The traditional way of funding early-stage startups is through Venture Capital. Decentralised projects have experimented with innovative ways of raising funding by issuing security and utility tokens. We compare the different approaches and analyse how tokens can align the incentives of customers, founders and investors.
Venture capital is the traditional way of funding early-stage start-ups. Because they are very risky and there is significant asymmetric information about their prospects and profitability, they are usually not suitable as an asset class for retail investors, who may not understand the risks or have the means to acquire sufficient information about their business models and operations. To protect retail investors, there is often regulation that prohibits them from directly investing in start-ups, while crowdfunding in the US is limited to $1 million every 12 months.1 On the other hand, since a start-up initially requires a small amount of money, it is not worthwhile for large institutional investors to directly invest in them. Venture Capitalists (VCs) fill this gap and guide the company until it fails, it is acquired, or goes public through an IPO.
This funding model has several advantages for start-ups. First, it is usually easier to convince a few VCs to contribute the total capital, rather than persuade many retail investors to contribute small amounts. It is also easier for the founders to keep VCs updated and communicate their vision and plans. As VCs are usually experienced investors and have a long-term horizon, they can provide valuable guidance and steer the project in the right direction. The founders do not need to worry about the daily fluctuations of the share price, as VCs typically lock their funds for 8 – 12 years before they demand a return on their investment.
However, the incentives of the founders and the VCs are not always aligned. For example, it could be that VCs push for an early exit through an acquisition by a bigger firm, rather than support the founders to build a company for the long-term. While they typically have a decade long investment horizon, building strong independent businesses often takes longer. The ever-growing pools of VC money inflate the prices of loss-making start-ups and put pressure on companies to “hyperscale” in order to maximise return potential and stay alive. These “hyperscaled” loss making companies can undercut profit making competitors, leading to “a winner takes all” type of a game and eventually concentrated markets and monopolies. VCs can command high fees by acting as the gatekeepers to capital. Without the finance that VCs provide, it is often impossible to compete against VC backed competitors, who can operate at a large loss. VCs can off-load the shares of these loss-making companies at an IPO or SPAC takeover, with retail investors becoming the ultimate “bag-holders” if the company fails to become profitable and falls in value. Further, the best VC deals are concentrated between the top VCs backed by a small circle of the richest investors, raising potential social inequality questions.
Finally, although VCs act as the gatekeepers of what is funded and what is not, they are not representative of the population. For instance, very few VCs are women. This unavoidably introduces a bias on which ideas get funded, so it is possible that the society misses out on significant projects that could be supported if the pool of potential investors was larger and more diverse.
An alternative way of funding projects is by issuing tokens. These are usually of two types. First, security tokens are connected to assets that exist outside of the blockchain, for example equity on the start-up. Second, utility tokens are used to access a service or application within the blockchain.² Although regulation has been relatively light up to now, it is important to note that if a token is deemed a security, the standard regulation on securities applies and the Securities and Exchange Commission (SEC) in the US has pursued cases on these grounds.³
In previous years, the main avenue of token offering was through an Initial Coin Offering (ICO). Ethereum is one of the most successful projects which raised funding using this method, but there have also been many others that failed or that proved to be scams. Recently, different funding methods have being tried. One example is a fair launch, where there is no private sale of tokens, no ICO or pre-mining. This means that founders do not have an equity stake at launch and must buy-in, like everyone else. The main aim of a fair launch is that everyone can participate under the same rules from the beginning of the project. Bitcoin used a fair launch and currently there are several projects that use the same method of token offering, such as yearn finance.
The main benefit of a fair launch is that it can accelerate network effects because everyone is incentivised to participate at the beginning, as the benefits are shared equally as the network grows. In an ICO, the founders have already pre-mined a considerable proportion of the tokens and stand to gain more as the price of the token increases, so the incentive for newcomers is not as great. However, a fair launch does not raise funds that can be used for the development of the project. This means that it is more appropriate for projects that do not require a large initial investment, and their success relies more on the size of the network that is created.
