Tokenizing a VC fund for liquidity: how SPiCE VC built on the Blockchain Capital model
Since we launched our new project, a tokenized fund called SPiCE VC, the number one question we have received is how do we compare with Blockchain Capital. They were the first to tokenize a fund through an ICO back in spring this year and to do it also as a security token. In this post, we will go over the structure of Blockchain Capital and how it compares with what we are doing at SPiCE VC. Please note that we will only discuss Blockchain Capital as the only other liquid fund, in other words, a fund that has been tokenized to provide liquidity to its investors and to crowdsale the fund-raising process. I will also not be covering other tokenized funds (ICONOMI, TaaS) that have been doing fund raising as a utility token and not a security token, that discussion (whether they are actually utility tokens or not) requires an entirely separate post which we will be doing in the future.
“LP interests are likely to be tokenized…illiquidity will be a competitive disadvantage in fundraising that only the top firms will be able to justify”.
We totally agree with this statement and besides liquidity there are other aspects of tokenized funds that are very interesting like inclusivity (open up VC funds to more people than traditionally it has been), transparency (manage the fund itself on the blockchain and provide regular portfolio updates including publishing the Net Asset Value of the fund) and finally the ability to manage digitally on the blockchain and via smart contracts thousands of LPs, something that will be impossible in the traditional way.
So despite of all these advantages, it is surprising that after Blockchain Capital did their ICO back the spring, we are going to be the second one doing something similar. We hope that if we are successful (fingers crossed, looking good so far) we can encourage more people to go down this path. We are also very eager to see how companies like Blackmoon Crypto or Polymath are now trying to set up platforms to create tokenized funds. However, as you will see below, it is as much a legal issue as well as a technical one.
I will also not discuss here the different investments thesis of Blockchain Capital vs SPiCE VC but my primary focus will be on the fund regulatory framework, token economics of the token in the fund, how it works and which role it plays and how returns are managed with respect to token holders, etc.
Enter Blockchain Capital Token
In Spring 2017, Blockchain Capital, co-founded by Brock Pierce (a cryptocurrency leader and chairman of the bitcoin foundation) with Bart and Brad Stephens who successfully closed the first ICO for a tokenized fund. Blockchain Capital was an already functioning fund that raised its third fund and tokenized only a portion of it, $10 million of the $50 million third fund. Those $10 million were raised by selling BCAP tokens and the ICO was closed within 6 hours after they reached their hard cap.
Blockchain Capital was revolutionary in several aspects but primarily because of two things:
· It was the first company doing an ICO as a security token and trying to be compliant with the regulation rather than find work arounds, and
· It was the first VC fund to provide liquidity to investors via a token
The regulatory framework for BCAP and SPiCE tokens
By now, if you are in the crypto space you might have heard about all the discussions of utility tokens vs security tokens. The main way to tell them apart is by applying the so called Howey test, you can read about it here but for the purpose of this post the only thing you need to know is that BCAP tokens, the way they were defined, are clearly a security. And rather than trying to find some artificial way of providing a utility to the token or blatantly ignoring the law, they openly decided to sell it as a security token setting the path for many more to come.
Selling securities is a regulated activity in most jurisdictions and therefore not something you can generally offer to retail investors so this is the main reason why people preferred utility tokens since they can reach a larger pool of investors and it obviously cheaper and less complicated. In the case of Blockchain Capital, Brock Pierce was very vocal in many interviews about how they were a security and they were trying to play by the law and not trying to circumvent regulations like other people did.
