Could security tokens offer a lifeline to early stage companies?

In recent years, seed/early stage deals have been drying up. Security tokens could provide a lifeline to startups that depend on this capital
John Wu
CEO, Digital Assets Group

We are clearly living in the era of the unicorn, emerging growth firms worth at least $1 billion. Thanks to an influx of cash from mega venture capital funds and institutional investors like mutual funds and endowments, unicorns like Uber, Palantir, and Airbnb already enjoy big valuations even before going public.

But this largess comes at a cost. Even as investors shower cash on late stage unicorns, startups looking to raise seed and Series A capital have noticed fewer takers. Goes without saying that that we need early stage firms to survive and develop before they can grow into unicorns and IPOs.

Security tokens could provide a lifeline to early stage startups. These companies can raise money from a broad pool of investors without having to haggle over complicated term sheets with venture capitalists and give up enormous amounts of equity in the process.

Since security tokens represent one of the most exciting innovations to emerge from cryptocurrencies and Blockchain technology, STOs represent a more credible alternative for startups to raise capital versus crowdfunding platforms like Kickstarter and Indiegogo. Institutions like Goldman Sachs and Yale University have already expressed interest in this emerging digital asset class.

Where are the early stage investors?

In recent years, seed/early stage deals have been drying up. In the third quarter of 2015, such companies closed 970 deals, according to the MoneyTree report from PricewaterhouseCoopers and CB Insights. Three years later, the number of deals fell 43 percent to 554 deals during the third quarter of this year.

However, the number of dollars raised has increased during this time period. Therefore, the data suggests that investors are pouring more money into a fewer number of companies.

We might already be witnessing the repercussions. Of the 1,098 tech companies CB Insights tracked that raised seed rounds in the United States from 2008-2010, less than half, or 46 percent, managed to raise a second round of funding. Only 14 percent of these companies went on to raise a fourth round of funding, which typically corresponds to a Series C round.

Another CB Insights analysis of failed companies finds that a lack of cash is the most common reason why startups die behind a lack of market for the company’s product or service.

Investors flock to late stage unicorns

Of course, early stage companies typically see a high failure rate. But the data shows a corresponding and significant shift of investor interest into later stage companies and unicorns. Investors have flocked to these companies because they are much more developed, on the verge of an IPO or acquisitions, and therefore less risky than early stage firms.

As a result, we’ve seen the emergence of both “private IPOs,” single funding rounds of at least $100 million, and unicorn funds armed with at least $1 billion in capital.

In 2009, only one such fund existed. Over each of the last 24 quarters, an average of 1.6 unicorn funds has emerged, according to SharesPost research.

Eight years ago, only 8 percent of total capital raised originated through unicorn funds. In 2015, the number jumped to over 27 percent. Over the last 12 months, unicorn funds accounted for 16 percent of total funds raised.

So we’re more likely to see more unicorns minted over the next few years, even as the economy slows. Today’s current crop of 285 unicorns around the world boast a cumulative valuation of $875 billion.

Security tokens offer an alternative source of cash to early stage firms

But we can’t neglect early stage firms, some of which will grow into the next Ubers or WeWorks over the next decade or so. Furthermore, China last year surpassed the United States as the world’s top producer of unicorns. We need to keep the U.S pipeline strong.

Congress seems to have already recognized the problem. Earlier this year, the U.S. House of Representatives passed a bill that authorized the creation of “venture exchanges,” in which Main Street investors can buy and sell securities in early stage companies.

In other words, security tokens.

Such an asset presents companies and investors with some distinct advantages. For investors, they won’t need to wait the 10-15 years a venture capitalist typically waits to see a return on their money. They can sell their tokens on the open market just like any stock.

Companies can get quicker access to a deeper pool of liquidity around the world and bypass venture capitalists, a small, elite group of investors that have traditionally enjoyed a monopoly on funding tech startups. Selling tokens to the broader market might help neutralize the power of VCs who typically require lucrative shareholder rights in exchange for their money.

But there are challenges. Selling security tokens would significantly complicate the ownership structure of a company, which raises important questions about corporate governance.

In addition, venture capitalists not only provide money to startups but also valuable expertise and connections to potential distributors, advisors, and executive talent. Venture capitalists might not want to invest in companies that have already sold security tokens to the general public.

Nonetheless, any new funding mechanism that can help companies survive the perilous days of a high risk, early stage startup is a welcome thing. And that includes security tokens.