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Venture capital is the money allocated to investments into a new or expanding business, which naturally carries substantial risk. By investing into companies that haven’t yet reached product market fit the VCs take a huge gamble on the team’s ability to deliver a sound idea. They also act as advisors that help these companies succeed.
Given the article is about fundraising, let’s look at the typical investment process:
> Find a company
> Value it based on revenues, assets, growth etc.
> Agree to give them $n and they give you n% equity
> Put money into escrow (typically the lawyers)
> Rewrite Articles and Shareholder Agreements to include you on cap table
> Docs signed, money leaves escrow
It was made even simpler with Y Combinator’s SAFEs - Simple Agreement for Future Equity:
> Find company
> Value it based on revenues, assets, growth, etc.
> Agree to give them $n and they give you n% equity IN THE FUTURE
> Sign 3-4 page piece of paper, give money
But you see, in crypto, things are different. Not different in a way that implies a fundamentally different approach, but different in the sense that we took some parts of this process and ran with it.
We took SAFEs and turned them into SAFTs. We took equity and started raising with tokens. But this came with legal troubles. So, to bypass regulators, projects focus hard on ensuring their tokens are “utility tokens” instead of “security tokens”.
But crypto investing in “utility” tokens is peculiar because these tokens are needed to be utilised in the ecosystem: it’s similar to investors investing into Starbucks coffee beans instead of Starbucks Inc.
That being said, this brings with it a unique perspective: investors should exit their positions because the projects’ users need them to utilise the ecosystem. Can’t buy coffee if investors are hogging all the beans 😉
I digress.
The point is that things are similar in name but very different in implications.
For all intents and purposes, when talking about tokens, I mean specifically utility tokens. Security tokens are literally tokenised equity, and other legally-defined token classes are boring.
Let’s have a look at some of these differences and discuss what they mean.
Since equity is a piece of the company, and a token is an asset of said company, the way they’re valued is very different.
A company’s value stems from its revenues, profits, growth, assets & liabilities, and so on. Easiest way to see it is, if you were to buy a company right now, how much would you pay for it?
A token’s value stems from 5 fundamental types of value (that we have identified) and its valuation (price * supply) is the practical application of value within the laws of demand and supply (read more here).
Your company could be losing money and about to hit bankruptcy, but your token can be at $2Bn valuation. Why? Because to value equity people look under the hood, whereas a big chunk of token value comes from speculation - the former requires tangible data, the latter a mere narrative.
A good example is WeWork - the company is bankrupt, but if they had an access token, the token’s valuation will be much higher than $0 due to mere demand and supply.
There are common, preferred, redeemable and other types of shares out there in the wild. In crypto however each token is the same, in the context of projects fundraising with a token. You can’t really give investors a different token to the one that your users will hold, because then the VCs can’t exit. This is additional evidence to the fact that investors should exit to retail by design.
One interesting caveat is that often shares are diluted over time, but tokens often aren’t due to most tokenomics enforcing max supply.
Companies grow. Their value grows. They fundraise at different stages of said growth, hence, the valuations grow with them; unless it’s a down round, of course.
Tokens on the other hand grow only after you launch, since, you know, they’re just code the value of which stems from the value of what it interacts with.
Point is that the valuations of rounds before the Public round are based on nothing, meaning when one is designing tokenomics the valuations of each round should be derived as a result from a balancing act between the deltas in valuations, vesting schedules, TGE unlocks, and so on (read more here).
One could argue that one could base the early investment round valuations on an assumption such as, “If the token was launched right now, what value would it hold?”, and that would be a good counter argument except for the fact that nobody will launch the token until the Public round, so it’s pointless to think of it like this.
The issue here is that the Public round valuation is determined before the project even gets close to that round, whereas IPO shares are priced based on company valuations, which are based on tangible data.
The conclusion to this point is that calling these investment tranches things like “Seed” and “Private” create a line of confusion.
Some projects raise “round” by “round”, some open all the “rounds” to investors at once. There is no right and wrong choice here. But let me be clear, these are not Seed and Private rounds. What we have in crypto is different tranches - different vesting options for investors to choose. This may seem pedantic, but its a massive paradigm shift.
