Venture Capital - Structuring solutions and Tokenisation
This article explains the main challenges Venture Capital Managers face, possible financing solutions and additional advantages which Tokenisation can offer
Venture Capital – Challenges
Venture Capital is long-term financing given to startup companies seen as having growth potential. They however face several challenges, including:
1. Raising enough capital – The majority of VCs, particularly the small and/or newly established ones, struggle to raise financing, particularly if they do not have a track record or are not materially out-performing the market. The industries and markets of the 21st century cannot be powered by last century’s financing routes and those VCs which will not adopt new forms to raise finance, will start losing relevance, cost advantage, differentiation, and market dominance;
2. High minimum entry levels – VC are mostly sold to U/HWNIs, investment banks and institutional investors and when they are also open to investment by smaller investors, they are usually more expensive, and the minimum investment is usually above Eur100k;
3. Exit opportunities – VC have lack of exit opportunities and this is cascaded on to their investors who are usually asked to commit for 10+ years;
4. Keeping money after exits – This is not always easy, unless the returned IRR was materially above the market and the same is also expected of the new project.
VC can be structured through different vehicles including investment funds and securitisation vehicles and their issuance of the financial instrument can be tokenised.
VC Funds – Tokenisation
In VC funds, the General Partners will be contributing the seed capital, with the bulk of finance coming from the Limited Partners. In some countries, such as Luxembourg or Malta, the same result is usually achieved through SICAVs (PIFs, SIFs, AIFs, other) having share classes on which distinction can be made on voting and profit participating.
The GPs will search for the best investment project buys whilst the LPs will commit to deliver a contracted amount of capital when needed by the project. When the investment project is sold, proceeds are usually returned to investors, and if the return was good, the LPs would hopefully be an easier target for subsequent investments. This is a very competitive market in which GPs are continuously competing to find the right projects, retain existing investors loyalty and raise the necessary capital needed to finance the projects at the right time to maximise IRR.
The above is a simplified flow explaining a VC Fund Tokenisation. Various other structured are possible this depending on factors such as type of investors, underlying assets, financial asset being issued and so on.
Projects are usually wrapped into one or more SPVs (depending on type of assets) which are subsequently invested in by the VC Fund. At the same time, the VC Fund will be calling for the necessary capital from investors through a Token issue. Such tokens would become tradable on the secondary market and can be bought or sold by other investors, this rendering the issue a liquid one.
Securitisation - Tokenisation
Apart from a fund structure, other routes are possible, these including Securitisation Vehicles. In Malta these SVs are also allowed to have compartments (called Cells) with separate balance sheets and income statements. These Cells will own the assets being securitised on one hand and issuing the token from the other.
In general terms, Cells can provide a similar operational result to that of a Fund and private placements are usually a cheaper option. Each Cell is limited to one originator and are thus particularly attractive when there is an entity seeking capital and such finance can come from a defined class of investors which are willing to invest only in that originator and / or project. Cells are not as flexible as funds in terms of underlying originators and will thus pose a concentration risk to investors.
Tokens - Advantages
Tokenisation of securities can offer various advantages, including the following:
Stage 1: Selling to Investors
Tokenised securities (in the form of equity, bond, other) are easier to sell on the primary market since they become tradable on a secondary market and investors are not constrained to hold the investment till exit date, which could be 10+ years;
Tokens sold on the Web portal, particularly when the volume is material, are cheaper than selling illiquid shares in a VC through roadshows and/or paying brokers’ commissions in the tune of 5%;
Programmable securities can be designed to allow wider investors groups’ reach, potentially at materially lower cost when compared with high-street selling;
Issuers of such tokens are in effect issuing securities from their company and are therefore legally and regulatory bound to security holders. Much like traditional investment contracts, investors can receive an asset-backed token in return for their investment with the attached rights and obligations as specified in a prospectus;
Tokens require compliance with established laws and regulations and thus the potential for scams is drastically reduced, particularly when using the right vehicle, contracts and jurisdiction;
The process of issuing Tokens is cheaper and easier than issuing equivalent IPOs;
Multiple jurisdictional sales to investors is simplified;
Blockchain technology can render the KYC and due diligence process more efficient and thus cheaper;
Should the issuer want to include crypto currencies as an acceptable currency from investors, this can also be done thus increasing the potential client base.
