How Security Tokens Will Disrupt Traditional Venture Capital
We are now seeing the new token economy take hold with the Venture Capital sector aiming to be positioned on the front lines or face being left behind. VCs are being forced to look inward and now have the opportunity to embrace the latest technology and market innovations. It is survival of the fittest,. In the coming years, security tokens will offer VC funds a whole new mechanism to fundraise quicker and cost-effectively while increasing liquidity and maintaining control of their investor base.
What Are Security Tokens?
“Security tokens” are digital tokens that fully comply with the guidelines set out by regulators in the jurisdiction the token is issued and can be used to represent ownership in any asset, such as real estate or a portion of a venture capital fund. Security tokens are expected to account for 80% (or $4 trillion) of the total Global Market Cap (“GMP”) of cryptocurrency by 2025, with the trading volume of these tokens exceeding $40 trillion for the same period. So what does this mean for the traditional VC model?
The current VC model for its Limited Partners (“LPs”) is to lock up their capital until an exit occurs with the fund. This lock-up period (which can vary between 7-10 years) makes sense because the fund’s holdings, primarily equity investments in startups, are generally illiquid, and therefore fulfilling redemptions would be extremely costly and risky to the fund, so they pass the illiquid nature of the investments on to their LPs.
Utilizing both security tokens and blockchain technology can play a role in disrupting this traditional model. For example, Blockchain Capital, an early adopter raised a portion of its VC fund ($10 million) by issuing a blockchain token (BCAP); investors in BCAP would be able to exit before 10 years by selling their tickets to another investor in a secondary market. While this provides earlier liquidity to the LPs, improvements can still be made.
Since the BCAP token was issued, a couple of changes have taken place:
- The development of compliance protocols and
- The introduction of regulated trading platforms. Neither of these existed before, but they are now emerging as essential components to the future success of security tokens.
Using security tokens imposes additional obligations on the issuer, including, Know Your Customer (“KYC”) and Anti-Money Laundering (“AML”) requirements, qualification of investors as “Accredited,” and tracking of these security tokens and the holders (“verified”) after the fundraising process. Tokenized securities will be recognized as legal under federal law; therefore, ownership protection will exist. Harbor’s R-Token protocol is one example of a layer that manages some of these compliance responsibilities not just in the primary issuance of the token but also in the secondary market.
There are limited secondary market options available where security tokens can be traded. Open Finance Network, tZero, and Templum have taken the lead in providing this service. The arrival of these two categories suggests the next generation of infrastructure in this ecosystem.
Tokenized funds and security tokens are set to transform traditional venture capital and private equity markets. If you are planning to launch a tokenized fund, we have reviewed some structures that you may consider
— Flag Theory (@FlagTheory) November 28, 2018
As more VCs develop funds on the blockchain using security token offerings and are motivated by “tokenized” fundraising,g the concept of an “illiquidity discount,” will dictate the token price,e with investors charged a reduced risk premium for increased early liquidity.
Also, read – What skills do you need as a blockchain engineer?
Concerns and Questions
With changes in the industry comes to elicit questions and concerns from both VCs and investors surrounding topics of cap-table management, disclosure, Net Asset Value calculation, and legality.
Cap-Table Management: Utilizing security token offerings will open up larger investor pools. Since all security token trades will be verified, the protocol has complete visibility of the Token-Holders’ identity and other attributes. VC funds will start to curate a bespoke allowlist, which will specify a list of approved accredited investors.
Disclosure: Then there is concernsexposure. VCs must inform their LPs of Net Asset Value (“NAV”) and the fund’s holdings periodically. For funds with public pensions as investors, this information is already being disclosed publicly, and anyone can purchase it through platforms like Preqin. Disclosure portals like Messari are being built now to facilitate information dissemination for Token-Holders.
Net Asset Value Calculations: The standard process and tools for evaluating a fund’s holdings by VCs have involved comparative modeling and NAV measurement, which is subjective but provides a solid educated guess. Significant advancements will be needed to avoid claims of price manipulation.
Legality: The ICO boom of 2017 raisedmanyf questions about what is a utility and what is a security. There is little ambiguity for a tokenized VC fund — it’s a security. As such, any legitimate issuer will follow securities laws, and there are a variety of SEC exemptions to choose from, such as Regulations D, S, and A. Each has pros and cons, but all can be accommodated by security token exchanges and automated compliance protocols. The buyer and issuer should bear no more regulatory risk than they would in a traditional VC fund.
Sportvest: Disrupting The VC Model
At SportVEST, we aim to solve many LPs’ concerns. The SportVEST token (SVE) will be registered under Regd 506(c) and Reg S with SportVEST VC Fund providing Token-Holders liquidity after a one-year vesting period. We are not relying on demand in a secondary exchange; our buyback and burn model will not only offer earlier liquidity but also increase scarcity and stability of SVE – meaning the token price is not driven purely by speculation on a secondary exchange. A verified token will allow us to curate a bespoke allowlist of accredited investors.
SportVEST VC Fund will live in perpetuity and continue to increase in value and market share rather than remain limited to the current standard 5-10-year VC fund shelf life. In addition, tokenization brings inclusivity and liquidity to the model much sooner than the current model allows. We are combining a solid team and industry experience along with innovative tools and metrics that include market forces to assist in the NAV measurement of the Fund’s holdings, utilizing a “Power Law Sales” model and, to a lesser extent, a “Brand Equity Algorithm” to supplement and improve upon the traditional NAV measurements.
The following 12-24 months will be a testing ground for security tokens, but if the model turns out to be the way many envision, it will impact funds of all types. Once LPs in VC funds develop a taste for early liquidity, it will be hard to pull them away.
NOTE: This article should not be considered financial or legal advice and is the author’s opinion.