017. Now we can see that the smaller deals are going to zero.
Passive security investors have good reasons to avoid these smaller offers. They often don’t have enough disclosure to enable fair pricing, they won’t have enough shareholders to develop a secondary market, and there is often nobody in place to represent passive investors if something goes wrong.
Enlargement and Shrinkage
The minimum size for a successful stock offering has been increasing. Intel did an IPO in 1971 that raised $6.8M. Microsoft did an IPO in 1986 that raised $61M. More recent IPOs had an average market cap of $1.5B, according to this study, and the larger IPOs were more likely to go up in price.
The tokenization movement is attempting to reduce the practical size of a securities distribution through a combination of increased exchange opportunities, and a reduced cost of distribution and compliance. On the graph below we represent the plan to increase opportunity (in blue) and reduce cost (in orange).
Does it measure up?
Here is a simple three part test to determine whether an investment offer can be securitized or “tokenized”.
1) Is it a Good Investment?
Would it be an attractive investment for a knowledgeable investor who can buy a big piece of it?
The deal is likely to have the highest value for a buyer who has knowledge and some control over the deal. If it’s not a good investment for that investor, then security buyers with fewer advantages probably shouldn’t buy it, and probably won’t buy it.
I have heard issuers claim, in various ways, that security buyers are stupid enough to buy non-competitive investments. However, security buyers seem smart to me. They may be temporarily insane. They may briefly buy small IPOs with no underlying value. But they are not stupid enough to make the same mistake twice. Some variations on this theme include:
- The mythical guy in Singapore who is smart enough about money to accumulate a lot of investment assets, but stupid enough to buy anything “token”.
- Sports fans who will buy non-voting shares in money-losing teams in order to get T-shirts and a night with the stars. That’s probably a good pitch for someone who is putting in $500. However, these deals are looking for tens of thousands from accredited or sophisticated investors.
- People who are desperate because they can’t get “access”. Yes, it’s true that they can’t send money for your exclusive Mongolian yak ranching syndicate any other way, but they have literally thousands of other assets to choose from, including assets that may be a better bet, have similar returns, or more liquidity.
This first test shows why small cap securities markets suffer from “adverse selection” (only getting bad deals). When an issuer has a good deal that they can sell by visiting a small number of investors, they are unlikely to expend time and money to package, sell, and manage a security offer for a larger number of investors.
2) Is there an economic reason to distribute it?
So we must ask, is there a reason to distribute it to more investors? Does this reason have a monetary value that pays for the extra expense of a distribution?
There are reasons to do a security distribution. For example:
- Liquidity. Your investment will gain in value because it’s easy to buy and sell. This is the large cap solution. The bigger your deal, the more likely it is to have active trading. Liquidity only adds value if it is actually available, and not just a promise.
- You are marketing to a community and a customer base, and your customers will use your security. They may use it as a utility coin, or as a membership or a stake that is required for using a product or service. This was the original promise of utility tokens. I expect it to become popular with normal securities that can be used to buy memberships. The New York Stock Exchange used to require that brokers buy a “seat” or a “membership” in order to trade on the exchange. Now we can do the same thing for services on a smaller scale. This adds some marketing and product value to the security.
- You have a lot of shareholders already. They may be employees or mutual customers or other stakeholders.
- There is a category of investors that wants to buy your offer that requires a global distribution. The nice thing about blockchain format securities is that blockchains are borderless, and they naturally have global distribution. Many new categories of buyers are mythical. You can assume they don’t exist until you have interviewed real people and you know they are willing to pay a premium compared with local private buyers.
- You don’t want to give the money back for a long time. Real estate, VC, and PE funds will usually want their money back within about six years. They run “self-liquidating” funds that need to get the money back on a schedule. A security can be outstanding for a longer time, especially if the initial buyers can trade out of it. This may be important if you are making long term investments.
“Monetary value” means that the issuer will pay a higher yield or accept a lower price to get the advantages of a security distribution. You should be able to quantify this. For example, an entrepreneur might say “I want to finance this yak ranch with a security, because yaks take ten years to mature, and don’t want to pay back a PE fund in five years.” You might ask “specifically, how much extra yield, or lower price, are you willing to give your investors for the extra five yak years?” If the answer is “zero”, then you are done. You need some actual monetary value to work with.
3) Are passive investors represented and protected?
A lack of investor representation creates problems. Many tokenized securities are designed by the issuer. This hurts them in the primary sale, because, with no pushback from a lead investor, the issuers will usually ask for uncompetitive terms. That’s why none of these offers are currently selling.
