Venture Capital for Everyone?

By George Salapa, Bardicredit

Published: 21 March 2019

Good ideas tend to stick. When Rockefellers persuaded their friends to spray some of their wealth on young and hopeful startup-ists in the 1960s, they began what we now know as Venture Capital(-ism). Ever since then, VCs have been a domain of ultra-rich, super-successful ex-founders and large corporations with deep, deep pockets.

Since then, venture capital has had a profound impact on the world. Some exceptional businesses have been created that have managed to disrupt entire industries, and surpass the size of smaller European countries. Many VCs have grown to a ‘corporate-like’ complexity and become well-recognized brands. Some of them have become somewhat dehumanized - an army of analysts reporting to a remote invisible panel of partners sitting atop.

There are several issues that challenge the model of big-brand VCs. Venture capital is not bottom-up investing. Good accounting, a great projection model and a detailed go-to-market strategy often say little about the startup’s growth potential. It is hard to measure vision, energy, soul, excitement. In some respects, VC is everything but bottom-up investing. It is about understanding the Zeitgeist, and making bets on the potential of people with not much more than a slide deck.

A study by CB Insights looking at top 100 US Venture Capitalists found that neither the years of experience nor whether they had founded a successful company in the past matter. Indeed, many of the highest ranked VCs came from a regular job. Ex-entrepreneurs are also not necessarily good VCs - they may have a tendency to be forceful in the boardroom.

Indeed that same study found that one common denominator of all super-successful VCs is their deal flow. To put it bluntly, the more deals that they can ‘afford’ to look at and turn down, the more likely they are to stumble upon the next Facebook.

...and neither the quality, nor the size of the deal flow necessarily coincide with the VC’s wealth or seniority. In fact, Venture Capitalists that are able to draw a community of followers and supporters may have a clear advantage. Pocket Sun and Elizabeth Galbut, the twenty-something year old founding partners of SoGal Ventures attained a celebrity-like status precisely because of what they are: girl millennials starting a VC fund. Championed by media, they have gained a community of supporters, who also point them to interesting deals.

Traditional VCs may also be prone to suboptimal decision-making. Since they are limited by time (they have to make exits and return money to their investors within 7-10 years), VCs have a tendency to push companies too hard. For years the VC model has been to throw cash at businesses, and then some more, but also expect them to grow super-aggressively, faster than anyone else; certainly much faster than their competitors.

Others suggest that Venture Capital has turned into a game of statistics. The urgency to deliver double-digit returns means that VCs like to shoot for the stars. A naturally high rate of failure among startups is driving VCs to make up for the loss by searching for absolute moonshots. Put simply: a 100B+ company with a 1% chance of success is more appealing than a 200M company with a 10% chance of success.

All this casts a very bad light on VCs, degrading the model of Venture Capital(ism) to a cold, soulless apparatus.

Many if not all of these inefficiencies could be solved with tokenization. Security tokenization is shaping up to be one of the most disruptive trends in finance. At its core, it is about ‘cutting’ real assets into regulated intelligent securities (‘tokens’) tradable in a pre-programmed way on blockchain.

Tokenization could be transformative for alternative investment funds: VCs, private equity and hedge funds. A tokenized fund would be offered to investors as a security that they can resell as soon as a year later (in U.S., for example in acc. with SEC’s Rule 144). And it will be intelligent, so that it will know who & where can trade it, or how it should distribute returns.

There are, of course, the obvious practical advantages. A pre-programmed security with rules encoded within, will remove tons of paperwork and the need for middlemen. And being on blockchain, it can be traded instantly, globally and 24x7x365.

But, there are several other much more significant positive externalities that tokenization can bring to the funds industry. Removing the lock-up would open this space to a much larger audience of investors because they would not have their money ‘locked’ in the fund for many years; they could simply sell their token when they want to. Indeed, the age-old problem of Venture Capital (and the entire alternative investment funds industry, actually) is that the high minimum sign-up cheque and the 7-10 years lock-up restricts the access to invest to only a small group of investors.

Tokenized funds will also be tradable. Liquidity removes the urgency to achieve exits and return money within a certain period of time — investors can simply sell their stake in the fund if they want to. This gives the VC fund freedom to be transparent about its investments; it also allows it to let its portfolio companies grow at a more natural pace, arguably building sustainable businesses for the long-term, not moonshots with a sacrificed moral core.

The lack of liquidity in the alternative funds industry in general (not just VCs) is somewhat puzzling because there is a clear need for it. The massive growth of the secondary market for alternative funds in recent years (Preqin: USD2B in 2002 -rising to approx. USD46B in 2016), a market which was more or less nonexistent a few years back, has been in no small part due to increased confidence in the process thanks to ease and legal clarity with more advisors and secondary market funds focused on this space.

However, perhaps the most profound improvement that tokenization can bring to the funds industry relates to the process of fundraising, which can open the industry to emerging independent fund managers. For decades, the act of giving money was a project in itself for investors - a paperwork-heavy process with no easy in-and-out. This may have been fine until now when the sector was dominated by large funds closed to anyone but a few super-rich individuals and large institutional investors. This is changing.

The past few years have seen the emergence of independent fund managers. This is for several reasons. The instantaneous access to knowledge brought about by internet has erased the information gap between institutions and individuals. It is this proliferation of knowledge that allowed Luca Lin, Christina Qi and Jonathan Wang to start a hedge fund from their dorm room. Numbers collected by PREQIN show that emerging managers can have far superior performance.

There has also been a growth of funds run by influencers - investors that people can identify with and that they like to support. SoGal Ventures that we have mentioned before are a prime example of this trend. And if indeed the bar to enter the funds industry has been removed from below, then why should it remain closed top-down. Why couldn’t the middle class also invest in a VC?

Well, with tokenization it will be able to do just that. The expectation is that tokenization will change the investing into a one-click process. When a potential investor comes to the website of a tokenized fund, he/she will undergo a number of onboarding steps, including KYC and AML checks, but also whitelisting in relation to his/her investor status (retail, professional investor).

Tokenization UBER-izes the fundraising process by removing the institutional apparatus that are presently needed to connect managers and investors. It puts emerging talent on the same level as established veterans. Imagine that the access to alternative funds investment is as simple as lending on a P2P platform.

A number of ‘paperwork-heavy’ functions currently performed by middlemen can be automated away thanks to the use of smart contracts. To put it simply, ultimately the process will no longer involve an issuer, lawyer, authority, investor, but merely issuer-investor.

The profoundness of the technological advantage that tokenization can bring hasn’t gone unnoticed. Several tokenized funds have emerged, each of which has been domiciled in one of the exotic jurisdictions recognized for their flexible regulation. This was necessary because there was no legal framework to regulate the new technology.

But, since then, the countries that are perhaps most recognized for wealth management - Switzerland, Liechtenstein and Luxembourg - have embraced the new technology and began forming the necessary rules. They are on a path to pass their own versions of a ‘Blockchain act’ that will recognize representation and transfer of securities on blockchain without intermediaries.

Thanks to the progressive, if strict procedures in these countries, it is possible to tokenize a fund and attain legal certainty even now in a regulated manner compliant with the incoming framework. Progress favors the first-movers.