Democratizing Venture Capital — A Few Thoughts on How the Blockchain and Tokenized Funds May Change the Venture Capital Market
Based on a recent article written by Erin Griffith in the New York Times, that reports on a new countermovement where entrepreneurs consciously refrain from taking on Venture Capital, I was inspired to write a slightly different article on Venture Capital and how it is likely to change due to recent technological advancements. In what follows I will shortly recapitulate on common characteristics and shortcomings of the VC industry and elaborate how blockchain technology and tokenized funds bear the potential to change this industry for the better.
What is Wrong with Venture Capital?
Right now the VC market is highly restricted in terms of who can participate. On the investor side you typically find a few well-off individuals so called accredited investors that fulfill the necessary requirements (i.e., they are wealthy enough) to partake in these investment opportunities. On the start-up side you find a selected group of new ventures that fits the pre-conceived notions of profitable business according to these investors. One consequence of this is, that a large part of the market is still unserved which leads to a lot of business opportunities not being realized. This concerns startups looking for adequate financial support as well as potential investors that would be interested in holding equity in these companies but are not allowed due to current financial regulations. For those who argue that Crowdfunding is supposed to fill this gap — I totally agree — at the same time it seems as if this type of investment is simply not equipped (by that I mean it is too inflexible) to facilitate the changes that are necessary to democratize Venture Capital.
For those companies that are eligible for Venture Capital they usually face a seller’s market in which VCs stipulate the agreements and terms upon which capital is exchanged. This often puts a startup at a significant disadvantage as it has to settle for a deal that put the financial interests of Venture Capitalists above the founders goal of building a valuable and innovative business. Hence, engaging in these investment agreements deprive startups of the opportunity to employ a financial model that fits their individual needs and helps them to achieve their envisioned goal. Rather, these startups have to engage with investors who do not really understand their businesses and of which most follow a similar investment strategy (that is optimizing for return on investment). Ultimately, this results in a market that is characterized through low innovation as it promotes a self-sustaining VC cycle, which yields homogeneous startups (e.g., the fifth AirBnB) that paradoxically fall short of the high expectations dictated by this industry.
“Looking at today’s Venture Capital landscape it becomes quickly apparent that VC funds, lack diversity, meritocracy, balanced risk structures and transparency. This is also supported by numbers showing that profit margins of VCs decrease despite an increasing number of investment opportunities (i.e., startups). While this fact seems odd and counterintuitive at first, it indicates that VC funds suffer from bad internal judgement and financial decision-making. What is even worse is that this problem might be endemic to most funds in the industry”
Despite these shortcomings of VC, a solution to solve some of these issues might be just around the corner. The solution I am referring to concerns recent advancements in decentralized ledger technology and tokenized funds. In the coming paragraphs I will shortly outline how these advancements may foster the creation of innovative VC funds that — if designed properly — may help to alleviate some problems discussed above.
Possible Ways Forward for Venture Capital
- Micro-Equity
One way how blockchains and tokenized funds will change Venture Capital is through so called micro equity. This micro equity is usually obtained through tokens that allow investors to hold fractional ownership in a company. The concept is not entirely new, but was originally initiated through the JOBS Act, that allowed investors to invest in startups sums as little as US$10–15, mostly via equity crowdfunding. Blockchain technology takes this development to the next level as it allows decomposing and managing ownership stakes at levels that were previously not viable from an economic perspective. Participation thresholds are further lowered through the new liquidity introduced by these tokenized funds — I will explain this in more detail in one of the following paragraphs — that allow significantly shorter holding and monetization periods of Venture Capital. This is likely to open up the market for a lot of new types of investors such as industry experts, consumers, and many more, who were previously excluded from this market that was only open to wealthy individuals and accredited investors. Furthermore, this development might also lead to an influx of new more tech-savvy VCs with the talent and determination to challenge the unsustainable models of VC incumbents.
- Networked VC Funds
Another advantage of tokenized funds concerns the diversification of risk. This is usually achieved through the blockchains ability to facilitate large and open networks. As a result of this risk is not shared among a few selected investors anymore, but among a large crowd of investors around the globe. Thus, the open access to (public-)blockchains allows, theoretically anybody to participate in such funds. Even more, it allows the ad hoc creation of funds that can be used to support a variety of new causes. For example, the decentralized nature of these funds may enable local communities to easily create and organize their own funds to support special causes such as building local infrastructure. Another interesting point to consider is the virality that these networks allow. One example that showcases this potential is word-of-mouth promotion of investor networks within crowdfunding campaigns that result in so called herd effects, which lead more and users to join and support the project within a relatively short amount of time. That these networks cannot not only be used for funding or viral marketing effects is shown by current blockchain projects that engage the network through so called bounties in which users take on a variety of tasks (e.g. coding, debugging, content creation etc.) that are crucial for building and growing a company. Hence, the networks created through tokenized funds may provide new possibilities to leverage the expertise and skills of the community. One of the main functions of these funds will thus not only to manage investments, but to coordinate and organize a large crowd of users that assist the growth of companies and hence the whole portfolio.
