By Carlos Domingo from Spice VC
A few days ago Yannick Roux pointed out a Twitter thread by Gil Dibner suggesting that “tokenizing a VC fund was a deeply flawed” thing to do. As you can imagine, for someone tokenizing a VC fund, that caught my attention right away. I read the entire thread and the few replies from people with interest. I have never heard of or met Gil Dibner before who is a VC himself but then I found out he had actually recently talked with one of my partners at SPiCE VC and has heard about our project. He does not mention us explicitly (although there are not many other people doing what we do out there except Blockchain Capital). Answering a tweetstorm is complicated so I am setting down my thoughts in this post. So here it is.
The main argument of Gil’s thread is that there is a reason for funds to be closed and private and to not have liquidity (he calls this a “feature” and not a “bug”) as that gives them the freedom to operate, take risks and “be deeply contrarian” and that funds only work because they are not democratic (I assume he refers to inclusive in the sense of letting more people to invest and not that someone else takes the decisions in the fund) and illiquid. He also argues that inclusivity for investments is already there due to equity crowdsourcing sites (Angel List, OurCrowd) and that liquidity is also available due to secondary trading of LP interests (so funds are already “buggy” then?).
In his thread he does not discuss the potential advantages but goes on to list the disadvantages or “features” of a PE/VC fund that will be lost when you tokenize it. Needless to say, I respectfully disagree. Let’s first review the “features” that you are presumably losing for tokenizing a fund and how much of that is true.
- A tokenized fund is still a fund (an organization established to manage an amount of money and invest it in multiple ventures on behalf of the fund investors) and you still get the portfolio effect (since a tokenized fund is still investing in multiple startups), there is no reason why you stop being a fund as a result of tokenizing it.
- There is also no reason for a tokenized fund to “stop taking calculated risks or to do investments that are deeply contrarian and/or difficult” as he discusses in his thread. The fact that the fund is tokenized has nothing to do with the fund investment thesis and the level of risks the fund will assume in its investments. In fact, due to nature of the investors that a tokenized fund will attract, I think that you will be encouraged to take even more risks on your investments than dealing with traditional LPs.
- A tokenized fund does not have to have ”less freedom to operate” than a traditional fund. In fact, due to the nature of the current light governance of the token model as opposed to the traditional shares model, I would argue that you will have more operational freedom with a tokenized fund than a traditional fund. Also, the fact that your investors have liquidity, allows you to take a much longer term view, if needed, in an investment since the pressure for liquidity of the LP interests is not there anymore. They can exit when they want to.
- “Democratization of investments has been around due to existence of crowdfunding sites like AngelList and OurCrowd.” Yes, equity crowdfunding has brought to the masses investing in startups and has been widely successful. However, with crowdfunding sites, you do not get the portfolio approach that Gil initially defended as an important feature of a fund. The other issue is that rounds on series A and above are typically not available to regular investors since crowdfunding sites are focused on seed deals and those investments are restricted to traditional LP investors in VCs like family offices or mutual/pension funds. A tokenized fund is, in some sense, the evolution of crowdfunding for individual startups but rather than investing in a single or few startups and without access (most of the time) to proper due diligence, besides what you can read on the crowdfunding site about the company, you invest in a portfolio approach from professional investors so you are reducing the risk of failure. The likelihood of an investor making money in a single company versus in a fund is very different. And you can also get exposure to investments in later VC rounds like series A and beyond.
- “Liquidity has also been around for a long time. There has been a robust secondary market for years for pvt companies equity and LP stakes”. Liquidity is not a black and white concept, it is a continuum. If you own a Picasso (art is known to be a very illiquid market) and you want to sell it, you just need to lower your price sufficiently enough till you find a buyer. Same applies to secondary liquidity for LP interests when your contract actually allows you to sell. I am an LP in two funds in Spain and both explicitly prohibit me from selling my LP interests except to the GPs which have very little incentive (or money) to actually buy me out I wanted them to. As far as I know and from the research I have done (doing a quick search on Google does not show much information about the topic as you can see below), I fail to see that there is any meaningful secondary market for LP interests in funds.
- “It is disingenuous to argue that it makes sense to tokenize a fund in the name of democratization or liquidity while charging a fee for investment judgement and portfolio construction”. So Gil is arguing that GPs in tokenized funds should work for free because their fund is more inclusive to other investors and provides them with liquidity. Extending his argument, perhaps Larry Page or Tim Cook should also work for free for their companies given that they also provide inclusivity and liquidity to Google or Apple investors after they did their IPOs. I think that everyone should be adequately compensated for their work and the value they bring to their investors, whether you are a GP in a traditional fund or in a tokenized one.
