The Venture Capital model is broken and needs to evolve with the times.
Venture capital has played a very important role in the setting up of some of today’s leaders in technology, media, communications and other industries. It has enabled access to little understood early stage businesses, fostered entrepreneurship and risk taking, and created large amounts of wealth for risk takers, both entrepreneurs and investors and VC fund managers.
However, venture capital’s business model has remained the same over time. Times have changed. More and more capital are chasing deals. Deal sizes are growing and most of it is going to later stage ventures. Promising seed funded ventures find it difficult to raise series A financing. Competition among start ups in every market segment has gone up. And survival and then scaling to grow sustainably and profitably is taking more and more longer than fund life terms.
And in 2017, there came a new elephant on the scene : ICOs or Initial Coin Offerings. Many billion dollars flowed into startups and new ventures with little more than a whitepaper on a website with a call for money using an Ethereum contract. For the uninitiated, an ICO is crowdfunding using crypto currencies such as Bitcoin and Ether paid in exchange of tradeable tokens issued by the ICO project sponsor. Even some VCs invested in ICOs !
Going into 2018, while raising money using ICOs may become more challenging as scams and failure rates go up, the concept of tokenizing assets for fractional ownership is not going to die away. And therein, lies a possible road ahead for a new business model of venture capital.
No matter what the investment model is, three important factors always are
- Quick and Inexpensive access to capital : this is always important for entrepreneurs and probably a reason why ICOs took off so fast. It was relatively quick compared to raising VC which could take a long time. However, marketing an ICO and administering a crowd funding with crypto currencies and its security and regulatory challenges is significantly higher.
- Liquidity in early stage venture assets : this is important to any early stage venture backer, be it an angel investor or a VC fund or its Limited Partners. It is a big reason angel and seed investors struggle to make money after taking most of the early risk. And it is a big reason VC funds sometimes promote unsustainable spending to spike growth and valuation of startups that they can sell off or use to attract new investors who would buy them out.
- Governance and reporting realities : reporting use of funds, revenues and having processes to ensure the startup stays its course is important and is something that is lacking in ICO funded ventures which make them risky.
So, what can be a new business model for venture capital ? Something that combines the better aspects of ICOs (quicker access to liquidity) and VC (solid governance). One that is better for entrepreneurs and for investors.
In this model, venture funds would raise their fund corpus by issuing tokens to investors. Investments can be made in crypto currencies (like in ICOs) or with regular fiat currencies. A token is simply a participatory note that can be used by holders (investors) to invest in startup companies sourced and qualified by the venture fund. Once this happens, the startups (investees) pass on the tokens to the venture fund for endorsement. The venture fund then invests money in exchange of shares in the startup at the qualified valuation. Against these shares, the venture fund endorses the token and delivers this as a derivative instrument back to the token holders (investors). Token holders (investors) can trade these derivatives and such trading will establish pricing points of underlying shares driven by performance, and holding patterns based on risk assessments of the startup and the industry it operates in.
The advantages of this new business model for venture capital are many.
- Positions VC as an advisory product and removes selection bias : VC has long been seen as an asset product by investors. And that asset, barring select few funds, have not generated any sizeable returns. Positioning VC more as an advisory product where investors get to choose and invest in startups that are sourced and qualified by VC funds also removes selection bias that affect a large number of startups at any time.
- Makes early stage investments tradeable and drives liquidity : this therefore also allows a larger number of investors to participate in VC and can potentially bring in a larger pool of funds for early stage investing. Retail fractional ownership of startups also removes biases and situations brought on by strong arm and shorting tactics of VC fund managers.
- Removes stress created by fixed VC fund life terms : current 8–10 year VC fund life terms no longer fit the profile of startups that may take longer to create a new product, scale and establish a profitable business. This new model makes VC fund life terms obsolete. It also allows VC funds to issue participatory notes (tokens) from time to time based on demand that its sourced and qualified portfolio of startups generate.
- Regulation and Taxation friendly : this VC model possibly fits current regulation in many countries. Funds themselves can be raised in jurisdictions that are friendly to token based fund raises. Asset management companies can possibly qualify as foreign portfolio investors, that are responsible for adherence to local KYC/AML norms, issue of offshore derivative instruments, and reporting transactions and financials. Dividends and Capital gains may possibly get taxed at the hands of derivative instrument (participatory note or token) holders.
- Changes the VC reward structure and mechanism for better : fat fixed asset management fees that are not linked to any performance is the bane of the current VC model. The new model can afford many innovations in reward structure and mechanisms for VC fund managers. For example, a percentage of value of a token can be paid to the asset management company when it endorses a participatory note (token) and issues a derivative instrument to the investor. Similarly, transaction fees on traded instruments and advisory fee based products can also be created.
A common reaction to ICOs from many in the VC community is amazement bordering on ridicule. Some others are talking of the numbered days VC has. The new normal will be somewhere between.