- Liquid VC Funds
Another great advantage of tokenized funds — that I touched upon earlier in this article — is the increased liquidity they bring to the market. One characteristic of current VC markets is that they are highly illiquid. This has to do with the fact that VC hold onto their investment for a period of 7 to 10 years — a typical VC investment cycle — until they achieve a positive return on investments. Exiting such investments prematurely is usually very difficult due to the rigid contractual obligations stipulated in the VC agreements as well as due to the fact that there is no functioning secondary market on which such investments can be traded. The same holds true for crowdfunding which ties up investors capital for at least a few years before investors can recover their capital and realize some potential returns. This usually poses a high risk for investors, whose capital is locked up in these funds and who therefore do not have the possibility to invest in alternative and possibly more promising projects. Blockchain technology and the creation of tokenized funds offer a way to sidestep this risk. They do so by introducing equity-like shares in the form of tokens that can be traded on exchanges 24/7. This creates a secondary market for Venture Capital that allows investors to flexibly liquidate or enter new investment opportunities. Beyond this the consecutive price listings of equity shares can be used by investors to more easily determine the objective value of startups. This is in contrast to current approaches where a startup valuation is determined through a VCs subjective estimate at time of investment.
- Programmable VC Funds
Another interesting characteristic of blockchain-based VC funds are their programmability. One example that showcases the potential of this are smart contracts which can be used to automate the creation and enforcement of VC agreements. While this is likely to result in the more efficient procurement and allocation of Venture Capital there are also a lot of other benefits that come with it. Thus, decomposing and translating Venture Capital agreements into small chunks of testable and enforceable code will likely result in VC agreements that are less complicated and hence easier for startups to understand and see through. So one legitimate hope is to see more transparent VC agreements that will discourage the use of disadvantageous investment clauses that are sometimes forced on startups. Another advantage of programmable VC funds is their potential for disintermediation. Thus, as already mentioned above smart contracts will allow to automate a lot of the tasks that a currently conducted by middle men such as brokers, lawyers, etc. Another example of this are automated KYC and AML procedures which protect certain types of investors from taking on too high risks. However, in my opinion, one of the most interesting potentials of tokenized funds is the programmatic inclusion of new incentivation mechanisms that can be used to coordinate investor networks more efficiently. Imagine for example a protocol that rewards investors for good behavior and proportional to the effort they are putting into a fund (e.g., either through providing their knowledge or other efforts). This may allow the creation of funds in which interests of investors and entrepreneurs are better aligned and in which all actors work towards a common goal i.e. to develop a sustainable and competitive business.
Conclusion
So what does all this mean for VCs, startups and the general public?
As concerns Venture Capitalists, I hope that some of these new funds will force them to pursue more rational investment strategies. As a result of this we will hopefully see VCs moving away from their rather egocentric “get rich quick mentality” to a more customer-centric mentality which entails providing startups with new investment opportunities that are tailored specifically to their needs as well. Moreover, these new offerings may provide startups additional value in the form of strategic resources such as domain expertise and knowledge, thereby enabling them to build more sustainable and innovative businesses. Venture Capitalists who are open to these changes might encounter a lot of new and surprising market opportunities along the way.
For startups these new types of funds bring access to new equity pools. At the same time startups may also obtain access to new networks of experts and intelligent crowds that can help them to develop and grow their business to an unprecedented level. As tempting as this sounds, startups should be aware of the following: Developing and managing such funds is a huge effort and therefore represents a risk for startups who lack the adequate capabilities to do so. To be fair this may apply to the majority of startups which will be forced to build up these new capabilities step by step.
As concerns the general public we will see that tokenized funds will facilitate broader access to the Venture Capital market. This will hopefully lead to the creation of viable new business opportunities that will yield more diverse and consequently more innovative startups. On top of that, I believe that these new technologies hold the potential to transform the general public from passive investors to more active investors. Hence, instead of sitting and waiting for their capital to accrue interest these investors will take their financial future into their own hands. By doing so, they will use all their efforts to develop the companies they invested in, thereby proactively contributing to the creation of new rents for the company and for themselves.
Granted, my outlook on tokenized funds may seem overly positive, especially against the background of the recent ICO bubble that caused a large amount of investors to lose money. Still, I believe that technology is not the culprit here. It is up to us to design and use technology in a way that it helps us to tackle important problems and to promote socially desirable change. If you are interested in helping us to change the world of Venture Capital for the better join our mission and visit us at vencortex.
