This chapter focusses on the needs of the Buy Side for Portfolio Construction and how that relates to the boring but essential subject of financial reporting and from that to the ultra nerdy subject of XBRL.
This is Part 1/Chapter 5 in The Blockchain Economy book. This serialised book is a practical guidebook for investors, entrepreneurs and employees who want to learn how to prosper during the transition to an economy where value exchange is permissionless and disintermediated. For the index please go here.
A quick look at Google Trends shows why ad-driven media ignores XBRL – quite a few searches for Blockchain, lots for Bitcoin and very, very few for the shy, nerdy XBRL. Our mission at Daily Fintech is to spark conversations that will be in the news in the future, so we will indulge in some geeking out over XBRL.
The XBRL thesis is that machine readable financial reports is an essential tool for equities investing. The problem that has delayed XBRL going mainstream is that here is very little fundamental investing, the sort of work that actually requires reading financial reports (and that made the likes of Warren Buffet and Peter Lynch rich) as opposed to simply watching price signals and Central Bank tea leaves.
Now XBRL’s moment has come in order to power the coming wave of Security Tokens.
This post will outline:
- XBRL 101
- Why the Equity Token wave will soon be coming to a surfboard near you.
- Milestone Based Financing is the baby that got thrown out with the bathwater in the long hot summer of ICO
- Why XBRL is essential to Milestone Based Financing
- The smart regulation that will/should drive this change.
Daily Fintech has been banging the drum for XBRL for a long time. We dedicated a whole week to XBRL back in August of last year.
For XBRL aficionados, please skip to the next section. For XBRL newbies, here is our 101:
- XBRL (eXtensible Business Reporting Language) is an open data standard based on XML, created by an accountant named Charlie Hoffman.
- If you tag content consistently, software applications can more easily analyze the data and present more useful information. Think of XBRL like a barcode on financial statements.
- XBRL gained attention after the Global Financial Crisis (GFC) in 2009 when the US SEC mandated that public companies report their financial results in XBRL. Many markets and regulators around world then also adopted XBRL and more have it under consideration. Although XBRL got famous because SEC mandated it for public equities, there are use cases and mandates in almost every asset class and every geography.
- For more research, go to XBRL.org
It was this superb article in Wired called Radical Transparency in the dark days of February 2009 in the thick of the GFC that first got me excited about XBRL. The usual analogy for the Global Financial Crisis was a heart attack. XBRL is like an MRI machine that lets you see inside to understand what is going on.
There was a simple design error in the SEC Mandate that explains why XBRL failed to meet expectations. The SEC said, first big companies must comply and small companies can do it a bit later. That was logical. The assumption was that big companies would find the burden easier. However it was a mistake because:
- Investors had no problem researching a few big companies. What they wanted (and still want) are efficient tools to research a lot of small companies. That is where there is valuation inefficiency that can be unlocked.
- Big companies had no problem with Investor Relations. They knew the Analysts and those Analysts took the time to cover them. By contrast, small companies need to be discovered by investors; it’s like a website that wants to be discovered by Google.
- Big companies had a lot of legacy processes. They had a long-established process for taking ERP data and turning it into HTML for investors and regulators. So they outsourced the work to meet the mandate to turn HTML into XBRL. It was all cost and no reward. If small companies had to comply from day one, they would have told their ERP vendors to output Inline XBRL (see below) i.e Straight Through Processing.
InLine XBRL is the technical advance that makes XBRL more useable:
- HTML = human readable.
- XBRL = machine-readable.
- – InLine XBRL = machine-readable + human readable in the same document.
Note: some machines can read HTML (badly) and some humans can read XBRL (badly) but machines prefer XBRL and humans prefer HTML. Inline XBRL enables ERP vendors to do Straight Through Processing (STP) from Accounting to Investor Relations and Compliance.
Why the Security Token wave will soon be coming to a surfboard near you.
The old adage, “if it ain’t broke don’t fix it” has a natural corollary – if is broken DO fix it. The Public Equity markets are broken in 3 ways:
- shrinking supply due to BuyBacks and BuyOuts.
- The crazy high hurdle to do an IPO means that it is only an option for something like 0.001% of new ventures.
- Very little real investing – trades are all about reading Central Bank tea leaves, HFT (High Frequency Trading) and naked short selling.
Once Security Tokens become legal, entrepreneurs will be able to offer equity in ventures that have liquidity without waiting 10+ years to get on NYSE or NASDAQ. That is fixing a big, big problem.
The public equities markets are broken and Blockchain offers an opportunity to fix them. That is why the Security Token wave will soon be coming to a surfboard near you.
Which platform and jurisdiction surfs the Security Token best remains to be seen.
Milestone Financing is the baby that got thrown out with the bathwater in the long hot summer of ICO
Traditional venture capital went through 4 basic Financing stages
- Pre MVP (Minimum Viable Product). Nobody wanted to finance this. So the only products that got built were simple apps that used SMAC (Social Mobile Analytics Cloud) platforms. This became so easy to do with open source and open APIs that the MVP could be built as a side project or funded by FFF (Friends Family & Fools) or using the bench of a software services business.
- MVP to Product Market Fit (PMF). In ye olden days, VCs funded this. Then angels funded this. Now nobody wants to fund this. “Show me traction” is the mantra.
- PMF to Scale. This is where VC like to play. If you have massive growth that needs capital, Wall Street West (aka Sand Hill Road) wants you. They write a check and then call their friends at Wall Street East (aka bulge bracket Investment Bankers who do an IPO or broker a trade sale.
