Decentralised autonomous trust: a better way to raise money
The Traditional Venture Capital Model is Broken
Words by, Randy Boyer, Federico Fernandez, Jonathan Ayerbe and Luke Schembri Warr.
The traditional venture capital model has become more and more dysfunctional. In the 1990’s when IPOs were frequent and lucrative liquidity was relatively easy, the traditional venture capital model thrived. But in the last 20 years, with liquidity becoming more difficult within the model, the traditional venture capital model has become increasingly out of touch with the needs and interests of new start-ups and fast-growing companies, their founders, their employees and the community of users surrounding the company.
Here are some of the key issues with the traditional venture capital model. It is difficult for an early stage company to secure traditional venture capital money. According to the article “How Do Venture Capitalists Make Decisions?”. Stanford University Graduate School of Business Research Paper. Archived from the original on July 4, 2017, only about 1 out of 100 start-ups are successful in securing money from a venture capital investment fund. Most technology companies need some investment to grow from seed stage to prove their business model. Because of the scarcity of investment funds, most companies don’t make it through the “valley of death” between seed funding and the first “early stage” third party investment funding (see graphic below for a graphical description of the “valley of death”):
The traditional venture capital model, based on eventual liquidity events (exits) which usually take at least five to ten years via a purchase of the company or an IPO, are becoming increasingly more difficult and risky.Because of the difficulty and risk from liquidity events (also known as “exits”), traditional venture capital money is shifting to funding companies at much later stages where an exit is closer and the risk is much lower.
The needs of traditional venture capital investment companies (“VCs”) are increasingly out of alignment with the needs of the investee company’s founders and entrepreneurs. The traditional VC model is a bit like roulette where the venture capital fund bets on 10 companies knowing that only 1 or 2 will actually turn a high enough return to support the VC model. Because the venture capital fund wants to preserve capital for the 1 or 2 “winners”, they often accelerate as many of the remaining 8 or 9 investments to failure even if those that are being accelerated to failure through the holding back of needed capital would otherwise provide a reasonable return (3x-5x)– but not the spectacular (10x+) return which is needed to fuel the VC model. This practice and other short-term focus practices among VCs have made many entrepreneurs vow not to seek traditional venture capital and make them very susceptible to new, innovative funding approaches.
In the latter part of 2018, Thibaud Favre, a clever technologist and entrepreneur developed a new innovative funding concept called the decentralized autonomous trust (DAT)[i].The DAT concept is based on automating the buying and selling of units in a type of digital investment in a trust created by a company as a separate investment vehicle by funneling some of the company’s revenues into the trust and using a bonding curve embedded in a smart contract to automatically determine its buy and sell price. Each unit of the trust is called a FAIR[ii]— a construct that is similar to a token. The DAT’s smart contract, via a mathematical formula, determines how the FAIRs are bought, sold, created, destroyed and distributed. Even though the following analogy is an oversimplification, the DAT concept is not far from the construct of an automated promissory note whose terms are created and enforced by a smart contract and whose returns are partially or fully underwritten by revenues from the company. The concept of using a bonding curve to automatically determine the buy and sell price of tokens has been under development for a few years by several writers, technologists and business people including Simon de la Rouviere in 2017[iii].
DAT Solves Key Issues with VC Model
The DAT concept solves the key issues in the traditional venture capital model identified earlier–(1) hard to secure, (2) liquidity issues for investors, (3) only available for very late stage companies, and (4) misalignment or no alignment between needs of the various stakeholders of a company.
Because of its liquidity, the DAT concept is much lower risk than an equity investment. The level of risk is more on par with a promissory note. The investors could buy and sell FAIRs in the DAT easily because any minimum buy or sell price would be automatically fixed by the smart contract so there would be no liquidity issues for investors like in the traditional VC model. The liquidity of the FAIRs would be further enhanced by likely secondary market activity with buying and selling FAIRs in among investors in informal or formal FAIR exchanges. Some companies like Network Society Ventures are already discussing and planning the launch of FAIR exchanges as soon as there are a critical mass of FAIRs and FAIR buyers.Even though companies that had revenue would be the lowest risk investment for investors buying FAIRs, the DAT concept could be made available to any company not just very late stage companies like increasingly is the case in the VC model.
The lack of alignment among the company’s stakeholders in the VC model would be much better in the DAT model because, even though the investors wouldn’t be receiving equity,the founder would want the FAIRs to be attractive to investors so it could make a good return on investment. Employees would be given FAIRs that had immediate liquidity (although it would be reasonable to put employees on some kind of FAIR earning plan with some kind of reasonable restrictions). The key point is that the FAIR would have value and liquidity to founders and employees unlike stock options. And just like tokens, the community of users that were excited about the company could buy and sell liquid FAIRs and benefit, unlike the community of users in private venture-backed companies.
Those companies that, under a traditional VC model, with a not so attractive 3x-5x return that would otherwise be accelerated to failure, would be a very attractive candidate for investment using the DAT concept.
Because it is a new concept, most jurisdictions would likely classify and regulate a DAT as a type of security. People like Thibaud Favre and the authors are discussing the DAT concept with the financial regulators in various countries to smooth the implementation of the concept among entrepreneurs and investors.
[ii] FAIR stands for “Frictionless Agreement for Investments and Returns”.
All of the authors belong to Network Society Lab (“NSL”), a venture development consulting company that has subsidiaries in Europe, Latin America, and the US. NSL is working with several companies on the DAT concept and is educating various government departments in the world about its benefits.