Gary Herick

Startup Funding, Venture Capital & Innovative Blockchain Capital

Blockchain Security Tokens and Early Stage Equity

Investing in Early Stage Equity via Security Tokens (fka Venture Capital)

July 22, 2018
This article originally appeared on:
https://dailyfintech.com/2018/07/22/investing-in-early-stage-equity-via-security-tokens-fka-venture-capital/
The author is Bernard Lunn

This is Part Three (Chapter 3) of The Blockchain Economy serialised book. Part Three is where we focus on investing in the Blockchain Economy. This Chapter focusses on Investing in Early Stage Equity via Security Tokens. For the index/table of contents of The Blockchain Economy book please click here.

This chapter covers:

  • Real time settlement is the game-changer for investors
  • Easy fractionalisation brings in new capital which enables liquidity
  • Trust through verifiability and immutability
  • The appetite for early stage equity is driven by two megatrends
  • Its the company stupid (not the asset class or financing tool)
  • Why the passive watch and wait and time your entry investor strategy no longer works
  • The R word – Regulation
  • The convergence of Legacy and Crypto Finance

Real time settlement is the game-changer for investors

In January 2016, I ran a workshop in Luxembourg with people who really understood the nuances of fund operations and payments. I raised the prospect of Real Time Settlement in Capital Markets and took a straw poll among the participants. This small but super knowledgeable group indicated overwhelming agreement that real time settlement a) would be mainstream within 10 years and b) that it would change the capital markets industry in fundamental ways.

If I had asked, at that January 2016 workshop in Luxembourg, “how many people think we will see Real Time Settlement in live deployment within 2-years”, I suspect very few hands would have gone up. That more rapid traction happened with the ICO disruption that went mainstream in the summer of 2017. Change normally comes from an intense need from people left out of the status quo – early stage entrepreneurs in this case.

Trading and Settlement in Legacy Finance is the story of the Ferrari and the Donkey.

We measure trading in fractions of a second. That is the Ferrari. Then we climb out of that speed machine and get onto the old grey donkey to do settlement.

The donkey world as described by Investopedia:

“A settlement period is the period of time between the settlement date and the transaction date that is allotted to the parties of a transaction to satisfy the transaction’s obligations. The buyer must make payment within the settlement period while the seller must deliver the purchased security within this period. For certificates of deposit and commercial paper, the transaction must be settled on the same day; for U.S. treasuries, it is the next day (T+1). Forex transactions are settled in two days (T+2).”

All of that changes when we move to Real Time Settlement or to be more technically accurate – concurrent Delivery Versus Payment (DVP), which was defined by Bank of International Settlements (BIS) over 23 years ago in 1992:

  • Transfer has to be final & unconditional and concurrent. Any time lag between the two is ripe for fraud; all the post trade settlement processes are designed to manage this fraud risk. This concurrency requirement is absolute. Just faster (e.g. Getting from T+3 to a few hours or even minutes) does not meet the concurrency requirement, because hours or minutes are eons to a fraudster.
  • Transfer must be on a gross (trade for trade) basis. Any attempt at netting creates delay and creates a multi-tier market infrastructure that will impede innovation. We have Real Time Gross Settlement (RTGS) today – between Central Banks. The disruptive change is RTGS between individuals and companies in a permissionless network (i.e the way that the Internet works).

The conceptual requirements have been known a long time. We had to wait all this time for a technology to enable this. Then along came Blockchain…

Gary Herick - BlockchainNote that the donkey does NOT need to become as fast as the Ferrari. In fact, it might be good for the Ferrari to slow down a bit as few can argue that High Frequency Trading (HFT) adds much value other than for HFT traders. What matters is that trading and settlement happens at the same time. This is precisely what happens on Crypto Exchanges. You send something with BTC or ETH and get a Token instantly in your wallet. Smart Contracts enable simple conditional multi-party logic (when party A does X, send Y to Party B).

VC Funds tell the story that investors don’t want liquidity in early stage equity, because those VC Funds need long term committed capital. It is true that investor don’t need liquidity, but want is different. There are three reasons why investors want liquidity:

  • optionality. You invest in Startup A, but then see a better deal in Startup B and you want to sell your equity in Startup A in order to buy that better deal in Startup B without changing your allocation to early stage equity.
  • irrational exuberance. If you think Startup A is worth $100m but the market is offering $200m, you should sell.
  • macro story. We are at the late stage of a big bull market. Investors may want to change their macro allocations and reduce exposure to early stage equity Regardless of whether changing allocation is the right move, having the option to do so is clearly desirable.

Liquidity is what makes Crypto Token Finance different from traditional crowdfunding. Investors can source early stage deals through crowdfunding networks, but still need to wait for exit to get capital appreciation.

Real time settlement is a big step towards liquidity, but it is only the first step. The fact that you can put your asset up for sale does not mean that any buyers will notice, so it is only the first step; for example, I can put my home up for sale via a blog post but that does not mean buyers will find my house. To get to liquidity we also need the two other benefits of Blockchain which we cover below – easy fractionalisation and trust through verifiability and immutability. Real time settlement is only one step, but it is a critical first step. Crypto Token Finance needs real time settlement and easy fractionalisation and trust through verifiability and immutability.

