STOs May Push Old School Venture Capital Funding Out of the Batter's Box

Frictionless trading of a historically illiquid asset class

May 13, 2021

Introduction

The emergence of Initial Coin Offerings (ICOs) and their use of Internet marketing, coupled with bounty programs and airdrops, opened unprecedented crowdfunding opportunities for startups. However, it was in 2017 that Blockchain Capital made history by raising $10 million through a security token, introducing the venture capital industry to the blockchain world. This groundbreaking event gave birth to a new phenomenon, the Security Token Offering (STO).

STOs are now poised to revolutionize the world of regulated venture capital and private equity funding, creating an exciting frontier of equity and revenue sharing through digital tokens. The potential of securities tokenization surpasses the original visions of Satoshi Nakamoto and Vitalik Buterin, unlocking markets and opportunities on a global scale.

Unlocking International Investments through Security Tokens

The advent of security token offerings (STOs) presents an enticing avenue for attracting international investments. Previously, startups with modest valuations faced significant limitations in accessing foreign investments. However, STOs supply a regulated framework that enables traditional capital to enter cross-border private securities investment opportunities.

Through internet marketing, small to mid-size ventures can capture the attention of venture capitalists, ultra-high net worth individuals (UHWIs), private and public equity groups, and family offices worldwide. Once a security token lists on a public exchange, it gains accessibility for trading by retail investors across the globe, available 24/7/365.

Compared to traditional venture capital funding, the tokenization of securities offers a faster, more cost-effective, transparent, and efficient method of raising capital, enhancing asset liquidity, and managing investor participation. STOs provide any capital-hungry venture with a compelling use case and Minimum Viable Product (MVP) access to substantial pools of capital.

Tokenized fundraising mitigates the "illiquidity discount" associated with limited liquidity, as security tokens offer enhanced liquidity and may even command a "liquidity premium" over traditional paper LP shares. Consequently, security token offerings have proven to be an excellent means of swiftly and affordably raising substantial equity capital.

The disruption caused by blockchain technology in the traditional venture capital model has progressed steadily over the past few years, with STOs gaining prominence on a larger scale. The question is no longer "if?" but "when and to what extent?" STO crowdfunding will replace conventional venture capital funding. Furthermore, it asks how soon venture funds will begin creating and issuing security tokens to represent fractional ownership in their funds.

The Conventional Venture Capital Model

For cash-strapped startups, the journey begins with seed capital funding from angel investors or startup accelerators. From there, founders navigate the infamous "valley of death" phase, striving to establish a Minimum Viable Product (MVP) and rapidly acquire users before seeking venture capital funding through multiple rounds.

During a Series A funding round, a venture capital firm injects cash into an early-stage tech company in exchange for equity. The VC understands that such investments carry a substantial risk of failure. They take the gamble by investing in a startup with a limited operational history, an inability to secure a bank loan, and a size too small to attract public market interest in terms of revenue or employee count. In return for their high-risk capital, the VC gets equity and gains board seats, granting them varying degrees of control over the startup's strategic and executive decisions.

In the traditional venture capital model, Limited Partners (LPs) lock up their capital until an exit event occurs. This multi-year lockup period is necessary because a venture capital fund's equity holdings lack liquidity. The fund passes on the illiquidity of investments to its LPs while earning revenue through fees and a percentage of profits and proceeds during exit point liquidation.

The Tokenized Security Fundraising Model

An investor buying a traditional security agrees to a written contract. A security token investor's contract executes via a smart contract on the blockchain with ownership immutably recorded and locked. The token's protocols define any rights, obligations, or claims to profit attached to ownership.

Though we are concerned with the tokenization of startup equity in this article, a security token can represent tradeable ownership in almost any real-world asset, including bonds, real estate, a revenue or profit stream, or art.

Custom-tailored security token protocols create functionalities such as non-fungible linkage to a physical asset such as gold or other precious metal, the limiting of post-STO transferability to only native tokens or specific addresses on a curated whitelist, or dividend payments in fiat currency, the platform's native token, or ETH.

Pros and Cons of Tokenization

Advantages of Tokenization:

STOs can achieve higher valuations compared to Series A fundraising rounds.
They enable the possibility of a global and borderless fundraising campaign, surpassing the average VC raise. However, founders aiming to retain strategic control must set a maximum raise, known as the token offering "hard cap," on the STO launch platform.
Post-STO token liquidity is more robust and accessible across borders than traditional security issuances limited to a single jurisdiction.
Founders can keep board seats and voting rights, eliminating stressful board politics and allowing them to focus on their business without concerns of demotion or ejection from their own company. Tokenomic structures can mitigate the short-sightedness often seen in VCs seeking early exits, supplying founders peace of mind.
Unlike preferred stock, token issuers can offer dividends or share-of-profit options to investors.
Operating with a smaller legal team is possible, as issuing a regulated security in traditional financial markets often requires significant legal and advisory expenses to navigate complex jurisdictional securities laws.
Reduced or eliminated travel requirements for negotiation meetings.
Lower jurisdictional regulatory compliance fees.
Lower ongoing due diligence costs through partially automated KYC/AML protocols, supplemented with accredited investor vetting and PEI ("politically exposed person") whitelisting.
Ease of promotion in multiple countries and languages, with bounty programs incentivizing individuals to translate content or promote the STO on social media platforms specific to their country.
Security tokens are resistant to hacks and irreversible loss associated with cryptocurrencies, and they provide ownership protections and mechanisms for recovery, as they are regulated securities.
The flexibility of security token development, combined with the trustless architecture of distributed ledger technology, allows issuers to design token protocols limited only by their imagination and the risk appetite of their legal team.
Token customization can provide certain STO investors preferential treatment, such as early access to platform features or loyalty rewards for long-term token holders.
While traditional VC funds typically close after 5-12 years, tokenized VC funds can potentially exist and grow in value indefinitely.

Disadvantages of Tokenization:

Token platforms may only be suitable for some startups or profitable enterprises, and professional tokenomic modeling is necessary to determine feasibility.
The market for STOs is still nascent and unproven, leading many potential investors to view it skeptically.
The lack of long-term performance data makes it challenging to predict the future performance of security tokens over an extended period.
Legal precedents for STOs are limited, and their regulatory compliance relies on their "regulated nature" to mitigate potential legal implications.
While STOs can use tools that contribute to the success of ICOs, significant differences in target marketing and messaging require further exploration. The perceived risk of extreme volatility among existing crypto tokens may be a short-term barrier to security tokenization as market participants remain cautious.
Regulators in less crypto-friendly jurisdictions may impose compliance requirements and regulatory hurdles.

Scenarios where an STO can serve as an optimal fundraising option:

Your business or operational model can effectively use the network effect inherent in a funding method that connects with the customer base.
You require private funding while wanting to keep complete control over company decision-making.
You have a strategic and tactical need for asset liquidity.
Your product or service is experiencing rapid growth in adoption or revenue.
You have a product or service with a global market.
You generated $12 million or more in revenue within the past 12 months.

STO Compliance

Security token protocols, including features like custom whitelisting, empower issuers to keep control over the cap table once the token lists on a public exchange. This feature attracts a broader pool of potential investors. By collaborating with the exchange, the security token issuer can restrict trading to an approved whitelist of accredited investors or investors who meet specific criteria.

STO Regulation

The advent of regulated trading platforms for securitized asset tokens is underway, with several countries implementing robust frameworks to monitor and regulate token offerings and security token trading platforms. These jurisdictions have established regulatory protocols such as vesting periods and secondary market trading restrictions.

Fintech regulators are adopting a "technology first" approach to token offering regulation, with some even vetting prospectuses. The global vision among top regulators is to facilitate the launch of the best STO projects compliant across jurisdictionally cooperative blocks, whether in Asia, North America, or the EU.

Regulatory authorities play a crucial role in certifying the security of token platforms and ensuring that smart contracts fulfill the promises outlined in the whitepaper, such as vesting periods and lockups. They disqualify flawed technology or tokenomic models that do not deliver on their promises. Token exchange smart contracts and custodial wallets are audited and sandboxed. The aim is to consolidate jurisdictional safeguards for token buyers and attract more security token issuers and exchanges to choose a particular country as their home base.

Conclusion

The advent of security tokens and distributed ledger technology transforms the future of venture capital funding. Secondary markets, like OTC and token exchanges, will allow investors to exit positions. Venture capitalists will lock up capital without locking in investors indefinitely.

Particular challenges need attention in this evolving landscape. Claims of price manipulation can arise, even with the engagement of a Net Asset Value (NAV) disclosure portal, as subjective judgments can come into play. Additionally, the networking value that Lead Investors bring to startups must integrate with the more free-form crowdfunding accompanying VC fund tokenization. Developing protocols to address these issues will be crucial.

Nevertheless, a sizable part of the venture capital industry is poised to embrace equity tokenization and distributed ledger technology to stay caught up. The industry dynamics, driven by a "survival of the fittest" mentality, encourage swift adaptation and evolution.

Once venture capital investors experience the inherent liquidity of security tokens in the secondary market, they will be unlikely to return to traditional venture funds. The ease of issuance, regulatory compliance, and cost-effectiveness offered by STOs will likely propel VC fund tokenization into the mainstream, reshaping the landscape of venture capital as we know it. The future of venture capital funding lies in embracing these emerging technologies and their opportunities.

Jay Derenthal