Why Venture Capital should embrace Equity Tokenization
There seems to be a prevailing thought process in the crypto space that the combination of crowdfunding and equity tokenization spells the end of venture capital as we know it. While I think there could see some truth to this over time, I don’t necessarily think this is a bad thing for venture capital, particularly early-stage funds.
The VC Model
For those new or unfamiliar with the world of VC, I’ll go into some very high-level basics of how the venture capital model works. The basic concept of early-stage venture funds is to invest in start-up companies at the earliest stages with the assumption that only a small portion (~10%) of the investments will provide the lion’s share of the returns and the rest will provide little to no return at all. This is known as the Power Law. For those curious about the math behind this, Jerry Neumann does a great job of breaking it down. So VCs continuously look for high-risk, high-return bets that have the potential to “return the fund” — that is, potentially return the size of the entire fund in a single huge exit scenario.
In order to get that illustrious VC term sheet, a founder must convince the investor that he/she is building the next billion dollar company. Anything less than that simply doesn’t fit in the model.
Now some might argue that this VC model is broken — That it forces entrepreneurs into a hyper-growth mindset that can sometimes kill a company. Yet, this model is what some of the most successful funds in VC are built on.
So which is it?
Well, I think the parameters of the model are broken.
Let me explain.
One of the assumptions every VC model must take is time in investment. The average VC holding is around 4 years but VCs must look at fund life cycles of ~10 years. Why? Because they are investing in an asset class (private market equity) that has traditionally been illiquid. To put it simpler — it usually takes quite a bit of time to build a very valuable business and until a company decides to IPO you have very limited options to sell your stock in the business.
Flipping the model
What if we could change some of the longstanding assumptions in the model? Specifically, what if equity in the most promising companies became liquid from day 1? How would that affect venture capital?
Tokenized equity has the potential to do just that — create liquidity in previously illiquid asset classes such as early-stage equity.
It really opens up the potential to rethink the optimal model for success in venture capital. More variables = more potential outcomes. More potential outcomes = more potential paths to a desirable outcome. The “all or nothing” approach would likely take a backseat as funds won’t have to write off or kill companies who can’t quickly scale to a billion dollar outcome. There is a lot of value between $0 and $1,000,000,000+ and new models can be created that focus on empowering entrepreneurs that are building real, sustainable companies, even if there isn’t a quick path to a mega exit (a couple funds are already ahead of the curve on this. I’m looking at you Indie.vc).
Of course, some funds might elect to stay the course and unicorn-hunt. I think a new breed of fund will emerge that is a part VC fund- holding the best investments for the long haul, and part hedge fund- trading in and out of opportunities as value and thesis fluctuate. Over time I believe this hybrid model has the potential to outperform the existing model.
Fund Tokenization
Another use case for tokenization is to tokenize the VC funds themselves. This is already happening with funds like Spice.VC and CityBlock Capital — who are both focused on supporting the tokenization ecosystem. I think a broader range of funds will decide to tokenize, opening up access and flexibility for limited partners to move in and out of funds easily.
In either case, I think venture capital should embrace this new wave of technology that opens up more options and flexibility to unlock value for their partners and investors.
Originally published at www.pieslice.com.
