The future of funding... or the end of the company?
Updated: Jan 28, 2022
As we celebrate the winding up of another memorable year, we get into that period of reflection, of looking back and taking stock. Collins Dictionary just announced 2021's 'word of the year': the ubiquitous non-fungible token (NFT). Maybe unsurprisingly then, one of my most popular posts to date has been this piece on NFTs, in which I share my experience buying my first NFT.
On the broader subject of blockchain, I greatly enjoyed this piece by Jordan Hall (hat tip to wizard-philosopher Dr Jason Fox for the link) about the future of blockchain, in particular in the world of finance. It's a long read and you can skip the middle section if you're in a hurry, but I'm sharing it because of his eloquent description of the battle between DeFi and TradFi: decentralised finance (built on blockchain) vs traditional finance (the incumbent global financial market).
He makes some pretty bold predictions, including that "by roughly 2023 (and this is a *very* rough estimate), DeFi will have “won” although it likely will take the rest of decade (or longer) before the results of that victory will be fully realized out in the world."
His arguments are well-reasoned. While DeFi is still only a David to the Goliath of the global finance industry, it's growing at such a pace the foot soldiers of TradFi (people who work for Goldman Sachs because that's the optimal monetisation of their time and smarts) will end up defecting to DeFi because it offers a faster path to personal enrichment.
On a related topic, I'm heavily involved in three simultaneous capital raises at the moment, one involving a publicly-listed company and two involving private companies. One of the private raises has provided me with a career first: a venture capital fund that has never previously invested in equity (I'll come back to this). The VC in question is part of a new breed of funds known as crypto VCs, who invest in tokens, coins, DeFi, NFT and tokenization projects, as well as decentralized infrastructure providers.
According to CoinDesk, crypto VC funding reached an all-time high of $6.5 billion in the third quarter of 2021. Earlier this year well-known VC firm Andreessen Horowitz raised over $2bn for a new cryptocurrency fund, at the time reported to be the the largest crypto fund ever raised. This record has just been beaten by Coinbase co-founder Fred Ehrsam and former Sequoia Capital partner Matt Huang, raising $2.5bn for Paradigm One, their first venture capital fund, which they describe as having an early-stage focus. According to the Financial Times, Paradigm's previous flagship fund made an internal rate of return of over 200% (annualised) through the first half of this year. 25% is considered an attractive IRR in the VC industry.
One of the most active funds in this space is Coinbase Ventures, which might be described as a corporate venture fund, except it's not even a standalone fund or firm, it's just Coinbase (the US's largest crypto exchange) investing directly in more than 150 ventures and counting. The company writes predominantly small checks of up to US$250,000, often investing alongside other VC funds, with the money coming straight from Coinbase's balance sheet rather than through a formally established fixed-size fund.
But back to the VCs who don't invest in equity. Welcome to the future of funding, and the world of token investments. While it's true not all crypto VCs shun equity investments - for instance about 25% of investments made by the Horowitz fund mentioned above are through traditional forms of equity - my recent experience with the VC firm doing its first ever equity round is not unusual.
Tokens vs coins
What do we mean by 'tokens', and how are these different to 'coins'?
Coins are, simply put, digital money built on a blockchain. They are digital assets that exist on a dedicated blockchain and act like money. Bitcoin really has no value to us beyond a method of payment (then there's also mining, but let's not get into that here).
A token is more complex and versatile, it introduces the concept of utility (which I'll come back to in a bit): it has some functional value to you beyond just acting like money. Where coins are like money, tokens give you access to goods or services, or perform other valued functions. They can also act like a certificate of ownership of something (hence the relevance to replacing traditional equity). Remember that piece on NFTs? The 'T' in NFT of course stands for 'token'. If the tokens are exchanged in a transaction, this is using what's called a smart contract, a small piece of self-executing code written in the blockchain that dictates how the transaction takes place (and makes it automatic).
Another difference between tokens and coins is that a token doesn't have its own dedicated blockchain, like a coin does. For example the Ethereum blockchain, which also supports the Ether coin, supports an array of tokens (including stablecoins like USDC). In fact this is what makes the Ethereum blockchain more attractive to its proponents than Bitcoin, offering "a tool for real usage of blockchain technology in third-party projects." While Bitcoin is a digital currency, Ethereum is a programmable platform. Ether has appreciated 300% to Bitcoin's 50% in 2021.