Easy fictionalization brings in new capital which enables liquidity

Today an LP (Limited Partner aka High Net Worth) can sell early stage equity assets through Secondary Markets, but the supply of buyers are limited. Easy fictionalization brings in new capital (aka buyers), which enables liquidity.

A Security Token is referred to as an Asset Token in some jurisdictions (e.g in Switzerland which is leading the pack in Crypto Token Finance). Any asset can be tokenised – it could be Public Equity, Private Equity, Real Estate, Funds, Bonds, Gold, Diamonds, IP Assets, etc.

Tokenisation enables:

  1. Real Time Settlement – described above.
  2. Easy Fractionalisation; for example buying a share of a commercial property not the whole building.
  3. Trust through verifiability and immutability – described below

Easy fractionalisation through tokenisation will open up many new markets to a much bigger pool of investors. That leads to liquidity. It is a win/win/win:

Win 1: entrepreneurs can more easily raise capital.

Win 2: investors can get liquidity more quickly.

Win 3: intermediaries who add value will have many more assets to work with.

Easy Fractionalisation through tokenisation applies to any asset. We focus on the early stage equity assets for two reasons:

  • that is where there is huge unmet need on the issuer side. Ask any entrepreneur how much they love raising early stage capital the legacy way.
  • Investor appetite for early stage equity is driven by two megatrends (see below)

Now lets look at the third enabler of Crypto Token Finance – trust through verifiability and immutability.

Trust through verifiability and immutability

If you are an accredited High Net Worth Investor (HNWI) who is active in Angel Investing or you run a VC fund or invest in VC Funds, you might say “who needs Tokens, I can sell assets on secondary markets today”. True, because HNWI have lawyers and accountants and other professionals who can do the required due diligence (DD) work and deal with all the paperwork. Real time settlement enables those assets to be traded immediately. Fractionalisation brings in more buyers. None of this makes sense if you are dealing with scanned documents, analog audit processes and all the other paraphernalia of Legacy Finance. Blockchain based data that is verifiable and immutable can change that game. We are still in the early stages of Security Tokens with changes coming that will enable:

  • accounting DD through XBRL.
  • legal DD through machine-readable smart contracts.
  • team DD through online sources (is XYZ CEO really living in YYY country and does he/she have a criminal record).
  • cap structure transparency (registers of who owns what).

This could be seen as incremental efficiency improvement to the mechanics of investing, but add them all together and add real time settlement and easy fractionalisation and you can see a game-changing disruption to Legacy Finance.

By making the mechanics of investing massively more efficient, it changes the game; but that is all about how you invest in early stage equity. Next we deal with the why. What is driving investor appetite for early stage equity?

Investor appetite for early stage equity is driven by two megatrends

software is eating the world (hat tip to Marc Andreessen). The takeaway for investors – it is better to be in a risky venture like AirBnB than a safe old Hotel stock that is being disrupted by AirBnB or a risky Fintech rather than a safe old bank, etc.

decline of of the traditional IPO and reduction in public growth stage stocks. Late stage private equity has replaced the public markets. See this research from California Institute of Technology; “private capital going to startups four or more years past their first financing round has grown by a factor of 20 since 1992.” This led to a historically abnormal valuation inversion when private companies are valued higher (on paper at least) than public companies; because the pricing discipline of shorting and large numbers of investors is missing in private markets; it becomes a clubby world of insiders who say “if you buy my overvalued stock I will buy your overvalued stock”.

In short, investors need to get into the early stage. The question is how? The answer is Security Tokens.

The next question is which companies do you invest in. At this stage some old fashioned maxims rule.

Its the company stupid (not the asset class or financing tool)

Legacy Finance uses Equity + Debt + Hybrid instruments.

The emerging Crypto Token Finance uses Security + Utility + Hybrid Tokens

What is the same is the company. Its the company stupid (not the asset class or financing tool).

The constant that does not change is that you invest in a specific company which you think will do well. That means doing some traditional things like looking at plans and teams and getting to know the entrepreneur. Above all focus on timing (see this research for why timing matters more than any other factor).

Then buy some Security and Utility Tokens (and maybe a Hybrid that lets you do both). Get in early because timing your late entry via watch and wait strategy no longer works in most cases.

Why the watch and wait, late entry strategy no longer works

Most legacy VC investors run away from early stage product risk. This flight from product risk, makes no sense because the cost to build the MVP (Minimum Viable Product) has fallen about 50x in last decade or so, thanks to open source, cloud services, APIs and remote working. So now the MVP is often funded by one of these new types of investors:

  • A company that knows the market and does a Blockchain spin off.
  • An executive leaving a company that knows the market who uses personal cash to fund the MVP.
  • A software services business using the talent bench.
  • A developer building the MVP during free time from a day job (moonlighting, passion projects).

Passive investors have historically tried to invest when they see the MVP get market traction, when the venture moves to Product Market Fit (PMF) and then Scale. The real money is made after PMF, during the Scale phase.

Read the full piece here, along with much more of Bernard’s fine work.

Bernard Lunn is the CEO of Daily Fintech and provides advisory services to companies involved with Fintech (reach out to julia at daily fintech dot com to discuss his services).

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For the index to Bernard’s serialised book, The Blockchain Economy, please go here.