Sheldon Freedman will return next week with the last of his 4-parter on Security Tokens. Today’s post is stepping back and looking at the motivations on both sides of the table. What do entrepreneurs and investors want and how do their needs offer a To Do List to Security Token platform operators?
Innovation comes from deep pain meeting disruptive technology. Security Tokens can tokenise just about any asset. Our thesis is that the early adoption traction will happen in early stage stock, because that is a big broken market where there is deep pain on both sides of the table.
The deep pain of entrepreneurs raising money from Legacy VC has been detailed many times, including here in our first take on ICOs in March 2017. During the ICO bubble of 2017, the pendulum swung too far in the other direction (evidenced by raising $100m+ in hours without even a working product). Now the pendulum needs to swing back a bit towards investors (but not as far as it used to be before the Token revolution started).
Investor Pain
The other side of the table – the investors – also suffer pain based on having a lousy set of options:
- Public Equity Markets. Investors have an ugly choice of IPO valuations of tech growth stocks at nosebleed valuations or more conservatively valued old companies that are badly impacted by disruption (e.g do you invest in AirBnB at high valuation at IPO or in conservatively valued Hotel stocks that will be disrupted by AirBnB?).
- VC Funds. Investors who want equity much earlier than IPO have the option of buying into sub par VC funds, when the lion’s share of returns goes to a few top tier funds that are not accepting new investors.
- Direct Angel Investing. investing in early stage deals directly is risky when there is almost no price discovery, liquidity, or portfolio construction ability and a lot of Due Diligence overhead.
To Do List for Security Token platform operators
These are the 5 things that Investors want from a good Security Token platform. This the To Do List for Security Token platform operators:
- Basic quality filtering to create a short list for investors.
- Price discovery & liquidity.
- Portfolio construction ability.
- Co-Investors.
- A network of service providers.
Basic quality filtering to create a short list for investors.
It is NOT hard to get Security Token issuers (aka entrepreneurs). They will be lining up at the doors of Security Token platform operators. Within the crowd of entrepreneurs lining up at the door will be a mix of:
- Really great ventures in their early days (what every investor wants).
- Ventures that do OK, make some money for investors but not a lot
- Ventures that go smash with money back for investors from something like an Acquire Hire deal
- Honest Ventures that go smash with zero back.
- Scam Ventures that go smash with zero back.
The last two are similar in terms of returns but the last one is relatively easy in most cases to get via a fairly crude filter (but not all, think big public market failures like Enron and Worldcom). Basic quality filtering should deliver a short list to Investors and the platform needs to ensure that the ecosystem of investors, advisers and service providers are compensated well to do that filtering job.
Basic quality filtering only delivers a short list to investors. Then the hard work starts. Without that basic filtering the job is well nigh impossible – meaning investors ignore the platform and eventually entrepreneurs desert the platform. That is why basic quality filtering is Job No 1.
Price discovery & liquidity.
The public equity markets are excellent at delivering price discovery & liquidity. Private markets (where all early stage deals are done) are totally opaque. Valuation/price is set in bilateral negotiations behind closed doors. There is no price discovery via shorting (which explains the historically bizarre inversion where private stock has higher valuations than public stock). The hope for Security Tokens is that markets develop that bring price discovery & liquidity to these opaque private markets for early stage equity. The question is how that price discovery & liquidity will come about. I can only see two scenarios:
- Centralised exchange dominance. We get something similar to the NYSE/NASDAQ duopoly plus a lot of second tier regional exchanges.
- A more decentralised data feed driven ecosystem, where aggregation can be done by whoever takes the data feed.
I reckon that two is more likely for one simple reason. In the Legacy Finance era we had one dominant geographic market (USA) and so it was natural for NYSE/NASDAQ to rise to dominance. We now live in a multipolar world and the Token market is naturally global. The promise of the Token market is that a great team anywhere can raise capital. That requires a decentralised data feed driven ecosystem. This means that aggregation can happen by whoever takes the data feed. So there will be competition to add value at this level.
This data feed is also what enables a portfolio construction ability.
Portfolio construction ability
Classic portfolio diversity means getting ventures that are diversified across geography, domain, stage and business model.
Investors in early stage stock have two options if they want to follow prudential norms for risk management through portfolio diversity:
- Delegate portfolio construction to a Fund and pay them 2 and 20. You accept their model for portfolio construction.
- Use a data feed to construct your own portfolio.
That is relatively easy to do if we get a decentralised data feed driven ecosystem. All the platform operator needs to do is make sure that Security Token issuers fill in a basic form detailing geography, domain, stage and business model and make that data available in a data feed.
A more sophisticated form of risk management will be enabled by a platform operator that insists that entrepreneurs report financials using XBRL (see this post for more). Imagine, for example, being able to see total cash position and cash burn across a portfolio of early stage stock.
Geographic diversity is a particular issue for early stage equity. It is an axiom of early stage equity that entrepreneurs and investors must be close enough to meet regularly (the famous “one tank of gas in a Ferrari” for Silicon Valley VC). That problem is solved by having co-investors who trust each other.
Co-Investors.
This is where the interests of entrepreneurs and investors align. The biggest fear of both is the venture running out of cash – that is how ventures fail in practice.
If you are limited to investing in local ventures, your pool of investors is small (unless you are in Silicon Valley). This is where investors need to build relationships with co-investors in other locations. For example, lets say you are in London but you see a good deal in Dubai. If you know a good investor in Dubai, you bring that deal to him/her. He/she does the same for you if they see a deal in London. The same can happen by domain and business model. In some deals you are a Lead, in others you Follow.
A network of service providers
Investors need Lawyers, Accountants, Domain Experts and other experts. Due Diligence is a critical step in investing. A winning platform will have a good network of service providers who are vetted and rated.
What entrepreneurs want from a Security Token platform
Entrepreneurs raising money are always in a hurry. They see a window of opportunity and want some cash in the bank so that they can execute on a plan. Investor conviction needs to take time – it should be hard. It is the next bit that should be easy. The mantra is schmooze offline, transact online. Once you have a lead investor it should be easy to close the round. It is not easy today. This is a deep pain point for entrepreneurs. These entrepreneurs will be highly enthusiastic early adopters of Security Token platforms that will make the step from finding a lead investor to closing the round and getting cash in bank. What entrepreneurs want is a simple way for everybody who wants to invest to do it online. Execution of what we all want should be easy. You know, all those boring bits from “yes I want to invest, to money in the bank”. Shaving say 10% off a boring process like that is…boring. Taking a 90% axe to processes like that is exciting and game-changing. Security Tokens can enable that. This is win/win for investors and entrepreneurs – nobody likes this cost/delay.
If we get Security Token platforms that deliver on this To Do List, it will be great for entrepreneurs and investors and for everybody else who benefit from good jobs and wealth creation from the increase in innovation. I am an optimist because a) none of the things on that To Do List is rocket science and b) the prize for a platform operator who gets it right is very big.
Bernard Lunn is a Fintech deal-maker, investor, entrepreneur and advisor. He is the author of The Blockchain Economy and CEO of Daily Fintech.
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