This is chapter 5 in The Blockchain Economy serialised book. For the index please go here.
VCs typically back ventures that disrupt artisanal models via networks. It is not lost on fans of irony that VC partnerships, remaining small by design, are the poster boys for artisanal models in the digital age.
As champions of tech-driven change, VCs can hardly emulate the original artisans who resisted tech-driven change – the Luddites in Victorian England scared that factories would disrupt them. VCs may prefer the status quo and will certainly work hard to convince their LP customers that this blockchain stuff is not going to impact their business. At best this is a delaying tactic until even conservative LPs see that the world is changing. The world is changing because the other customer of the VC – the entrepreneur seeking funding – knows that funding via blockchain based technologies (whether ICO or TGE or Equity Tokens) is very real. Entrepreneurs want incumbent VC funds to have more competition.
The idea of Internet disrupting VC has been forecast for so long that it is tempting to take the Eeyore point of view that nothing will really change, that the status quo will always prevail. This post will argue that real change is happening by describing what happened with two earlier waves of change:
- Wave 1 = Networks of expertise and Wave 2 = Crowdfunding and Follow Model.
The post then goes on to explain why the current Wave 3 = ICOs and TGEs (Token Generating Events) builds on the first two waves and why this wave is the real game-changer.
Then the post looks at the big driver for VC returns and how Token sales reduce technical, market, portfolio and macro risk
Finally we will look at how the VC business will evolve to deal with this disruption by changing the revenue model from 2 & 20 to 0 & 30 and some second order impacts of this change.
Wave 1. Networks of knowledge and expertise.
10 years ago, with the Internet and social media already mainstream, pundits argued that all the knowledge needed to be a VC was already out in the open web and you could assemble the experts needed to evaluate an investment using social media. That turned out to be wrong for three reasons.
- Problem 1: knowledge not insight. The value hierarchy is data to knowledge to insight. The data was mostly open/free and VCs and other experts shared knowledge, but the real insight – pattern recognition of what makes a great investment – stayed within the small VC Fund partnerships.
- Problem 2: no simple monetisation for experts. VCs know one thing – how to spot and nurture a great investment. They are not functional or domain experts. So they built networks of experts and could bring a lot of business opportunities to those experts. Without a VC directing that opportunity flow, so that the experts could make money from their expertise, the experts remained peripheral.
- Problem 3: risk management. Despite conventional wisdom, VC returns are largely about risk management – avoiding bad deals and getting out fast when they go wrong. VC GPs could argue – based on a strong track record – that adding a new-fangled investment approach would only increase risk. To conservative LPs, the big funds look like low risk. This is where ICOs and TGEs are a real game-changer (see later for why).
Wave 2. Crowdfunding.
The biggest of the crowdfunding networks – Angel List – fixed Problem 2 perfectly via share of Carry and partially fixed Problem 3 via Syndicates.
By fixing Problem 2 – monetisation – it also created an incentive to move up the value hierarchy to insight. Sharing insight is one way to a) get good qualified deal flow b) get investors to follow your deals (so that you get “carry” fees). Look at one of the best VCs – Fred Wilson of Union Square Ventures – who has been sharing insight every day for more than a decade via his blog (AVC). Aspiring VCs who get carry from followers want to show insight to augment their track record.
Wave 3. ICOs and TGEs. The current wave.
This is enhanced crowdfunding. The single innovation is almost-instant liquidity. Despite what GPs tell LPs, liquidity matters even for sophisticated investors. The reason is portfolio risk and macro risk – see below:
Managing Risk: How Token sales reduce technical, market, portfolio and macro risk
- Technology Risk. If a venture has technology risk – think something like Ethereum but also most BioTech and CleanTech – it helps if those with the tech smarts to evaluate that risk vote with their wallets by buying the tokens.
- Market Risk. VCs like to invest Post Product Market Fit for good reason – this is where most ventures fail. If potential customers pre order through a Token sale you know that demand is likely to be high.
- Portfolio Risk. Investors need a big enough portfolio, with enough diversification across domain, stage, geography and macro cycle. LPs get diversification by investing in Funds. The bigger the fund, the more diversification. With a cambrian explosion of innovation around Blockchain funded by Token sales, investors can assemble their own portfolios or follow somebody who shows expertise in portfolio construction. Tools for portfolio construction is an evolving area of innovation. Angel List Syndicates are a crude form of portfolio construction by following all deals from one investor. More sophisticated tools will allow construction by domain, stage, geography and macro cycle.