“We’re a security just like someone doing a big crowdfunding campaign, but we’re tokenizing that security. The difference is everyone else is trying to circumvent these regulations. We’re saying, ‘Is there a way to work within them?’, and the answer is ‘yes’.” Brock Pierce
“Our view is: let’s just face regulation head on, and see if this can be done compliantly.” Brock Pierce
“One of the problems I have with ICOs today is they’ve created convoluted structures to circumvent securities law, which in some cases doesn’t work at all.” Brock Pierce
We applaud that and we have followed their example by also categorizing ourselves as a security token and complying with the security regulations. How each fund treats the regulation in each country is slightly different because we are also different from a jurisdiction perspective. BCAP is a US fund while SPiCE VC is a Singapore entity registered with the FCA in the UK (local securities regulator) under the European Union AIFM (Alternative Investment Fund Management) directive. Similarly, we both are blocking certain countries from participation either because ICOs are now prohibited (China) or because in some countries it is illegal to sell unregistered securities without an approved prospectus to anyone.
Given that Blockchain Capital is US based, their primary objective during their ICO seemed to be complaince with the SEC regulations. For that, they came up with a clever way of being able to sell to US investors without registering with the SEC as a security (a potentially very long, tedious and expensive process without a clear outcome since the registration could be rejected) by filing an exception under Reg D 506c which allows to sell to up to 99 accredited investors (under the US definition of accredited investors). This has now become the standard for anyone doing an ICO with a security token and targeting US investors and several other companies have use it (Science, Protos). Filling this exception is neither a long nor an expensive process so we recommend that people do it and we are doing it as well for our token. Both funds do KYC/AML on all investors since this is required to sell securities and it also facilitates then the release of crypto into fiat since you can explain to a bank where the funds are coming from and from whom.
Overall, the message here is that you need to look country by country, see in which ones you need to file and which ones you don’t (as far as you sell to accredited investors or a small number of retail investors). You also need to decide which jurisdiction you need to completely exclude (China being the obvious one). It is a bit of a tedious process and requires legal guidance for each country about what to do. We ended up developing our own ICO platform to do this and treat people differently country by country to comply with regulations. You can read about it here. No other ICO platform does that but definitely worth doing it to make sure we comply with the laws and regulation everywhere.
Blockchain Capital fund structure vs SPiCE VC structure
The main difference between how the two funds are set up is that Blockchain Capital is an evergreen fund. That means that they reinvest their gains to continuously increase their fund size or to at least keep it constant and it has an undefined period although after ten years they can redeem the tokens with investors it and close it. In contrast, we are a 7 year closed-end fund with a 3.5 years investment plus 3.5 years of follow on investments only in existing portfolio companies, a more common approach in a VC fund. I believe that their choice of evergreen vs closed-end was driven by the token design described in the next section given that their non tokenized funds do not appear to be evergreen. Given that most VC funds are not evergreen but closed-end we decided that we wanted to follow the more standard VC process and as you can see below it has also other advantages in terms of token holder remuneration.
BCAP Tokens vs SPiCE Tokens: indirect vs direct economic interest in the fund
The biggest difference between our two funds is the role the token plays. In the case of the BCAP token, they only have an indirect economic interest in the fund (meaning BCAP tokens have no distribution or dividend rights). SPiCE tokens on the other hand have a direct economic interest in the fund, we will return all net proceeds from exits directly to SPiCE token holders.
From private conversations with Brock, I believe that their choice was driven mainly by what their lawyers told them that they could do while now the market has evolved and our lawyers (Allen and Overy and Cooley) have allowed us for a different scheme.
So let’s understand first how BCAP tokens work. When one of the portfolio companies of Blockchain Capital exits (either a company is sold or does an IPO or if they hold tokens from an ICO they sell them) and BCAP receives the proceedings from the exit, the fund (given that is evergreen) will reinvest at least 50% of the exit proceedings in the fund while it reserves the right to use between 0% to 49% of the proceedings to repurchase tokens in the open market and burning them on the blockchain effectively lifting the value of the token as well as increasing the NAV (Net Asset Value per token) of the fund. So as a BCAP token holder (disclaimer, I have some) the only way you make money is when the token appreciates in value and then selling it in the open market, you never receive any money directly from BCAP. Therefore, it has an indirect economic interest in the fund and not a direct one,
In the case of SPiCE, every time there is an exit in the portfolio, we will be sending the pro-rata amount to each token holder and buying back a percentage of their tokens directly from them effectively reducing the number of tokens that exist until the entire fund is liquidated and there are no tokens left. So if we exit 10% of our fund, we will return that 10% to all our token holders proportionally to how many tokens they hold and remove from each wallet 10% of the tokens and burn them in the blockchain. All the details are in our white paper. This is what we refer to as a direct economic interest in the fund.
