The rise of the crypto economy has brought promises and perils to the venture capital industry. By mid-2017, initial coin offerings (ICOs) had surpassed angel and venture capital funding as a more efficient and less costly method of early-stage financing for blockchain tech start-ups. In addition, crypto-assets have become a new investable asset class that is uncorrelated with any other asset class and is highly liquid.
There are various reasons why entrepreneurs and investors prefer ICOs over venture capital. First, ICOs are less costly than venture capital in raising finance from the public, in part because ICOs are conducted online and without any intermediary between the investors and the fundraisers. By contrast, entrepreneurs have to present their business ideas to a substantial number of venture capitalists (VCs) and go through several rounds of negotiations before obtaining venture capital. Furthermore, the online medium by which ICOs are conducted allow start-ups to raise funds from global investors, thereby eliminating geographical constraints and reducing transactional costs. In contrast, venture capital investment is typically geographically confined, which restricts start-ups’ access to funding should they not be situated in a venture capital-rich area. Second, ICOs are more liquid than venture capital. Investors may potentially get quick returns on their crypto-asset investment given the flexibility with which they can exit the market.
Beyond the threat of replacement, distributed ledger technologies (DLTs) also offer new investment opportunities to VCs. Traditional VCs are gradually diversifying their portfolios to include investments in crypto-assets and blockchain tech projects, and have also begun launching crypto-centric funds. Simultaneously, venture capital funds are developing various hybrid financing models to adopt and imitate the fundraising mechanism of ICOs. However, the polymorphous and evolving features of crypto-assets also introduce new risks to the venture capital market.
Current academic literature has mostly focused on the regulation of ICOs or economic comparisons between venture capital and ICOs. Hence, there is an academic lacuna around the problems and risks that arise from VC’s involvement in the crypto market from a legal perspective.
Our forthcoming paper entitled ‘Venture Capital in the Rise of Crypto Economy: Problems and Prospects’ seeks to fill that gap in the literature by examining the emerging models in the venture capital crypto landscape, identifying new risks, and examining the efficacy of current regulatory and contractual solutions in mitigating the risks.
Part II of the paper discusses the interaction between venture capital and the ICO model. It shows that venture capital has not and is unlikely to be replaced by ICOs. Unlike ICOs which only provide start-up capital to entrepreneurs, VCs contribute both financial and non-financial value to start-ups. Moreover, ICOs are currently confined to a narrow market segment – that of blockchain or crypto start-ups. By contrast, venture capital invests into a wide variety of high-tech start-ups. Meanwhile, the data collected by the authors shows that venture capital remains a far more popular choice than ICOs for investors. Even confined to the FinTech sector, venture capital remains the preferred choice for investors.
Part III examines the novel or hybrid models and their accompanying risks, including: (1) crypto funds, (2) tokenized venture funds, (3) reverse ICOs, and other hybrid models. Part IV elaborates on the most relevant risks associated with this crypto asset class, including: (1) extreme uncertainty, agency costs and information asymmetry, (2) regulatory uncertainty, and (3) cybersecurity risks.
Part V proposes regulatory and market solutions that would help to address these risks and problems. In particular, the paper recommends heightened regulations on crypto-centric funds and fund managers. The imposition of a registration framework on crypto-centric funds would help to ensure that managers are held to minimum standards of care, skill, diligence and disclosure in their administration of the portfolio and would help to provide some protection should investments go awry. The introduction of a licensing framework on crypto-centric funds also signals to the market the high risks that an investment in crypto assets brings.
Ultimately, this paper raises awareness of the specific risks that the venture capital-crypto interaction brings, and provides guidance for engineering a healthy and sustainable venture capital-crypto ecosystem.
Lin Lin is an Assistant Professor at the Faculty of Law, National University of Singapore.
Dominika Nestarcova is an associate with the Spartan Group.