The Value Proposition of Blockchain-Based Equity Fundraising
Most industry experts agree that the future financial infrastructure will to a large degree be based on blockchain elements. This seems intuitive given that any transfer of value can be made immediately and with less reliance on middlemen than today. This is an advantage for ordinary consumers and corporates, but also an advantage for banks in their own right, to optimize international transfers, etc. Over time it will lead to more efficient systems and lower transactions fees for everyone.
Industry experts also predict that everything will be tokenized in the future. This means that anything of value will be represented on the blockchain, or rather the ownership rights to anything of value will be represented on the blockchain, be it stocks, bonds, currencies, and assets, such as works of art, real estate, ships, expensive cars, etc. We are seeing thousands of teams world-wide working on this, all in a feverish haste to become first movers in getting some of the pieces in place. Already now the first 20-30 projects have managed to tokenize some type of value and hundreds are expected to follow in 2019.
New terms have been defined such as "security tokens", meaning tokens representing a security (stock, bond, etc.) – also termed "tokenized securities". As ICOs are becoming less popular, they are now being replaced by STOs (security token offerings) – meaning a capital raise conducted by offering security tokens for sale as either a private or public offering. These terms are very blockchain-centric. As blockchain becomes a standard part of the financial infrastructure and nothing unusual in itself, we expect these terms to be replaced with others such as "digital securities", "digital shares", etc. A blockchain-based fundraise may just be termed a good old-fashioned private or public offering of shares (possibly "digital").
This article will focus on blockchain-based capital raises and tokenized shares (digital shares) as this is the focus of our business: GoSecurity DigiShares.
Why should a company choose to conduct a private or public offering using blockchain technology rather than existing methods? And why should an investor buy token-based shares rather than good old-fashioned shares on a stock exchange?
Below we will list the main reasons for why companies should raise capital via the blockchain:
- The entire financial infrastructure is moving in this direction, so the company will be better prepared to take advantage from this (company share tokens may be easier adopted for trading on exchanges, in banking systems, etc.)
- Almost immediate transfer of tokens from seller to buyer and almost immediate settlement. Trading is much faster with less artificial delays. This may lead to higher interest from investors and as a result higher prices. For most unlisted shares, liquidity is close to zero, and early investors may be stuck for many years waiting for an option to sell. If shares are issued on the blockchain (with less trading restrictions), these early investors will be able to sell any time they want. This will make the investment itself much more attractive to investors, leading to higher prices
- Better access to international investors. Groups of investors are being organized and pre-registered in databases across the world. These commercial databases are increasingly connected to each other and available to tap into by companies looking for investors. Many platforms (such as GoSecurity DigiShares) are being developed that enables investors to immediately invest into companies issuing shares on the blockchain. These platforms will partner with international groups of investors and investor databases, in order to offer their clients increased access to international investors. This is possible to a much higher degree than old-fashioned technologies and systems, since within the blockchain ecosystem, all players are using compatible technology that is able to interconnect, interact and exchange information about investors and opportunities. At the end of the day this means that investment opportunities will be presented to many more investors than in the present day where most capital raising platforms are limited to their domestic market and where there is no easy interchange between capital raising platforms and investor networks. This will make it significantly easier for good companies to raise capital and perhaps even at better valuations.
- Access to more efficient and modern technology. Companies issuing shares via the blockchain will join in a new global trend which will lead to technology advantages (higher efficiency, lower transaction costs, wider reach, etc.) but in itself, the use of new and better technology will boost marketing and branding of the capital raise and make possible a "technology premium", i.e., higher valuation due the association with better and more efficient technology.
- Reverse liquidity premium. The liquidity premium is the compensation demanded by investors for investing into securities with low liquidity. It is well known that there is a significant liquidity premium required by investors investing into unlisted companies – simply because they cannot easily liquidate their position, indeed it may take many years. Liquidity premiums can be very high, sometimes several hundred percent. With blockchain-based shares that may be traded on exchanges, this premium is removed (or reduced very significantly), leading to higher valuations for companies raising capital on blockchain-based issuance platforms.