This also makes a token a lot easier to create as compared to a coin, as you're not building a new blockchain every time you launch a token, you can leverage an existing blockchain. As we move towards mainstream adoption, there will be services popping up allowing a business to create its own token with no technical know-how and little to no cost.
In a sense tokens have a long history in a pre-digital form, going way back before the days of blockchain and digital coins. A chip in a casino is a token, a discount coupon for a restaurant is a token. In fact a bank note itself is a type of token. But adding blockchain into the mix has made tokens far more powerful (through security, immutability, automation) - and hence the advent of tokenisation (not to be confused with tokenism - which is when I get invited to participate on an otherwise all female panel).
Utility vs security vs equity
Tokens can be utility tokens or security tokens (and as a further subset of security tokens, equity tokens).
Utility tokens typically offer a credit to be redeemed for services in the project being developed, and so help build an internal economy within that project. These tokens are limited in supply and can be traded, and might be expected to appreciate in value as the underlying products or services they give access to become increasingly valuable - but also as users speculate and bubbles form. There is no specific legal or regulatory framework covering utility tokens. An analogy may be a ticket to a sports game. Some people will buy one for the purpose of watching the game, others will buy a load of tickets and hope to sell them for a profit at a later date prior to the game. They're not primarily designed as an investment, but some buyers will treat them that way.
While utility tokens are practically useful in that they give the user the right to use a product or service, security tokens represent financial rights, like a company share represents the right to future profits. By 'security' we are talking about a financial asset that can be traded. Security tokens are regulated - in fact this is almost a definitional attribute that distinguishes them from utility tokens, in particular in the US where a security token is typically defined as a token that passes the 'Howey test', referencing the Supreme Court case for determining whether a transaction qualifies as an investment contract. But even then it's not clear cut - in some cases a utility token could be perceived by a regulator as a financial asset, in particular if the token creates an expectation of "profits in common enterprise". Still today most jurisdictions can still be described as in a state of regulatory confusion, due in large part to the pace at which the ecosystem is evolving and new products and protocols are emerging.
What does it mean, in practice, that the token is regulated or not? One example is that while you can anonymously deal in utility tokens, that veil of anonymity is pierced with security tokens, as in order to remain compliant with regulatory KYC and AML requirements the token's in-built protocols will require an identification step before allowing the trade to occur.
By the way, another type of token is the governance token, which gives users in a project voting rights over how the project evolves and is run, in a form of decentralised governance. By tokenising a company's ownership and governance, we end up in the realm of 'Decentralised Autonomous Organisations' (DAOs). These beasts bring a lot of these themes together, providing us with a potential alternative to the traditional company. DAOs are often described as 'internet communities with a shared cap table and bank account'. For an overview of the DOA landscape check this out. This will be another huge trend in the future of how businesses and investment funds are run, but off topic for this piece 😃.
A subset of the security token is the equity token. While the security token can attach to any kind of underlying financial asset, the equity token is a security token representing equity ownership in a company or venture. It will usually provide voting rights to the holder through the underlying code, as well as rules for payments of dividends etc. They've been deployed quite a bit with fractional real estate investments, but they naturally lend themselves to replacing venture capital too.
In some ways, I see utility tokens as the crypto equivalent of reward-based crowdfunding (eg Kickstarter), while on the other hand security (or equity) tokens are the equity-based crowdfunding equivalent (aka crowd-sourced funding in Australia).
And so at first blush, the equity token, conferring the holder ownership rights over a company, seems like the natural evolution from today's company share, and I can see myself as a CFO in future issuing a digital token instead of a share certificate.
But the devil's in the detail, and what form this will take is still unclear. There's an approach where the token is simply treated as a blockchain-based equivalent of a conventional equity certificate. There's the company maintaining two separate cap tables, with the traditional equity cap table representing 100% of a portion of the token cap table. There's converting the company to a DAO and doing without conventional equity altogether.
But wait, there's more. What role might the utility token play in the ownership of a venture?
While there is a direct relationship between the value of a security token and the commercial value of the underlying business, the relationship is more nuanced with a utility token. Israeli venture capitalist Gigi Levy-Weiss sees in utility tokens a "truly innovative form of funding and company building." They provide a solution to the conflicting incentives between owners of a company and users of its services.
