Venture capital began in the 1950s, when the Rockefellers persuaded their friends to sprinkle some of their wealth on micro-businesses (read: startups) founded by American soldiers returning from war.
A lot has happened since then…
The model has proven to be incredibly successful. Some exceptional businesses have been created that have managed to disrupt entire industries, and surpass the economic size of small European countries. The odds of an exponential upside meant that giant investors and institutions poured billions into VCs, and then some more after 2007, when the prospect of private market investments began to look surprisingly good next to the universally-hated Wall Street and financial markets collapsing on themselves.
VC has not always been successful. That is, not even at the sector level. VCs failed to time the e-commerce boom, throwing millions at startups 20 years before real people had any real demand to buy things online. On the whole, however, few would argue that VC has been bad for the world.
But recent years have seen a rising tide of criticism against venture capitalists. With so much money at play, venture capital has become a game of statistics. In their race to give back double-digit returns, VCs like to shoot for the stars. A naturally high rate of failure among startups is driving VCs to make up for the loss by searching for absolute moonshots. Put simply: a VC is not motivated to invest in ten decent, potentially $100 million businesses; it would rather place its bets on ten “crazy guys” if one of them has the chance to be the next Facebook.
That is why we have the UBERs of this world…
A few days after UBER’s IPO flopped, it had never felt more true that perhaps too much private capital had flown into technology in the past ten-or-so years. Companies promising to “disrupt” their sector have seen their valuations rise to extreme levels in a post-crisis world, filled with hatred for Wall Street. More money in the hands of VCs caused them to chase later-stage deals at breakneck valuations.
It would also seem that there are no niches anymore. The opportunities are no longer in having a sector specialism based on VC partners’ background and network, because there are several similar funds knocking on the door waiting to invest in the same companies. Rather, the opportunities for a big investment are in the exclusive UBER-like deals. In this new world, the omni-present, big-brand VCs like Andreessen Horowitz (a16z) often stand shoulder-to-shoulder against big private equity houses and even banks’ own private wealth arms in a race to invest in the next investment round of the unicorn “X”.
Just like the tech giants born out of VC - Google, Facebook and Amazon - which used to play in their own segments, but now overlap - hedge funds, private equity houses and VCs like to creep into each other’s territory. The news that a16z is renouncing its VC status to become a registered investment advisor should come as no surprise. Being registered will give the firm the ability to invest in many more asset classes. Born out of financial crisis, a16z has grown to be loved and hated at the same time. It has also changed what VC means. Given the media attention that a16z enjoys, many have naturally begun to ask the question if this is the sign of things to come within the venture capital sector.
So, what does a16z renouncing its status actually mean?
It is hard to see how a16z’s push to expand its investment freedoms is going to bring anything good or new to the VC model. Indeed, the change may not be all that welcome by its limited partners (LPs). Apart from the higher cost (due to higher regulatory burden of operating as an RIA), the change could throw their LPs’ investment objective out of balance. A VC fund after all, is an investment vehicle funded by sophisticated investors, who themselves want to have control over what they invest in. In other words, a pension fund doesn’t write the VC a check because it wants to invest in a hedge fund. For hedge funds, it may have a different pool of money reserved and risk allocation available.
If VCs are transforming into universal investors, does this mean that there is less of a need for them? Not likely. There will always be prodigy entrepreneurs in need of capital, who cannot tackle the institutional apparatus that lies between them and the public markets. Listing on a regulated stock exchange is either too costly and difficult, or simply impossible at the stage they are in as banks wouldn’t lend to them. A singular holder of private capital is still the best option for them.
What will it take for VC to get an upgrade?
Events like UBER’s IPO and the registration by a16z suggest that VCs are losing focus. Strangely one force that can help disrupt venture capital is technology - the very sector that VCs helped to disrupt the world, but remained virtually untouched by.
A trend that has been recently shaping up that could change the VC sector is security tokenization. Emerging from the failed and over-hyped ICO bubble, security tokens have the potential to revolutionize fundraising and make entire classes and groups of assets tradable. Indeed in the long-term, the use of tokenization as a better way of representing securities is inevitable, as shown by cases such as that of Dole Food, which reveal how the existing infrastructure based around central repositories is “starting to show its age”.
At its core, security tokenization is about “cutting” real assets into regulated intelligent securities (“tokens”) that are tradable in a pre-programmed way on the blockchain. Tokenization could be transformative for alternative investment funds: VCs, private equity and hedge funds. A tokenized fund would be offered to investors as a security that they can resell in the market. And it will be intelligent, so that it will know who can trade it and where it can be traded, or how it should distribute returns. A pre-programmed security with rules encoded within promises to remove mountains of paperwork and the need for middlemen. And by being on blockchain, it can be traded instantly, globally, and 24x7x365.
This can open up the VC model to be bottom-up (to more investors), as well as top-down (to young-but-not-yet established fund managers). Security tokenization ‘UBER-izes’ the fundraising process by connecting fund managers directly with investors. It removes the institutional apparatus and multiple middlemen that sit between the two. It puts emerging talent on the same level as established veterans. Imagine investing in a VC fund being as simple as lending on a P2P platform.
The first tokenized funds emerged in 2017 and 2018. Being on the brink of what is considered legal, they had to be domiciled in exotic jurisdictions recognized for their flexible regulation. This was necessary because there was no legal framework to regulate the new technology.
But, there has been a lot of progress since then. Especially, the countries that are perhaps most recognized for wealth management - Switzerland, Liechtenstein and Luxembourg - have embraced the new technology and began forming the necessary rules. They are on a path to pass their own versions of a “Blockchain Act” that will recognize the representation and transfer of securities on blockchain without intermediaries. Thanks to the progressive-yet-strict procedures in these countries, it is now possible to tokenize a fund and attain legal certainty in a regulated manner that is compliant with the incoming framework.
Clearly, it’s going to take something more foundationally disruptive than a16z merely registering itself as a registered investment advisor to create a modern version of VC. This act did little more than expand the capabilities and revenue streams of its own fund. However, with the potential of tokenization to democratize VC as we know it - bringing it to investors of all sizes and taking exclusivity away from the super-rich - we could be on the brink of a true upgrade to the venture capital system.
Article by George Salapa, co-founder of bardiventures
bardicredit provides turnkey fund tokenization services helping fund managers to use tokenization for easier capital formation. Our services cover legal, regulatory and accounting, and ultimately the tokenization process.