The Uphill Battle LAOs Will Face

Since the launch of Ethereum and other smart contract platforms, people have tried endlessly to democratize the venture capital industry. The DAO was the first real effort towards making this dream a reality. However, its quick and painful collapse has made investors bearish on participating in other DAO experiments. Recently, it seems that the trend is changing and 2019 is gearing up to be round-2 of tokenized venture experiments. So far this year we’ve seen Ryan Zurrer’s DAO 2.0 and OpenLaw’s LAO. Although they are fundamentally different in structure and compliance with existing laws, they share the same goal of bringing the VC game mainstream.

What Does It Mean To Tokenize The VC Industry?

From a distance, playing VC looks easy and fun. Venture capitalists raise money from wealthy investors (Limited Partners or LPs for short), allocate this capital to promising startups, and get to kick back and watch both the startups (and their wallets) grow. When these companies IPO or get acquired VCs make a lot of money through performance fees.

Easy enough! Everyone should be a VC! Let’s build smart contract platforms to automate this.

The main premise of the LAO or Zurrer’s DAO 2.0 is to enable exactly that. Every investor/LP can be part of the venture fund decision-making process through voting. When investors buy into the DAO/LAO, not only do they get member interests (profit) but also they get voting power to decide which companies/projects to invest in. Hence, in reality, investors are not just LPs, but also they are fund managers. For the LAO, the dynamics are even more interesting when you consider the ragequit capability that allows investors to leave the LAO if they don’t like the majority vote and to withdraw their proportional share of the unallocated LAO capital.

What Is The Catch?

The proposed tokenized venture approach seems great and fair. Investors have skin in the game, they invest, decide where to allocate the capital, and reap the benefits. However, there’s a catch. In fact, there are two.

First, the VC game is not as rosy as it appears. The current VC scene is challenging and competitive.

Let’s assume that you’re a new VC who has managed to raise capital from LPs. The real challenges lay in building funnels to discover strong teams building interesting projects and in convincing these teams to take your capital. The more the capital available for venture investments, the harder the game gets. The competition to allocate capital to good teams becomes bone-crushing. With a world of negative interest rate and automated smart-contract funds, VC is not getting any easier.

Secondly, DAOs trend towards reducing specialization and betting on the wisdom of the crowd. Venture capitalists spend their days sourcing deals and discovering talent. Good VCs build differentiated deal flow special to their funds. They also work hard to support their portfolio. The goal is two-fold; helping the companies to succeed and building a reputation as value-adding investors which is crucial to convince good teams to accept your capital.

In return for this hard work, VCs make money in the form of performance fees or carry when these companies succeed. With decentralized VC funding approaches like the LAO, the carry incentive is removed. All profits go to the LAO participants. In this scenario, it is not clear who would be incentivized to do the heavy lifting of sourcing the deals and supporting the companies. It is easy to fall for an impractical scenario where investors pool their capital, hope someone else finds them good deals to vote on, and convince these teams to accept the cash, all while ignoring the work needed to ensure venture-scale returns.

Is the LAO a Bad Idea?

The short answer is not necessarily.

As of today, the LAO is more of an effort to make decentralized funding efforts compliant. The LAO will be incorporated in the US and will be open only to accredited investors. The difference between a traditional fund and a LAO is that proposing deals, voting, and making investment offers will be performed via smart contracts instead of GP meetings. In this sense, the LAO offers more legal protection to investors than other competing investment DAOs. However, that legal protection won’t solve the inherent limitations of investment DAOs.

Although smart contracts and voting may appear to be a more efficient way of conducting VC business, deciding on an investment is usually a more complicated process. It usually requires meetings with the team, asking in-depth questions about go to market strategy, and evaluating the team’s track record.

Without a clear mechanism to do this diligence, the LAO will essentially be a dressed-up form of the ICO phenomena where teams were raising money on vague promises wrapped around a white paper. A possible way to design around this issue is to allow LAO participants to vote not directly for a project but for a lead investor who will lead the diligence process. The selected lead investor can be compensated for their work. In this structure, the LAO would be conceptually similar to an AngelList syndicate where investors follow or vote for a project based on a signal from a seasoned lead.

Another challenge concerns the possibility that the LAO’s plan of tokenizing invested company shares may lead to instant liquidity of these shares. Instant liquidity, although beneficial to investors, could be damaging to startups. Imagine a scenario where investors in a venture-backed company rush to realize their profits by selling their shares when the company clears a milestone. These rash actions could cause significant disturbance to the company’s business and stability. Long-term commitment to a company — as demonstrated by the illiquidity of company shares — is an essential pillar of the VC industry. Startups don’t reach success without several moments of ups and downs. Long-term commitment is the main reason investors help companies during the moments of pain instead of running to the doors. Instant liquidity would essentially remove the requirement of long-term commitment, making it even tougher for founders to succeed.

Although OpenLaw states that the LAO’s smart contracts handling tokenized shares can be governed by legal binding agreements which can protect against instant share liquidity, this won’t protect against transferring of the private keys, e.g., hardware wallet, owning the tokenized shares or when the owning address is a smart contract address that can have its own underlying logic.

In conclusion, the aim here is not to shoot down this new wave of DAOs but to start a conversation around the risks that investment DAOs pose and to figure out ways to improve their design. The goal is to ensure the alignment of incentives among all involved parties. It is important to learn from the massive economic losses of the ICO phase and work hard to avoid replicating them under a new flag.