"In a traditional business, the financial incentives of investors and the users are not well aligned. Investors have a financial incentive to maximize profit per user, which may contradict the user’s incentive to pay as little as possible for the product. It’s a zero-sum game."
By using utility tokens as a tool for funding the business, you align all the stakeholders (including shareholders) on the same outcome. Levi-Weiss's post is well worth a read.
Liquidity vs volatility
Increasingly with crypto businesses, there is an argument that their value lies in their tokens, and so for an investor, holding equity is less attractive. Partly I suspect this is because tokens are liquid, and so value appreciation is more evident through the company's tokens than through its unquoted equity - particularly in a bull market.
This extreme liquidity even leads some crypto VC firms to operate more like hedge funds, opportunistically trading the tokens rather than holding them for long term capital gain.
I've written before about Funderbeam, a company I worked with a few years back who provide a secondary market for private companies - a 'stockmarket for startups' as they describe it. The Estonian team very early on saw the potential of blockchain technology to introduce liquidity into startup investments. They launched in 2016, and were the first globally to allow users to trade shares in real-world assets using blockchain-based tokens, with the tokens representing a share of ownership in the underlying startup (in fact they used something called 'coloured coins', which in this case was Bitcoin but repurposed as a token by marking it with metadata). I worked with them in 2016-2017, working on their Asia-Pacific market entry, and they are today based in Singapore. The kicker is, they've since moved away from blockchain, because the technology and regulatory environment just wasn't ready for their solution. Good timing is not necessarily about being a first-mover.
But the flipside of liquidity of course is volatility. Investors will trade on what information is available, and in the absence of information even the smallest signal can have a disproportionate impact on the quoted value of a company. As the current CFO of both private and publicly listed startups still in search of their business model, I'm all too familiar with the perils of placing an early stage business in the comparatively unforgiving arena of the public capital markets.
Other than liquidity, tokens offer other advantages over traditional equity: transactions are faster and transaction costs are lower, and so micro investments are feasible, allowing more democratisated participation. Levy-Weiss describes tokens as "part of a natural evolution in venture funding over the past decade towards greater speed, easy of transaction, increasing inclusion and alignment of stakeholders." There's a lot to unpick here, but in particular the point about inclusion is a recurring theme, has long been common with proponents of crowdfunding too.
Crowdfunding (both reward based and equity based) that I've comprehensively written about previously can be seen as part of that evolution as well, and has played a key role in filling the gap between private and public sources of funding.
CoinList is a crypto and token exchange, and just last month raised US$100m at a US$1.5b valuation as it seeks to "accelerate the adoption of crypto". It's probably not a coincidence that CoinList's co-founder, Australian-born Graham Jenkin, began working on the concept while at AngelList, the world's best-known equity crowdfunding platform. According to the AFR, while he was at AngelList, Jenkin worked on the JOBS Act, the US regulations that protect investors participating in both equity crowdfunding and token sales.
The same theme of democratisation of investment underpins both equity crowdfunding and tokenisation. The recurring criticism levied at traditional venture capital and the financial markets more broadly is, why should the most attractive investment opportunities be restricted to institutions and high-net-worths? In Australia we have this arbitrary distinction between retail investors ('mums and dads') and sophisticated investors, where if you earn more than $250k per year or have more than $2.5m in net assets, you are deemed to be knowledgeable enough to not require the same protections as other investors - even though they may understand the investment better than you do. ASIC's rationale of wanting to protect retail investors from losing money on complex financial products is admirable. However it results in those investors being simply cut out of those opportunities, because it's too expensive for issuers and their agents to meet the disclosure regulations required to deal with the less wealthy. Similar regulatory landscapes exist elsewhere, eg in the US where the SEC requires investors have more than US$200k income or US$1m assets ('accredited investors') to participate in angel investment or venture capital.
Where equity crowdfunding legislation has notionally opened up 'angel investment' to retail investors in most countries, by providing a regulatory framework within which it can legally operate, tokenisation on the other hand is evolving to a large extent in a regulatory vaccuum. However it is arguably making more impactful in-roads in democratising the previously restricted world of early stage investment. The key point for me is that both are significant disruptors of financial markets and trying to solve the same market inefficiencies, and it would be unwise to ignore the inexorable revolution currently underway.