Bernard Lunn is a Fintech deal-maker, investor, entrepreneur and advisor. He is CEO of Daily Fintech and author of The Blockchain Economy.

Conventional Wisdom (CW) says that early stage equity will crash the hardest when the next crash happens. The CW logic is simple – crashes lead to risk aversion and nothing is more risky than early stage equity. The CW logic is impeccable but this post will describe some contrarian evidence from 2009, as well as the theory behind that evidence and what that tells is likely to happen in the next crash and what this means for Defi, ICO, IEO and STO.

Contrarian evidence from 2009

The last great financial crash was after Lehman collapsed in September 2008 (aka the Global Financial Crisis or GFC). Nobody knows when the next financial crash will happen, what will trigger it, how big it will be – although you will see plenty of opinions on all those subjects. What is extremely likely is that we will see another crash at some point.

The current bull market has been called the everything bubble because the value of all assets has been inflated by all the monetary stimulus from central banks around the world.

The question is whether early stage equity crashes hardest. That is the question I was asking in January 2009, in the depths of the bear market after the Lehman collapse, when I was Chief Operating Officer of ReadWrite. It was a practical question as we were writing about early stage tech startups.

Anecdotally from both founders and investors we were hearing that CW was NOT true and that early stage equity funding was holding up surprisingly well.

So we decided to track the data and it confirmed what we were hearing anecdotally. Here is the post from 2009, showing Series A financing growing strongly in those dark months:

• January: $30.3 million
• February: $45.5 million ($15.2 million, 33%)
• March: $55.7 million ($10.2 million, 18%)
• April: $73.7 million ($18.0 million, 24%)
• May: $178.2 million ($104.5 million, 59%)

So much for practice what about theory?

When practice is at odds with theory, I look for a new theory to explain the facts (yes, the scientific model works!). Why is it logical that early stage equity, the most high risk asset class, should grow strongly when investors were selling lower risk assets at fire sale prices? The reason is very simple – “it takes seven to ten years to get to real liquidity in a portfolio of early stage venture investments”. During those 7-10 years it is likely there will be another bull market.

For a more visceral glimpse of what it was like in those dark days, read this (it has some good advice for entrepreneurs, in a simple 10 point list, with no 8 reproduced below)

Start your most audacious venture now.

“8. Start your most audacious venture now. This is counter intuitive but real. No VC will back a small plan. They never have in the past and won’t now. When the world changes in big and fundamental ways, big and fundamental opportunities arise. Ten years from now it will be obvious what those fundamental changes are. Great entrepreneurs spot one of those trends before it is obvious. The beauty of a big and audacious plan is the next few years won’t matter to you. Build in tough times, launch when the worst is over, exit when it is boom time again.”

Any shred of business as usual won’t cut it.

One theory of what asset class will crash the market

Although I wrote above that “nobody knows when the next financial crash will happen, what will trigger it, how big it will be” I will now prognosticate on what will trigger it.

What we observe by looking at two recent crashes – in 2000 and in 2008 is that the “the epicenter of the current crash is the exact opposite of the last crash”:

2000 = Dot Com public equities aka about as high risk as you can get. This was seed level companies doing Series C type financing to public investors. To ratchet up the crazy dial you have to go to ICOs in summer 2017. 

2008 = real estate/property ie “safe as houses” compared to those ridiculous  Dot Com public equities. 

People investing now have visceral memories of both crashes. So although the everything bubble has inflated all asset prices, some such as public equities and real estate/property are not the most bubbly (although bubbly examples exist in pockets of these markets). Memories of the last two crashes prevent these markets getting back to bubble status.

Bubbles grow based on a sure thing fallacy that cannot be contradicted by looking at the two last crashes. 

Today, the sure thing is technology private equity. By using the word “technology” we get away from that ridiculous dot com stuff (ahem, they are the same thing). More importantly today’s bubble is in private equity run by super smart masters of the universe and funded by the ultra wealthy. The poor dumb muppet retail investors in the public equity markets, are not allowed to invest in exclusive Private equity.