- And his final remark: “If democratic, liquid vehicles could provide VC-PE style returns, we’re all be millionaires”. The type of returns a tokenized VC/PE will bring, will largely depend on the ability of their GPs, like in a traditional fund, to pick the right investments, help them grow and exit on a timely manner. If anything, liquidity can improve returns and not the opposite. First, you can exit the fund after, let’s say, 3–4 years rather than 9–10 greatly increasing your IRR if the NAV has grown sufficiently by reducing the investment period. Second, liquidity has a premium (the same way that illiquidity has a penalty) in terms of price so a liquid fund should actually be more valuable.
Advantages of tokenizing a fund
Now that we have argued about the lack of disadvantages that were the focused of Gil’s thread, let’s review the advantages that he failed to discuss. The main one is obviously liquidity. As Mahendra Ramsinghani said in his book “The business of Venture Capital”
“A VC partnership is a 10- year blind-pool — a long relationship in which investors have limited ability to exit, and no clarity of outcomes”
A typical Venture Capital investment curve will look like the one below. A negative IRR for 5 years and (hopefully) starting to get some returns after year 5 but only really starting to make a meaningful return between years 7 and 10.
In a recent interview David Sacks from Paypal, Yammer and Zenefits mentioned the following:
“LP interests are likely to be tokenized. The prestige VC firms will resist this, but there are already a few new VC firms at the margins that are tokenizing. Soon, a few more will do it. Then a few more. Eventually, illiquidity will be a competitive disadvantage in fundraising that only the top firms will be able to justify.”
Another well known VC that has been outspoken about the challenges of liquidity in traditional venture capital is Tim Draper and when he announced his investment in Bancor (which we have partner with to provide liquidity for our VC fund) he went as far as saying that:
“We are beginning to explore the possibility of issuing a VC Token for our diverse network of investors, entrepreneurs, local and global businesses. We’d like for this to be a Smart Token, so it can benefit from continuous liquidity from day 1.”
We agree with those statements and we think that when providing liquidity to a VC fund becomes the norm and not the exception a non liquid VC fund will have a hard time justifying themselves in front of their investors. So tokenizing a VC fund is a big deal since you solve the number one problem of this industry and the reason why it continues to be a small asset class compared to other financial instruments.
As Yannick Roux had mentioned to me and he remarked here, you do not need liquidity from day one in a VC since the value of the underlying asset of the token (the NAV of the fund) should not change overnight. It will require a few years to do so as you deploy capital and those investments appreciate in value. This is true and you might attract the wrong type of investor looking for a quick turn around. However, given that is also not easy to decide since when you start providing liquidity and everyone’s needs might be different, we have decided to implement the Bancor protocol to create a decentralized exchange from day one. This will provide some limited liquidity first and subsequently we will start adding our token to equity token exchanges to increase the liquidity as we approach subsequent years when we expect that more investors will want to start looking at this option.
Besides the liquidity aspect, a tokenized VC has other advantages, namely
- Inclusivity (or what Gil’s refers to as democratizing a fund). Yes, once you eliminate the long term commitment to your capital and provide liquidity, you also access new capital and investors that would have never invested otherwise in a non liquid VC fund due to the inherent risks of illiquidity. Also the fact that you can crowdsale the fund raising (primarily restricted to accredited investors since a fund token is a security) it also means that you can reach out to more people and it is the equivalent of equity crowdfunding for startups but for funds.
- Managing many LPs. By issuing tokens and managing the fund digitally (from the investment and onboarding process to the exit proceeds distribution via smart contracts), you can afford having thousands of LPs/token holders, something that under the normal paper and bank based fund will be impossible without drowning in bureaucracy.
Tokenized funds vs publicly listed funds
So one can argue, if liquidity is so good, why not just list a fund like Draper Esprit? In fact, Yannick Roux asked Gil Dibner twice on Twitter. His answer to this very legitimate question was to point towards the very succinct and questionable Wikipedia page of a company called ModusLink. Without understanding much this cryptic message, our opinion on the question asked by Yannick Roux is the following. First, yes, a publicly traded funds attempt to solve the same problem, providing liquidity to its investors so they can take a longer term investment view since they do not have to worry about exiting investments to provide liquidity to investors. However, IPOing a VC fund (like IPOing a company) is a complicated and expensive process not readily available for everyone. The same way that ICOs have brought a new way of fund raising for companies and provide liquidity to its investors, tokenizing a fund is a new and alternative way of doing it that is much easier, faster, cheaper and democratic.
By now, we have talked to dozens of LPs and investors in VC funds and there has not been a single one that does not acknowledge that liquidity of VC investments is the number one problem for more capital to be deployed into that asset class. The current VC model has basically not evolved since the 1950s when it started. The argument of not changing something because it has always been done this way is flawed. VCs invest in companies that are precisely trying to disrupt the status quo but should not be fighting against being disrupted themselves. We hope that by bringing liquidity to LP interests in VC we will actually increase the amount of money that is invested there and therefore make the overall VC industry bigger which in turn should benefit the entire startup ecosystem.