- Scale to Liquidity. Appoint an Investment Banker to start an IPO process and issue a Press Release to that effect. Field the trade sale bids that come in and accept one if it is better than what you can get in an IPO.
This process put investors sitting on big pools of capital in control. Entrepreneurs did less well. Entrepreneurs spent too much time raising capital and success was largely driven by how good you were at that job (vs actually building and marketing a product). As the VC business grew big and professional, entrepreneurs kept on being told the bar had been raised:
“Come back when you have an MVP.
Ok, here it is.
Come back when you have PMF.
Ok, here is evidence from our early adopters
Come back when you have Revenue.
Ok, here are our metrics showing our Revenue
Come back when you have Profits
Ok, here are our metrics showing our Profits
Come back when your Profits are growing at faster rate.
Ok, here are our metrics showing our Q-Q profit growth rate
Ok, we are ready to invest.
No thanks, we don’t need you now.”
The sort of ventures getting funded through ICOs would never have got through that gauntlet. So we would not have Ethereum for example. In the traditional funding model, ventures with a risk profile as high as Ethereum (both technical and market risk) would have either not got funding through the traditional Angel/VC route or would have got $100k Seed and then fallen into the Series A Chasm due to lack of capital to execute properly. Then in 2017 we had the Long Hot Summer of ICO, when a new breed of ICO opportunist entrepreneur raised more money Pre MVP than ye olde entrepreneur used to raise in an IPO (Tezos, Bancor etc).
Some of these ICO opportunists may turn into real Entrepreneurs who build real products that solve real problems, take those products to market and make a profit. Or these opportunists may have to return the money thanks to class action lawsuits. The market jury (and maybe a legal jury) is still out on this one.
In short, the pendulum swung too far in the opposite direction. For Capital Markets to work, both issuer/entrepreneur and investor need to do well. In ye olde VC world, it was great for VC and lousy for entrepreneur. In Long Hot Summer of ICO it was great for entrepreneurs and lousy for investors. Security Tokens may get the balance right.
Why XBRL is essential to milestone based financing
XBRL is the best way to do portfolio construction and that is the best way to get investors into the flood of new Security Tokens.
During the Long Hot Summer of ICO, it was just about possible to track the new ICOs by watching a few sites. Today, with hundreds of ICOs a week, automated portfolio construction tools are essential.
XBRL has traditionally been used to track mature, profitable companies, but it is equally relevant to early stage ventures. Early stage investors want to know how they can track investments through all the different milestones:
- Pre MVP (Minimum Viable Product). Investors want to track metrics such as Use Of Funds and Burn Rate. The Uncapped raises are a thing of the past because investors won’t stand for a response along these lines – “we cannot tell you about Use Of Funds because we are simply going to raise as much as we can get away with”. Lets say an entrepreneur raises $2.3m for a Pre MVP venture (about 10x more than in pre ICO days but only 1% of what Tezos raised) and says 50% will go to Product Development, 30% to Marketing and 20% for G&A; investors will want track that.
- MVP to Product Market Fit (PMF). Investors still want Use Of Funds and Burn Rate. At this stage they also want Pre Revenue Metrics (downloads, page views etc).
- PMF to Scale and Profitability. At this stage investors want to track Revenue growth and the path to profitability.
- Scale to Liquidity. At this stage investors want to track in the same way as a public company, using earnings and cash flow multiples and comparables.
Doing that manually would be a nightmare. Investors need a simple dashboard that shows their portfolio by stage and with appropriate reporting metrics.
The smart regulation that will drive this change.
XBRL sounds like the Semantic Web, and we all know that the Semantic Web has faced the chicken-and-egg problem (i.e. not enough content is semantically tagged yet and so developers don’t create tools to parse the semantic data). Imagine a Semantic Web standard where regulators demand that they must tag data that way. That is the SEC XBRL Mandate.
Now imagine an XBRL Mandate built into smart regulation for Security Tokens. Like many people I hoped for a self regulatory code of conduct for ICOs and started an initiative like this on Fintech Genome back in May. The idea was “ICOS had value if done properly and the community must get its act together or we will get crushed by heavy handed regulation”. Many people contributed a lot of valuable thinking, but not much happened. Many months later, in November, you can sense the same frustration in this LinkedIn Group addressing the same issue. For example, see this thread from Fabio Ciucci and his post about an ICO Editor.
“@Bernard, I’ve hit the nail with the ico editor post perhaps, yet in the 40 days since I wrote it, of the 1981 people who have read it (and 292 clicked like), no one offered true and practical support yet, except Bruno. Everyone is doing his own “ICO rating agency” or “standard body” just for either collect fees as consultant, or boost the own ego as “it’s mine standard”. The whole point in the article itself.”
The only way I can see this coming to reality is via a Regulator that mandates it AND offers open source code help make it happen. The investment is small compared to the prize. The ICO Editor would include all the data that a reasonable diligent early stage investor would demand PLUS a commitment to use XBRL for reporting. The Regulator would then reach out to cloud based ERP vendors for SME and startups such as Xero and get them to support XBRL if they don’t already do so. The mix of carrot (investors will like it if you do this) and stick (regulators will slap you if you don’t) plus pragmatic help to make it happen would be very effective.
Bernard Lunn is the CEO of Daily Fintech and author of The Blockchain Economy. He provides advisory services to companies involved with Fintech (reach out to julia at daily fintech dot com to discuss his services)