- Lower cost of raising capital. An IPO is hugely expensive, costing easily several hundreds of thousands of dollars, going into the millions. An IPO is not an option for many companies for this reason. Other options include raising capital from VCs (less than 1% succeed in this), crowdfunding (also less than 1%), and bootstrapping (98%?). The direct cost of raising venture capital is relatively low, between $2,000-10,000 in legal fees (more for later rounds). But the real cost should be measured in liquidity premium (lower valuation) resulting in more equity sold to investors and much higher dilution for founders. Another potential cost results from liquidation preferences where VCs ensure that they are paid out prior to founders on an exit. To run a successful crowdfunding campaign could easily cost $50k-100k + commission fees to the crowdfunding platform. Many pay less but these are also often unsuccessful. Equity crowdfunding is in some ways similar to blockchain-based fundraising, since equity is sold and this equity is "digitized" to some degree. However, equity crowdfunding platforms are isolated and not connected to other industry players – or potentially linked into the future financial infrastructure. So companies issuing on an equity crowdfunding platform will not enjoy the benefits of easy future trading of their shares on various exchanges, nor almost immediate trading and settlement of their shares. (Hint: some equity crowdfunding platforms may make deals with blockchain companies in order to offer their clients a "tokenization" service). So what does a capital raise with blockchain technology cost? Right now, from $30,000 up to $1M, including all elements (legal, marketing, platform costs, etc.). As these services get commoditized, it is however expected that they will decrease very significantly from 2020 and forwards. As the process is standardized, legal and platform costs will drop dramatically. As investor networks are increasingly linked into exchanges and issuance platforms, marketing costs will also drop significantly. Finally, lower costs of raising capital will make possible much smaller and lower capital raises and making a capital raise increasingly competitive compared to taking out loans.
- Tokenization of tokens. Tokens on the blockchain will represent ownership rights in a share in a company. Shares may in some cases be too expensive for some investors which will lead to a lower price for the share. However, in the world of blockchain, tokens may be tokenized – and fragmented into smaller elements. A share in a big company may cost $10,000. But if such a share is represented by a blockchain token – this token may be further fragmented and tokenized into 100 tokens, each representing 1% of the original share. Such a token will cost $100, and will suddenly open up the access to invest to many more retail investors – leading to a small but significant increase in the share price.
- Lower transaction fees. The forthcoming exchanges for trading tokenized securities have published their fee structure and it seems these will be a factor of magnitude lower than fees on existing exchanges for listed company shares. This will attract investors and will drive valuations and prices upwards.
- Process automation. A larger proportion of the processes surrounding issuance and trading with shares can be automated with blockchain technology, due to the scope and capabilities of smart contracts. For instance, processes related to investor verification (KYC), money laundering avoidance (AML) and investor accreditation verification may be increasingly automated, removing costly human elements, increasing efficiency and driving down overall costs. Company votes and distribution of dividends may in a similar fashion be simplified and at least partly automated with heavily reduced costs as a result.
- Increased design scope. First mover issuance companies, including GoSecurity DigiShares, recommend that tokenized securities emulate old-fashioned securities, i.e., precisely duplicate the properties of shares or bonds. This makes it easier for the national securities authorities to recognize and approve (or deny) the security, and it makes it easier for investors to understand the security (don't invest in something you don't understand!). However, in the future it becomes extremely easy for issuers to design entirely new types of securities with properties that cannot be foreseen today. The focus could be on rights allocation between company and its founders and investors. The focus could also be on adding non-security related rights, such as a discount when shopping in company stores, free tickets to sports matches, etc. In addition, the focus could be designing new types of derivatives, combining properties of shares and bonds, combining other tokenized securities and assets, etc. All in all, this will open up massive new business opportunities for issuers and investors.
- 24/7 trading. Blockchain-based trading exchanges will be open around the clock, i.e., around 4 times more than existing exchanges. This will enable trading across time zones and increased ability to trade and may be more attractive to investors than the current trading hours.
- Much more reliable and secure than existing alternatives. The blockchain itself is a trust engine with its shared, immutable and transparent ledgers. Trading history will be visible for anyone, including authorities. The risk of errors will be much reduced and the chance of discovering errors will be much increased. Investors can trade via exchanges – but they can also easily (at close to zero cost) trade directly, peer-to-peer. In the current system, if a company incorrectly updates the cap table and their shares are uncertificated, investors risk losing their shares. With a blockchain-based tokenized security, this can never happen, since the holder of the token will also by definition be the owner. (Hint: blockchain implementations will use the certificated approach).