For recent evidence of this bubble, look no further than the WeWork Softbank saga.

Public private inversion and the WeWork Softbank saga.

The saga is well known – from a $47 billion valuation to a possible bankruptcy. Click here if you don’t know the story.

This shows the public equity markets acting rationally; they rejected the $47 billion valuation fantasy. However, this does show bubbly craziness in the private equity markets.

The reason for fantasy in private markets is simple – there is no shorting to act as a pricing discipline in private markets, so fantasy mark to model valuations prevail.

Of course if you got in early, you may do well on WeWork. For example, Benchmark invested at a $97 million valuation  (yes million not billion).

The WeWork/Softbank saga shows how crashes in private markets take place behind closed doors in what we use to call smoke filled rooms. Crashes in private markets are different. Due to lock-ins, the Limited Partners will not be able to sell, so this  price discovery mechanism is broken. As you cannot short private stock, this price discovery mechanism is also broken. So the PR fantasy valuations may stay a lot longer than would happen in open markets. When a private market crashes it will be the end of the public/private valuation inversion which we first wrote about in 2016.  

Expect to see lots of pictures of unicorpses or wounded unicorns.

Implications for Defi, ICO, IEO and STO

The crypto world already had a recent crash, in 2018. The ICO (Initial Coin Offering) mania, which was too easy on entrepreneurs but lousy deal for investors gave way to a permissioned process where the big crypto exchanges act as gatekeepers called the IEO (Initial Exchange Offering). Top tier crypto exchanges do about as many deals as top tier VC in the legacy finance world. Entrepreneurs using IEO are swapping one gatekeeper for another.

Meanwhile, there is an ecosystem building on the Ethereum platform called DeFi (for Decentralized Finance). Within DeFi is early stage equity released via STO (Security Token Offering). STO is like ICO in that it is permissionless process. Unlike ICO, an STO offers investors a real economic benefit within a regulated environment.   

STO gets the balance right –  protecting the interests of both entrepreneurs and investors.

The DeFi space is building fast and a visible failure of the legacy finance world  during the next crash will lead to more positive momentum for DeFi. Part 1/Chapter 2 of The Blockchain Economy, entitled Layer 3: Creating the Blockchain Market Infrastructure at Light Speed, covered this space before the term DeFi was popularised, and included this introduction:

“Legacy Finance took centuries to build, while the Market Infrastructure for the Blockchain Economy is being built at hyper-speed over one or two decades. At that hyper-speed, there are bound to be some accidents. Those invested in Legacy Finance are publicly trash-talking the disruption, while investing quietly to be a player in Blockchain Finance. We have lived with Legacy Finance for so long that it is hard to imagine a real alternative. So in the first iteration, Blockchain Finance will look a bit like a version of Legacy Finance (like the talking heads era when TV imitated Radio).”

The IEO approach to early stage capital raising is like the talking heads era of early TV. What is emerging from the STO wave of change is an ecosystem of companies addressing 4 types of need:

• A safe place to store/custody assets. Without this, investors will rightly feel too nervous to participate. Many companies are working on this.

• Credit/Lending. This is an essential tool of any financial system and is starting to get traction in DeFi.

• Quality Filtering for investors. It should not be Exchanges who are the only filters/gatekeepers. The market needs independent buy side reports that help investors filter the assets that fit their needs.

• Liquidity for exchange matching and settlement. Just doing an STO ensures easy tradeability, which is a good start. Only when we get the first 3 will we get liquidity, which is the real end goal.

In an IEO, a crypto exchange tries to do all four. The DeFi/STO approach of building an ecosystem of companies competing to provide each of these services takes longer but is the more secure and scalable way for DeFi to replace legacy finance and for early stage equity via STO to thrive.

The big benefit of Blockchain based trading is that exchange and settlement happen at the  same time – eliminating all the cost and risk in the time gap between trading and settlement. However that is also useless without the liquidity that will come as this ecosystem develops.

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