Venture Capital vs Blockchain Tokens
July 17, 2018
VCs vs Security Tokens
Topic: Blockchain Tokens Security Token Offerings have inverted the traditional capitalization methods for startup companies. In the days of debt and equity, a successful entrepreneur would typically offer a convertible promissory note to friends, family and local angel groups, then raise a seed round, early stage, growth, expansion and mezzanine round before finally achieving liquidity in the public markets. Sometimes the entrepreneur would take on commercial loans, a revolving credit line or venture debt along the way.
This method produced extraordinary gains for investors in a small percentage of the companies funded on this model, while many of those funded failed. Most entrepreneurs who sought venture capital never received funding in the first place.
With the advent of security blockchain tokens, companies can be fully capitalized before they launch. Crowdfunding rules under the JOBS Act allows companies to pre-sell up to $1.07 million in security tokens under Reg CF to any investor, regardless of income level and net worth, and an unlimited amount to accredited investors under Reg D 506(c).
Liquidity can also be achieved quickly, with a $50 million Security Blockchain Token Offering issued under the Reg A+ exemption typically taking between 75 and 120 days to qualify with the SEC. Blockchain tokens can then be traded on compliant exchanges, known as Alternative Trading Systems.
The whole process of raising as much as $50 million in a crowd sale of security tokens can occur in as little as six months. For this to work out for investors and issuers long-term, we need a completely new model for corporate governance.
Blockchain Tokens & Information Asymmetry
In the old capital markets equity model, companies were primarily financed by venture capitalists, who raised money from limited partners. These limited partners could be public companies looking for insights into potentially disruptive startups, high net worth individuals, family offices, trusts, pension funds, hedge funds and other pools of capital.
The venture capitalists then conducted the due diligence and served on the board of directors. As directors they had a fiduciary duty to all shareholders, but venture capitalists famously protected their own interests first and foremost. If the company ran out of money, they could recapitalize it by putting in a small amount of money and then owning most of shares through provisions of their preferred stock, such as anti-dilution.
Because public offerings were rare, expensive and years away, entrepreneurs had to execute flawlessly, never stumbling, in order to reach a liquidity event that paid off for founders, friends and family, angels and employees.
Venture debt made this dynamic even worse. Entrepreneurs could leverage venture capital with secured loans, which were only granted to companies funded by blue chip venture capital firms. If the company defaulted on a loan or breached a significant covenant, the lenders and investors had a great deal of leverage. They could liquidate or extract significant concessions.
All of this was done behind closed doors. Venture capitalists had visibility into company performance, and would use that information to improve their position by characterizing the company performance internally in a negative light and simultaneously presenting it to the outside world as positive.
Because all venture capitalists do this to varying degrees, Silicon Valley has become something of a Ponzi Scheme, with funds waging psychological warfare on founders to lower valuations and courting other funds come it at higher valuations. Areas with less robust venture capital infrastructure, which is most of the world, then try to copy this dynamic unsuccessfully. Valuation of companies is based on perception, not reality, which continues even through the capital markets.
Information asymmetry is then propagated in the capital markets, with investment bankers and analysts having more access to companies and information, and retail investors trying to glean what information they can from message boards, analyst reports and broker/dealer intermediaries.
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