The securities are also risky to hold, because most of them offer no governance rights, or a diffuse minority stake at best. It’s not clear who will represent passive investors if something goes wrong. This risk to minority shareholders has a cost, which we have represented as the “minority discount” in the graph above. Investors will pay more if they get protection.
We have many ways to represent and protect passive investors, for example:
- Insurance, like a monoline bond insurer. They take an insurance premium up front and they pay for investor losses.
- Servicers. They make a small fee for collecting and distributing money
- Trustees. They make a fee for handling problems that arise in a debt deal
- Tranching, as with an asset backed security where the lead investor takes the first losses and then gets paid extra if there are no losses, essentially selling protection to investors in later tranches.
- Lead investors. They can make a profit by getting into a deal early, and “signaling” the value of the deal, and then bringing in later investors at a markup.
- Lead investors/managers controlling the investment, strongly representing the other investors, and earning a percentage of their profits
A good way to represent passive investors is through a fund manager. Investors make a long-term commitment to a fund, such as a PE or a VC fund. Then, the fund manager takes a large stake in small deals, and aggressively represents the investors, and gets paid if the investment delivers a profit.
A strong lead investor can fix two out of the three problems that I listed for a small-cap security — poor disclosure, a lack of secondary market interest, and poor investor representation. They directly represent the passive investors. And, they can smooth over some of the lack of disclosure, because they can look at non-public information.
The lead investor has some important responsibilities:
- Negotiating the terms of the investment.
- Participating in governance and reporting on progress
- If problems do arise, putting in significant amounts of work to recover the investment
- Pushing for a profitable exit
Lead from the buy side
I think that there is a category of security offers between $20M and $80M in size that can work if there is a strong lead investor. This person will put in some money, assume the responsibilities of a lead investor for this specific offering, and make a percentage of profits if the other investors in the offering make money.
These lead investors have the effect of unbundling a VC, RE, or PE fund. Freelance asset managers can skip the fund and add their services to a single asset. There is something lost with this unbundling because we don’t get the extra services that come with a fund management team. However, there is also an efficiency gain. The asset manager doesn’t need to raise money in advance, and doesn’t get paid for a long period of prospecting. That produces cost savings. And, the deal by deal approach can respond quickly to new market opportunities, and engage a wide diversity of asset managers.
I believe that small cap securities need to be rolled up into larger funds. There is a limited amount of money available to buy small offerings. Large institutional investors will avoid these offerings because they can’t buy enough of them to justify analysis and slippage costs. Traders will avoid them because there are few bids and offers. We can greatly increase demand by rolling up many small cap holdings into a large cap fund that offers bigger purchase volumes, and more trading.
Having these funds available is also important for attracting good offerings. An issuer with an attractive offering is not going to bring it into the security market if it’s not clear that funds are available.
Fortunately, we can do this rollup efficiently when we build active management into the single assets. We can create a fund that is like an ETF. We need to be careful about the price that we pay when we bring new assets into the fund, and ask for a discount in exchange for doing due-diligence and underwriting a significant chunk of the initial offer. However, ongoing management is inexpensive. We can reduce the probability that this type of fund will trade at a discount to underlying value by allowing investors to redeem fund shares for the underlying basket of cash (probably stablecoins) and securities.
So, after many steps, we finally arrive at a reason for “The Blockchain”. The tokenized format makes it easier for us to do low-cost rollup, distribute the related securities globally, and redeem them.
An attractive package
I propose to sell lead investor services that will create buyable security offers. Qualified issuers will be able to contract for these services, the same way they can buy insurance and trustee services for debt deals.
- Our single-asset group will provide protection and profits to investors in small-cap securities, using the same level of representation that is demanded by the world’s biggest VC and PE investors.
- Our multi-asset group will provide access to small-cap asset categories, through large, liquid, and efficient global ETFs. These categories have global scope and include VC, PE, real estate, and liquidity for emerging economies.
The value-adding ingredient is both of these services is asset managers who can represent the BUY SIDE of a securities market.
A lot of ink has been spilled on Medium about the potential for tokenized securities. The small security problem has killed all of these plans so far. This article presents some of the ingredients of a solution. First we need to identify deals that gain value from securitization, using something like the three part test listed above. Then we need to make small deals acceptable to remote security buyers, and we have to do it at reasonable cost. Then we need an efficient way to roll them up into bigger bundles.