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

Security Token Offering

When the invention of the ICO (Initial Coin Offering) was paired with the power of Internet marketing and augmented with bounty programs and airdrops, massive crowdfunding became available to the average startup. Now the fast-emerging STO (Security Token Offering) phenomenon is heralding in a new era of regulated private equity funding. This new world of equity and revenue sharing via digital tokens is coming into focus very quickly.

Compared with traditional venture capital funding, tokenization of securities is a faster, less expensive, and more transparent and efficient method to raise capital, improve asset liquidity, and manage the investor base. An STO can provide a capital-hungry venture with access to a deep pool of capital to build out a compelling use case or scale an MVP (minimal viable product).

Tokenized fundraising mitigates the ‘illiquidity discount,’ which pushes an asset’s price down to compensate investors for the increased risk associated with illiquidity. Security tokens may even demand a ‘liquidity premium’ over paper LP shares.

And so, security token offerings are proving themselves to be an ingenious way to raise equity capital fast and on the cheap. As such, blockchain technology has been noticeably disrupting the traditional venture capital model for the last few years, at first a little, and now a lot. The question is no longer “if?” but “when and by how much?” STO crowdfunding will replace traditional venture capital funding and how soon venture funds will start creating and issuing security tokens to represent shares of fractional ownership.

The traditional venture capital model

A startup’s journey starts with seed capital funding provided by an angel investor or startup accelerator. From there, the founders venture forth through the infamous “valley of death” period, where they try to establish an MVP and rapid user acquisition for which their enterprise can seek venture capital funding in a series of rounds.

A venture capital firm takes Series A equity in an early-stage tech company in exchange for an injection of cash. The VC knows, of course, that such investments, many more times than not, fail. The VC risks capital on a startup with a short operating history, an inability to secure a bank loan, and a size that is too small vis a vis revenue or employees to attract any interest from public markets. The VC trades its high-risk cash position not just for equity but also for board seats that give it anywhere from modest to significant control over the startup’s executive and strategic decisions.

The venture capital model mandates that Limited Partners (LPs) lock up their capital until an exit occurs. This multi-year lockup period is necessary because a venture capital fund’s equity holdings are illiquid. The fund passes the illiquid nature of the investments on to their LPs, while the fund earns money on fees and a percentage of profits and proceeds at exit point liquidation.

The tokenized security fundraising model

An investor purchasing 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 or the venture fund itself 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. Security token protocols can be custom-tailored for 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 Ethereum.

Security Tokenization Pros

· An STO may raise higher valuations vs a Series A fundraising round.

· It opens the possibility of a global, borderless raise bigger than the average VC raise. However, if founders want to retain strategic control of the cap table, STO launch platform coding is set for a maximum raise, i.e., the token offering “hard cap.”

· Borderless post-STO token liquidity is more robust than it is for a traditional security issuance limited to a single jurisdiction.

· Founders do not have to surrender board seats or voting rights. This eliminates stressful and potentially counterproductive board politics. For example, tokenomic structure can negate the short-sightedness that often drives VCs to look for a profitable exit position at the first opportunity and give founders the peace of mind to focus on the business however they wish with no possibility of demotion or ejection from their own company.

· The token issuer can confer special dividends or share-of-profit via a preferred stock token. Token customization may give certain investors preferential treatment, such as early access to platform features for early bird token buyers or loyalty rewards for investors willing to hold their tokens for a set number of months or years.

· Token offerings require a smaller legal team. Issuing a regulated security in a traditional financial market can easily require a 7-figure legal and advisory spend to navigate the thorny complexities of jurisdictional securities laws.

· Less or no travel to negotiation meetings.

· Lower regulatory compliance fees.

· Lower ongoing due diligence costs using partially automated KYC/AML protocols supplemented with accredited investor vetting and PEI (politically exposed person) whitelisting.

· Promotion in many countries in multiple languages is not difficult. A bounty program can reward people for performing tasks such as translating content into their native language or announcing the STO on their country’s social media hubs.

· Security tokens are resistant to the hacks and irreversible loss for which cryptocurrencies are notorious, and, as regulated securities, ownership protections and mechanisms for recovery in place.

· The blank slate nature of security token development, together with the trustless architecture of distributed ledger technology, means that the only limitations on token protocol design are the issuer’s imagination and the legal team’s risk appetite.

· Whereas VC funds typically close after 5–12 years, tokenized funds can conceivably exist and grow in value in perpetuity.

