Why STOs Will Challenge Venture Capital Funding
As 2019 is fast becoming the year of the Security Token Offering (STO) we look at how the next generation of crowdfunding opportunities could challenge Venture Capital funding.
Read more Opinion pieces here.
For many businesses, there comes a moment when they need to raise capital to expand. For almost 75 years, Venture Capital (VCs) had often been the route many companies looked to go down to raise capital. However, at the beginning of the new millennium, a different approach began to take place.
Crowdfunding was born as an alternative route to the traditional VC firms. Whilst there are some benefits that come with having one lead investor there are also problems. With this, crowdfunding brought about with it an exciting prospect. Crowdfunding democratised investment opportunities for the many. It also meant that businesses could set limits such as share price and total equity shared.
Now, we have seen the emergence of a new kind of investment through the likes of Initial Coin Offerings (ICOs) and Security Token Offerings (STOs). This new generation of crowdfunding saw much praise as well as its fair share of criticism. For TokenMarket, we expect that this new form of crowdfunding will be able to offer another viable avenue to raise funds, and stop VC funding being the only route to go down for exciting tech businesses.
Here, we look at how the STO framework can build upon the work of ICOs to create a new form of investor and the benefits it has for the business.
Does Early Stage Financing Lead to Control?
As with any business, having complete control over what direction the company is going in is important. For the most part, VCs help this by funding the project to carry on and progress as the founders want it to. These VCs are able to help Startups by offering the money they want with relative ease. Yet, this is not always the outcome.
One of the issues that come to light with VC firms is giving away a large percentage of equity at a lower rate. In a recent research paper by TokenMarket’s Head of Research, Jay Pazos, he estimated that VCs ask for a discount rate of anywhere from 40.6% - 70% when it comes to funding an early stage business. For a business in its infancy, this puts them in an uncomfortable position. Although the VC is, of course, trying to get the business off the ground, it hinders the company growth by asking for such a large discount.
As well as asking for such a high discount rate, VCs also try and claim a large stake in the business. On average, a VC will want around 20-25% of a new business, according to research carried out by Entrepreneur Magazine. For a growing business, this can be "make or break". 20-25% is a large percentage of the business, one that the team as a whole may not be willing to do. Although unlikely, a VC owning the business it has funded is not without precedence.
Crowdfunding has the ability to remove certain risks that can come with VC funding. By having a larger pool of smaller shareholders, the company can limit the risk of being bought out by its current family office(s) or VC(s) investments.
For the business looking to raise money, this situation provides a much better option. By creating a large investor pool and using a “little and often” approach the business is not looking to appease one person. In a 2018 report by Crowdcube, they found that the average investment for a project by one of its users was around £1,428. Crowdfunding was able to break down a lot of barriers and access to investments that otherwise most ordinary people would not be able to have. VCs are able to get early access in deals especially when it comes to tech Startups. This is what the STO framework is going to change. TokenMarket is one of the only companies to have this level of regulation which gives access to self-accredited and institutional investors to the same stage deal.
With STOs on the rise, and with the advancements of blockchain technology, creating equity which is a token makes sense. A tokenised security will create more transparency, faster liquidity for investors, set a level playing field for all involved and also provide an immutable database to store these records on.
What ICOs did leveraging the capabilities of crowdfunding in the blockchain space, STOs will be able to build on. It could also be said that there is one aspect to it that VCs are unable to create when investing; community.
Creating a Community
Crowdfunding, and in particular the ICO space changed the way businesses handled their investors. For the most part, this new form of raise gave individuals the chance to fund an exciting disruptive technology business. This alone drew many to the world of ICOs and brought with it a greater sense of community.
Business specific groups on channels such as Telegram, Slack and Reddit had excited users discussing upcoming projects with each other. For the business, it also meant that they could interact with their community in a more personal way. These groups gave the community a chance to ask the team and founders questions or to show support.
Community spirit and the creation of a group of like-minded people coming together to partly fund a growing business is a great thing. Of course, with ICOs and the community spirit, there also came the downside of falling out within the community. By opening an entire conversation up to thousands of people businesses also give the community the option to scrutinise them and, in some cases, losing their first mover advantage by allowing other businesses to copy their model. This is a risk that when using VCs is completely eliminated and for many businesses, it is one they would like to avoid altogether.
VCs will meet businesses in boardrooms and ask questions about when they can expect an ROI, as well as enquire as to how the business is progressing. Whilst these are all valid questions the excitement amongst the community that will end up using the product or service is not there.
We are not trying to paint VCs out in a bad way, far from it in fact. VCs are able to fund projects at a much higher level and give all funding almost immediately. As a growing business, this is a great tool to be able to access and, if you are using a VC, then that’s your choice. We know that the current systems in place can improve for future generations.
The Future of Crowdfunding
VC firms and early-stage funding will always play a part in the traditional financing of businesses as it has for the last 75 years. As of December 2018, the global venture capital industry value was estimated to be around £124 billion, trebling its value from a decade prior. With this, VCs have funded thousands of businesses, placing more money in 2018 than at any point in history. Funds such as Masayoshi Son’s SoftBank have an estimated $100 billion to spend on projects in the future. For now, it seems as though VCs will have the largest stake in the future of growing businesses.
Yet, there could be a change in the tide if crowdfunding continues to grow at its current rate. In 2015, the United States alone raised $34 billion in crowdfunding, a phenomenal amount of money for an industry that is still new to the financial world. Crowdfunding has been able to revolutionise the way in which businesses sell their equity. In 2017 and 2018, ICOs alone raised over $14 billion and saw a new lease of life given to the crypto community. More than 2,000 tech startups were able to use new technology and create a huge number of investors.
What equity crowdfunding has already set a precedent on, the STO framework will be able to improve. By taking paper shares and creating a tokenised form of equity that is then placed onto the blockchain, it creates an immutable system that will not only improve the means in which businesses choose to raise funds but create a totally transparent and more liquid environment. Crowdfunding 2.0 or as we like to call it “crowdfunding on steroids” will revolutionise the early growth and financing market. An estimated £77 billion-a-year industry, funding startups by using STOs could tackle some of the big issues and creating a level playing field in which more are able to take part.
Crowdfunding is not far away from becoming a staple part of investing in Startups and the world of ICOs brought about a new kind of investor as a whole. Now the STO market is showing a maturity that many have felt must happen if the token industry is to succeed. Whilst utility tokens do make sense, the securities market is simply too big to ignore.
Whilst VC firms will still make up the majority of growing businesses, we at TokenMarket are optimistic that by using new technology STOs will become a staple part of the market. By building on the sense of community that ICOs had and giving investors complete transparency in their investments, there will be an increased demand for the crowdfunding sector. In doing so, we know that the STO framework has the capability to give everyday investors access to the next generation of investment unicorns.