We both published the current NAV of the fund as a guide for the token value and in both cases the price of the token should track how the NAV grows over time as you do investments and they grow in value and as you reduce the amount of tokens over time through the two different buyback procedures. This makes security tokens that are asset backed like SPiCE, a lot less volatile compared to utility tokens or cryptocurrencies.
In our view, the main difference is that in the BCAP model to make money out of their token you need to rely on secondary market liquidity (for you to sell as well as for them to do buybacks) and effectively exit the fund to realize gains (since you need to sell the tokens) while in our case, you do not need to sell your tokens to make money (although you are free to do so in the secondary market if you chose to do it).
Currently, the dependence in liquidity is problematic for security tokens given that there are not many exchanges that list security token (although some have been announced already and many more are coming from what we know) and in fact BCAP is currently not listed anywhere following the decision of the only exchange they were listed in, liqui.io, to delist them. To avoid this issue, we have also partnered with Bancor to implement their decentralized exchange protocol and provide liquidity from day one to all investors without having to wait for exchanges to list us.
Another issue to take into account is that, given that tokens are P2P tradable, you cannot stop people from selling them or simply transferring them to other persons and you effectively lose control of who the token holder is (in spite of having done KYC and AML checks on the original investors). In the case of BCAP, this is not a problem given that they never return money directly to token holders so if the tokens end up in the “wrong hands”, it is not their concern anymore. Given that we return money directly to token holders, this is an issue we have to deal with. To circumvent this problem, and for a token holder to receive proceedings directly from us, they need to come back to our platform, register and pass KYC/AML checks again (if they have not already done it), otherwise we will not be sending money to people that hold tokens but we do not know who they are. This is a much better solution than to block secondary trading that in any case it is not something you can really control given the decentralized and P2P nature of tokens.
In terms of compensations, the two funds are also different (to some extent also driven by the different structure of evergreen vs closed-end). We both take a 2.5% average annual management fee but they do it based on the NAV of the fund (and that grows over time as they do exits and reinvest) while we do it based on the initial fund size and it is and average throughout the life of the fund (higher at the beginning and coming down in size over time).
There is also a difference in how we take the carry (meaning the percentage of the profits from the exits to the fund managers). BCAP takes a carry after each exit while we return all money raised first to token holders and only take carry from the profits accrued after that (so more like a standard closed-end VC fund). Another important difference is that we have reduced the carry (15% in our case vs 25% in BCAP case) but we are also keeping some tokens for the fund managers, 7.5% overall with a three year vesting period to prevent us from selling before we have deployed the capital (we are planning to deploy the capital in that period in to new investments and the rest of the period just do follow on investments). So our compensation is based on both the carry from the exits as well as the potential sale of tokens in the open market and we are incentivize to look after booth . We believe that for us to be compensated both in tokens as well as in carry aligns our interests with the token holders better since in the case of a liquid fund, it is important to pay attention to both the token value as well as the exists from the investments since investors benefit from both.
In an interview with Wired Magazine, Brock Pierce said
“Once we’ve done this, everyone is going to copy the roadmap we’ve created.”
We believe that we have not only copied what they did but also, in our humble opinion, improved the model.
In a recent blockchain conference that we attended, Brock used the video below of a dancing man in the Sasquatch festival, first joined by another person on the dance, then another and eventually the entire crowd follows on and joins the dance party. We hope that after us following the steps of Blockchain Capital to create a tokenized fund, many more VCs will follow.
We invite any VC fund (whether they are blockchain centric or not) to reach out to us and find out how they can do the same (some are already doing it).
Originally published at medium.com on October 20, 2017.