Security Tokenization Cons

· A token platform is not appropriate for every startup or profitable enterprise. Professional tokenomic modeling will make this determination.

· Though the market for security token offerings is burgeoning, it is still a nascent, unproven market as viewed by most potential investors.

· Long-term performance data is non-existent, so it is nigh impossible to predict with certainty how well security tokens will perform over a period of years.

· Largely lacking legal precedent, today’s STOs rely on their “regulated nature” to shelter the issuer from possible legal ramifications.

· While an STO can benefit from some of the same tools that made ICOs a runaway success, there are significant differences in target marketing and messaging that are being worked out. The main issue holding back security tokenization in the short term may be the perceived risk of extreme volatility among existing crypto tokens, as weak hands are washed out of the market entirely.

· Regulators in less crypto-friendly jurisdictions could put in place compliance and other regulatory hurdles.

Conditions whereby a Security Token Offering may be the ideal fundraising vehicle:
▸ business or operational model that lends itself to leveraging the network effect native to a funding method that connects with the customer base
▸ need to access private funding, but founders want to retain complete control of company decision-making
▸ strategic and tactical need for asset liquidity
▸ fast-growing product/service adoption or revenue
▸ product or service has an international market
▸ $12 million or more in revenue in the last 12 months

Securities tokenization may open markets and opportunities far beyond Vitalik Buterin’s original vision.

Security tokens offer an avenue with which to attract cross-border investment. Before the invention of the initial coin offering (ICO), startups with a modest valuation had almost no ability to attract foreign investment. However, in contrast to ICOS, STOs offer a regulated entry point for traditional capital into cross-border private securities investment opportunities.

Small to mid-size ventures can now use internet marketing to draw the attention of VCs, UHWIs, private and public equity groups, and family offices across the world. Moreover, once a security token lists on a public exchange, it can be bought and sold by retail investors anywhere in the world, 24/7/365.

Security token protocols, such as custom whitelisting, make it so that, once a security token lists for trade on a public exchange open to a much larger investment pool, the token issuer will, more or less, have control of the cap table. The security token issuer will work with the exchange to limit trading to an approved whitelist of accredited investors or investors with other specific characteristics.

The future of securities tokenization

The first regulated trading platforms for securitized asset tokens are launching now. Several countries have a robust framework for monitoring and regulating token offerings and security token trading platforms, having legislated compliance protocols such as vesting periods and other secondary market trading restrictions. Fintech regulators are typically choosing a “technology first” approach to security token regulation. Some are now vetting prospectuses. The idea among some of the top regulators globally is that the best STO projects can launch and be regulatorily compliant across a jurisdictionally cooperative block, be it in Asia, North America, or the EU.

Regulatory authorities may certify token platform security and ensure that smart contracts deliver on the promises laid out in the whitepaper regarding vesting periods, lockups, and the like. Flawed technology or tokenomic modeling that will not deliver on promises are disqualified. A token exchange’s smart contracts and custodial wallets are audited and sandbox-tested. The idea 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.

The future of venture capital funds

In 2017, Blockchain Capital became the first venture capital firm to cross the line when it raised $10 million by issuing a security token. Soon venture fund investors will be able to exit their position via secondary markets such as OTC and token exchanges, and VCs will be able to lock up capital without locking in investors.

One issue that needs attention is the possibility that claims of price manipulation could occur upon NAV disclosure because the numbers are partially subjective for security tokens that have exited lockup and are trading lightly on an ATS or exchange. Another issue is that when founders heed the advice of lead investors, enormous value may be injected into a startup. The more free-form style crowdfunding that occurs with tokenization requires the invention of token protocols that bring this networking value to the table.

Even considering these challenges, a significant portion of the venture capital industry may move quickly to position itself in the equity tokenization space, and embrace distributed ledger technology, lest it gets left behind. Though a fair amount of luck characterizes the venture capital industry, it is driven forward primarily by a ‘survival of the fittest’ dynamic.

Once venture fund investors experience the secondary market liquidity native to security tokens, it is unlikely that they will ever go back to old-school venture funds. And, once VCs experience the ease of issuance and regulatory compliance, and the economical nature of STOs, it is possible that venture fund tokenization will go mainstream, and venture capital firms, even those operating outside of tech, will never again look the same.

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Providing investor intelligence on Security Token Offerings and Tokenized Securities moving out of lockup and into secondary trading.