Vesting with shares is to incentivise good behaviour - you don’t behave, you get fired, you don’t get your shares. Nobody worries about “inflating supply” because the shares represent the company value - if people “dump” the shares, others will buy them back because they’ll become undervalued since they represent the company value, which wouldn’t have fallen. Moreover, you only can sell your shares to the open market once you IPO, which requires you to be a massive company.
In crypto, you can ICO within 30 minutes, meaning that the barrier to entry is borderline non-existent compared to equity (see how to do it here). Hence, the concern of “inflating supply” arises, because the tokens aren’t based on anything tangible, so people are concerned about the surface level “inflation” rather than the deeper problem with valuation.
In an ideal world, vesting schedules should be in line with user growth, and the investors, team, partners, etc. should exit their allocations because users need these tokens to use the ecosystems.
I already discussed industry standards here, but long story short is that equity values companies based on “industry standards” that are derived from inputs: the industry standard is to use discounted cash flow, or asset based valuations, or dividend discount model to value a company.
In crypto, the industry standards on what vestings to use, TGE unlocks, allocations, valuations, and so on, are based purely on the trend at the time. Now, in fairness, often these trends are based on market conditions, and given that token valuations are based on supply and demand, these industry standards are fine. They are also based on history - projects that gave lower allocations to investors faced less sell pressure, for instance.
However, beyond this, these standards are detrimental to evolution. Why is giving 50% to investors bad? Like, really? These tokens should go to users, and whether they come from the investor tranches or from the “ecosystem” tranche or from the “team” tranche does not matter. Sure, investors are less incentivised to hold tokens, but they also aren’t incentivised to dump them because the value of their exit will decrease - for selfish reasons, VCs are incentivised to exit smoothly. And we already discussed how these tokens realistically should go to users anyway.
One could argue, “Well if the token has governance, then giving 50% ownership to VCs is bad.” Agreed. In this context that one has created, it is bad. But that is not what “industry standard” means. Everything in context can be good or bad. But the whole point of an industry standard is to label something as either good or bad regardless of context.
Doing this based on outputs is ludicrous.
A good industry standard for example would be to derive investor allocations based on token utility, rather than simply looking at the % on an Excel table and judging.
The cost to IPO is millions of dollars. This prevents nonsense from reaching retail markets.
ICOs cost $0 and take 30 minutes. This (shockingly!) does not prevent nonsense from reaching retail markets.
On top of the millions of dollars, the only entities legally (in most jurisdictions) allowed to invest into venture are accredited investors - either qualified investors, high net-worths, or institutions with significant assets.
In crypto, anyone can invest at any point. This means that the crypto VCs don’t need to be doxxed, they don’t need to have a reputation to uphold, they don’t need to be legally compliant with their investment methodology and investments themselves.
They should if they want to build a reputable brand, but they don’t have to.
Crypto VCs also don’t have any repercussions for bad investments. “Oops, the team rugged :(“ is good enough. Did they do the DD? No. Could they have seen that the founder rugged before? Yes. Did they care? No. Did they invest anyway? Yes. Why? Because of short vestings. Who paid the cost? The retail users.
Retail believe that seeing loads of VCs back a project means there is a high chance it will be successful.
That is not the case.
To put the nail in the coffin, SAFTs are not legally binding in (as far as I know) most cases - the regulators don’t have the laws around cryptocurrencies to bear the enforceability of SAFTs.
Founders are also not protected from any misbehaviour from investors, such as malicious dumping of tokens.
This means that not only can anyone get investment from anyone and ICO into the public markets, but not a single entity here, neither the founders, nor the investors, nor the retail users, have any safety whatsoever from anyone.
The Wild West is an accurate description of the situation.
Overall, this article was intended as a thought exercise to plant seeds, to get people thinking, to help shift paradigms and axioms about an industry so new.
There aren’t many actionables, except maybe this one:
Don’t be set in your ways, and ask why at every opportunity.
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