Stage 2: Life of the VC Fund or SV:
DLT technology will be used to enhance pre-trade information and the matching of token buyers and sellers on the secondary market;
Fund managers will benefit from an exchange trading whilst keeping the private status advantages;
Smart contracts will automate processes, such as corporate actions. Apart from reducing the operational costs, this will help fund managers in their cash flow projections and management;
Dividends can be paid without buy-back, particularly using stable coins, and this can be done in an automated way and without exchange risks;
Ownership recordation is automated;
On-going due diligence is automated;
Physical contracts, registry or transfer agents and most reconciliations are reduced or eliminated.
Stage 3: Exits
The exit stage can be in one or various tranches depending also on the number and type of projects. Once a project is exited, the manager will need to decide whether the proceeds can be utilised on other projects or not. If there are such investment projects and he is contractually allowed, such proceeds are reinvested. This algorithm can be pre-programmed in the smart contract;
If the manager is limited to return the exit proceeds to investors, these will be distributed back through token buybacks. Such buybacks can be done either by having the fund buying back a proportionate rate of tokens from each shareholder or else buying the necessary tokens from the secondary market. The second type of buybacks could result in additional advantages such as increased liquidity and an option on investor whether to retain or sell, however this could only be a fair alternative if investors have the necessary information for a decision.
Real estate occupies a large chunk of wealth and consequently is also a natural candidate for tokenisation. Most real estate projects lack liquidity, have a long lock-up period and are not a very accessible investment. Valuation of real estate is however generally simpler than VCs since usually there are comparative similar assets being bought and sold and information is more readily available.
Real estate projects, particularly the development ones, are usually of a high-risk nature. Such risk can however be mitigated in various ways including wrapping the assets in the right structure, risk spreading on multiple projects, having a series of credit enhancements such as equity investment by (the developer to finance the riskiest part of the project), guarantees, insurances, and others. A credit rating would in some cases also add value. The resulting token could thus include such risk mitigants whilst also having the advantages explained earlier. This topic will be discussed in a separate dedicated article.
Jurisdiction for Token Issuance
The jurisdiction from which to issue the security Token is quite important in that it will also influence its marketability. The following are amongst the factors to consider when choosing the jurisdiction:
Technology-friendly government policy - governments which harnessed blockchain, digital assets and tokenised securities will have the necessary blockchain legislative framework to work on;
Established financial legislation – Security Tokens are governed and regulated by existing laws and regulations, and some countries would go the extra mile in extend and adapting such legislation to allow for the necessary changes related to digital ledger technology;
Fiscally friendly environment – taxation is one of the main costs and can wipe out 20% or more of issuer’s profits, in some cases approaching a total 50% in the hands of investors. It is thus important to manage taxation, including on: (a) investors’ subscriptions, liquidations, income and capital gains; (b) service providers, including the issuer, promoter, asset manager or investment adviser; and (c) the vehicle which is holding the assets backing the token.
Approachable and knowledgeable Regulators – there are jurisdictions with a reputation for having an accessible Regulator who welcomes a consultation with them at the planning stage and remains open for further discussions during the licensing process. Blockchain is a relatively new area, and approachable Regulators who can provide guidance when needed and who are not there just to rubber stamp issues are the ones to look for;
Good reputation, consistency and ability to quickly adapt to changing needs and technology.
For further information please contact Fiduscorp:
Mario Buttigieg - Managing Director
Email or Skype: email@example.com
Tel or Whats App: 00356 99829824
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