Security Tokens vs Shares
When it comes to raising capital, security tokens can be thought of as an evolution of traditional corporate shares. They are natively digital and reside on a blockchain, which means that they are easily trackable and accountable, more difficult to counterfeit, and transaction and capital raising costs are lower. Change of ownership of a security token can be as simple as registering a transaction on the blockchain. A custodian is not needed to hold them, whereas clearing times for transactions are shorter. Security tokens can also reduce costs by enabling a more automated process of compliance, using smart contracts that execute instantly when certain checks are performed, for example KYC, AML, country of origin and level of wealth. Moreover, monitoring by authorities can become easier and more rigorous, provided processes are implemented using open-source code. Security tokens are also programmable allowing for increased automation of corporate actions, for example, when enabling automatic sharing of revenues or profits. Programmability can also enable innovative forms of governance, such as delegated voting (liquid democracy) or quadratic voting. All of these advantages can provide several efficiencies which in turn may widen the pool of investors and increase the available liquidity for the project.
On the other hand, the project may be disadvantaged if funding is overwhelmingly provided by retail investors. They can be erratic in their investment decisions, buying and selling based on the prevailing market sentiment, instead of being focused on the fundamental value proposition of the project. This can generate significant volatility in the price of the security token, which in turn can disrupt the governance of the project, or even kill it completely.4 These investments may also be inappropriate for retail investors given the risk involved, and legally compliant Security Tokens are accessible to professional / accredited investors only. Therefore, security token offering can look a lot like traditional fundraising models, just using new technology to do so.
Utility Tokens vs Shares
Utility tokens represent a potentially more disruptive start-up funding model.5 They share many of the characteristics of security tokens but, as of now, are not regulated because they are not securities. However, this could change in the future. Although they do not represent claims on future profits, investors may acquire and hold them if they expect their value to appreciate if the start-up is successful.
More importantly, they align the incentives of founders, backers, contributors, customers and even speculators to use the project as much as possible, because using these tokens is what makes them valuable. The result is that network effects kick in relatively fast, creating a virtuous cycle of increasing investment through buying the utility tokens, increasing usage of the tokens to access the network, making the network more valuable and increasing the price of the tokens. This is to be contrasted with a VC-backed project, where the initial customers do not get rewarded for the positive externality they provide by making the network more valuable for subsequent customers. Moreover, the incentives of the investors and the customers may not be aligned, because the former want to maximise profits, whereas the latter want a better service and network. In a decentralised project, the largest customers are often the most influential in governing the network, hence the incentives of the owners and the users are better aligned.
Security and utility tokens provide a different way of funding and governing a new project, with the potential to disrupt the VC funding model and the way start-ups, not only in the crypto space, are funded. The biggest uncertainty currently is the absence of a comprehensive regulatory framework that can address the asymmetric information between the retail investors and those inside the project, such as the founders and backers. Regulation is inevitable, so the question is how effective it will be. If it is too light touch, it may fail to prevent the proliferation of bad or fraudulent projects, so in the long-term investors will choose to stay away. If it is too restrictive, for example by only allowing professional/accredited investors to participate, we may find ourselves back at square one, with no meaningful improvement over existing funding models.
1 For more details, see https://www.sec.gov/news/pressrelease/2015-249.html.
2 For more information on tokens, see “A Primer on the Economic Aspects of DLT and Cryptoassets”, at https://en.aaro.capital/Download.aspx?ID=2e6e0048-f80d-4c95-89e8-e7f5b2869306&inline=true.
3 See “An Introduction to Web 3.0” at https://en.aaro.capital/Download.aspx?ID=8c08120e-e629-4fd3-9dc7-293b16b352fb&inline=true, for more information on when security tokens can be considered to be securities.
4 See https://www.nfx.com/post/token-investing/ for a comparison between VC and funding through security and utility tokens.
4 See https://en.aaro.capital/Article?ID=cacf8798-c499-4add-b611-c3d092949ab6 for an introduction to the economics of tokens and platforms.