- Macro Risk. Look at VC fund returns and it is obvious that Macro timing matters. A 2002 or 2009 vintage does better than a 1999 or 2007 vintage for example. The simple reason is that entry valuation does matter. if you are investing at the late stage of a macro cycle (as we are at end 2017), the ability to sell early matters. “Dry powder” for the next stage of the macro cycle is critical. So while cash is a lousy investment (it does not beat inflation) it has huge optionality value (you have the option to invest in a great deal because you have the cash). So the ability to exit (to get liquid into cash) has huge value even to sophisticated investors.
Revenue Model:goodbye 2 & 20, hello 0 & 30
VCs often ask entrepreneurs – what is your revenue model? If you ask a VC for their revenue model, you might hear about 2 and 20; this is 2% of Assets Under Management (AUM) plus 20% of the “carry” (aka profit from investments).
The 2% AUM fee motivates VCs towards big funds – 2% of a $1 billion Fund is $200m per year before making any profitable investments.
The VC process has 2 basic first steps:
Step 1: Gather Assets (Pitch LPs)
Step 2: Make Investments.
The crowdfunding follow model reverses those 2 steps:
Step 1: Make Investments (with your own capital)
Step 2: Gather Assets (by inviting passive investors to follow your deals)
In the crowdfunding follow model there is no need to charge an AUM fee. There is no need for the 2 in 2 and 20. As the ability to pick good investments will always be prized you can charge more for carry/profit share. That is why we believe that 0 & 30 will be become the norm in future.
Deus Ex Machina – Carried Interest Tax reform
Today the 20% Carry fee is taxed at the Capital Gains Tax rate, not the Income Tax rate (which is considerably higher in most jurisdictions). Many argue that Carry is a risk-free fee for service that should be charged at Income Tax rates.
This is likely to change. The reason is politics. Politicians who want to tap into populist rage about inequality will find a way to present this rather wonky subject in a way that resonates with “sticking it to the man”.
This will accelerate the transition from 2 & 20 to 0 & 30. A Partner who leaves VC Fund Brand X and invests his/her own capital (more he than her in practice but that is another story) tells other investors:
- Here is my track record at VC Fund Brand X.
- I have left VC Fund Brand X and will be investing my own capital.
- You are welcome to follow my deals. If so you will pay me 30% of any profits (what we used to call Carry).
So he/she then gets taxed on gains on his own capital and the carry fees are “icing on the cake” that is taxed at a higher rate.
If your Hammer is Capital, then Capital Efficiency is bad news
Funds with a lot of Capital want ventures that need a lot of Capital. Capital efficiency is good in theory but not in practice. Capital efficiency is increasing at three levels:
- Tech. The cost to build a product has come down dramatically, as is well documented, thanks to open source, cloud and APIs.
- Marketing cost. See that hockey stick graph in the picture at top of this post (from Kauffman Foundation)? Thanks to social media and more than 50% of the world having a mobile phone, this is possible.
- Server costs. The VC game plan that worked brilliantly for a long time was wait until you see that hockey stick, then invest so that the entrepreneur can buy servers. Think of Peter Thiel investing in Facebook. In P2P dececentralized networks these costs are minimal.
Don’t Cry For Me Argentina
VC Funds have had a very good ride. Partners who leave to invest their own capital are already hugely wealthy and by making the transition to this new world will become even more wealthy.
However it is likely that startup VCs will move straight to the new 0 and 30 model. Investing before a Token sale can be a great deal as there is less risk of being “crammed down” by big Funds coming in later. A Token sale is non-dilutive.
In summary this is good news for entrepreneurs, harder work for investors but lots of opportunity for those who ride this wave. It is particularly good news for entrepreneurs and their families who do NOT live in Silicon Valley as “moving to the Valley” is no longer the only game plan.
Sources and references for further reading:
The Kauffman Foundation does a lot of great research and analytical work on the changing dynamics in the VC business. The image at the top of this post comes from them. The post I linked to is about VCs moving down the maturity ladder to seed.
A startup VC that is embracing ICOs and TGEs
You can reach out directly to discuss our advisory services by sending an email to julia at dailyfintech dot com
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