- Compliance will be automated and built into the smart contracts of the tokenized securities. Suddenly trading across jurisdictions become possible to a much higher degree than now, since compliance will be checked and guaranteed by the token smart contract. In the old system, to avoid compliance issues, trading of unlisted shares is limited to specific platforms and never possible across platforms or peer-to-peer.
- Lower ongoing cost due to automatically maintained cap tables. These can be maintained both by using smart contracts to update them, and by periodically scanning the blockchain for unreported trades. At the same time, in the blockchain world, the cap table will be more accurate and updated than in the current regime.
Below we will list the main reasons for why investors should consider buying blockchain-based shares. Many of these are the same or overlapping as above, so they will be abbreviated where already explained:
- Increased trading opportunities and increased liquidity. This is extremely important to all investors and even more so business angels and VCs investing into startups
- Access to invest into companies or assets that are not normally available. As companies tokenize their shares in order to provide liquidity for current investors or raise capital from new ones, more and more investment opportunities become available for investors. Currently, business angels struggle to get sufficient deal flow since most startups seeking investors are not connected with them. High net worth individuals and ordinary retail investors struggle even more since few opportunities are available to them. As it becomes easier and less expensive to raise capital via the new blockchain-based ecosystem, more and more startups and established companies will choose this route – and create more opportunities for investors.
- Faster and less expensive trading. Many investors are dissatisfied with current high trading fees on existing exchanges. These are expected to be reduced with a factor of magnitude as processes are automated. Trading of unlisted shares is currently a cumbersome affair but it can be fully automated with a very low cost on the blockchain.
- Tokenized fragments of shares. As expensive shares and assets can be tokenized in smaller fragments, more investments become affordable for retail investors. It becomes easier to spread your investment portfolio across different types of assets and securities. Business angels will be able to spread their investments across more startups. VCs will be able to tokenize their funds and attract funding from more investors in lower amounts.
- Higher security and transparency. It will be visible to anyone how the cap table in a specific company is structured (though individual investors IDs will not be visible). Trades will be (almost) immediate and non-reversible. Many errors can be avoided or reduced in frequency. The investor will have a higher degree of certainty that the investment is secure.
We are aware of 3 typical perceived risks among normal non-blockchain investors but all 3 can be debunked:
- Security tokens are like crypto. It dropped 90%! The same will happen here! No – the entire security token industry tries to disassociate itself from crypto, and indeed there is very little in common. The crypto market consists of currencies such as bitcoin and ethereum, stable coins such as Tether and MakerDAO, and thousands of utility tokens created to fund more or less well-developed business models and platforms. Most of these were funded by ICOs – the issuance of a large amount of tokens with some future promised value, often depending on the future success of the platform itself. Many crypto exchanges exist that make these tokens available to speculators, driving up and down prices of tokens with no (or very limited) real assets backing the token. Stable coins may be an exception but this remains to be seen in the future. Security tokens are always backed by an existing security or asset. Investors are required by law to be fully informed about the value of the backing security or asset prior to investing into the token. Therefore, investing into a security token is (from a legal perspective) exactly the same as investing into a share, bond – or other type of security. So if you are already investing into listed or unlisted shares, you should not be afraid of investing into tokenized shares on the blockchain – it is exactly the same – only better.
- Your wallet can be hacked and you can lose your token. This is often the case for utility tokens but most issuance platforms provide functionality to freeze and reissue a tokenized share, should this situation arise. Obviously, the investor will have to provide sufficient proof prior of ownership for this function to be used. The hacker also cannot transfer the token to his own wallet, since the built-in smart contract will prevent this.
- Your token may be issued using a blockchain technology that later becomes obsolete. This is also not going to happen, since blockchains are increasingly interoperable and most issuance platforms provide functionality to freeze old tokens and reissue new ones with new functions or new standards.
It is often claimed that the advantages provided by blockchain implementations of issuance and trading systems also can be provided by existing technologies – however, this author does not see any competing technology that comes even close to matching the blockchain benefits of increased efficiency, reduced trading and settlement times, reduced transaction fees, automation of compliance, increased cross-jurisdictional trading, increased liquidity of traditional illiquid investments, increased security and reliability, etc.