The token economy is arriving and venture capital is on the front lines. In the coming years, blockchain tokens will offer VC funds a new mechanism to raise capital and maintain control of the investor base, and the impact will not be confined to those firms investing in blockchain technology.
“Security tokens” — digital tokens that are fully compliant with regulations — can be used to represent ownership in any asset, such as a fractional portion of a venture capital fund. Let’s unpack what that means for the industry.
The typical contracting model between a fund and its limited partners is a lock-up from capital call until liquidity event. This lock-up makes sense because the fund’s assets — investments in startups, for example — are illiquid and therefore fulfilling redemptions would be extremely costly to the fund, so they pass the illiquid nature of the investment on to the LPs.
But this illiquidity is obviously not ideal to either the fund or its investors and thankfully we are beginning to see the early signs that blockchain technology can play a role in disrupting this model. In 2017, Blockchain Capital raised a portion of its fund ($10 million) by issuing a blockchain token (BCAP); investors in BCAP would be able to exit prior to 10 years by selling the token to another investor in a secondary market. As Harbor CEO Josh Stein observed, such a move allows a fund to “lock up the capital without locking up the investors.”
Two major changes had to take place before firms could easily and compliantly trade “shares” of their funds: compliance protocols and regulated trading platforms. Neither of these existed at the time BCAP was created, but they are emerging now.
For example, Harbor’s R-Token protocol is one of the leading examples of a layer that manages compliance not just in the primary issuance, but into the secondary market as well. Additionally, security tokens need somewhere to trade, and regulated security token trading platforms are just now coming online, including Open Finance, tZero, and Templum. Taken together, the arrival of these two categories of enablers suggests the first generation of infrastructure in this ecosystem is nearly in place.
We will begin to see more funds bypass the traditional limited partner model in favor of raising capital from the crowd via a regulated security token offering. One motivation for this kind of “tokenized” fundraising is the concept of an “illiquidity discount,” which dictates that an asset with higher liquidity will be priced higher than an identical asset that is relatively illiquid because investors demand a risk premium to compensate for illiquidity.
These changes in the industry elicit questions and concerns from both fund managers and investors around the topics of theft, cap table management, disclosure, and legality.
Regarding theft, in most cases, security tokens will not be subject to hacks or irreversible loss in the same way as Bitcoin or Ether. Tokenized securities will be recognized as legal securities under federal law, and ownership protection will exist. There will also be mechanisms for recovery such as a cancel and reissue feature.
The second concern is losing control of the cap table. Some funds won’t mind and will open themselves up to a large investor pool, such as all accredited investors. Others may want to keep some control over who can invest in the fund. This concern can be mitigated by automated compliance solutions like Harbor. Since all trades in these markets are subject to Know Your Customer (KYC) and Anti-Money Laundering (AML) laws, the protocol has full visibility on identity and other attributes. Someday, funds will be able to curate a bespoke whitelist, for example, specifying a list of approved investors or specifying required investor characteristics. However, there will be a tradeoff. The more restrictive the whitelist, the fewer potential participants in the secondary market.
Then there are concerns over disclosure. Funds will likely need to inform investors of Net Asset Value (NAV) and holdings on a periodic basis. For funds that have 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 to investors in tokens.
The final concern is around legality. The Initial Coin Offering (ICO) boom of 2017 raised a lot of questions about what is and isn’t 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.
The next 12-24 months will be a testing ground for security tokens, but if the model proves out the way many envision, it will impact funds of all types. Once investors in VC funds develop a taste for a liquid secondary market, it will be hard to pull them away.