The third quarter PwC Moneytree report was released and showed seed stage capital funding for startups as a percentage of deal share falling off the ledge. It has been trending downwards for several years, and most recently dropped from 28% at the start of the year to 18% in 3rd quarter.
Year over year, 2017 finished out with a drop from low 30s to 27% and 2018 is looking even worse.
Why is this such a big deal?
First we have to look at several underlying issues.
Tiny Pool of Angel & Seed Stage Investors
Angel investors provide cash, make connections, and offer encouragement to help develop ideas into actual businesses, or at least into a business that can attract funding from venture capitalist firms down the road.
An angel investor is a wealthy individual willing to invest in a company at its earlier stages in exchange for an ownership stake, often in the form of preferred stock or convertible debt. Angels are considered one of the oldest sources of capital for start-up entrepreneurs.
Angel investors are individuals that invest money in startups or small company growth investment opportunities. Frequently, these early stakeholders invest in ideas in the concept phase long before there is an actual “company”.
Typically, funds are invested in exchange for equity in the business or idea. In most cases, angel investors have little or no day-to-day management, nor do they necessarily participate at a board level.
The U.S. has an estimated 12,000,000 accredited investors. An accredited investor is someone who has a net worth of $1 million or more not counting their primary residence, or they’ve earned $200,000 per year for the prior two years.
These benchmarks were put into place as a safety mechanism to protect investors. The assumption is that if you have that high of a net worth, you are probably more financially savvy, and you can probably absorb any losses.
Decent rationale I suppose. However, the Angel Capital Association estimates that a tiny fraction of those accredited individuals actually invest in startups — only 370,000. This means that only 370,000 people in the private sector are supporting the birth of new innovation at the earliest of stages, which spells disaster for the rest of the venture capital markets who lean towards investing in businesses reaching later stages.
Meanwhile, the irony exists that anyone regardless of economic status can walk into any gas station and buy as many lottery tickets as they wish without even providing any identification at the cash register.
It’s almost as if U.S. policy simply doesn’t want investment in innovation.
Where will the inventory of potential later stage investments come from if we aren’t funding earlier stage innovations and fledgling startups?
Critically Important Insights Learned from the Blockchain ICO Token Sale Phenomenon
The ICO phenomenon over the past two years has provided some interesting insights as well.
After experiencing an explosion, regulatory concerns have chilled the launch of token sales on a global basis. But the past two years have shown a huge influx of capital pouring in to fund early stage software tech projects.
How much money?
The global estimates put ICO token sales at somewhere between $13 and $20 billion for 2017 and 2018 combined.
The demographics of the ICO and token market skews significantly younger, which means active participation by the elusive customers every segment of industry is trying to reach — especially the financial services industry.
The market also shows the appetite for global capital investment in early stage technology because most of the token sale projects in existence are software based businesses.
The other appeal of cryptoassets and tokens is rooted in a topic we will discuss further below — liquidity. Getting money in and out of a trading investment with active trading platforms means money movement at global scale.
The structural mechanisms of blockchain crypto tokens has been embraced by a global market as a popular investing activity.
Regulation Crowdfunding is Still Expensive and Inefficient
Similar to platforms like Kickstarter or Indiegogo, entrepreneurs launch campaigns and use their social network to invite people to review their business plans, market opportunity, financial statements, and video pitch. However, instead of getting the entrepreneur’s product in exchange for a donation, backers get shares in the business or interest repaid on a loan.
Since Reg CF only went into effect in mid-2016, equity crowdfunding is still very much an emerging market in the United States. However, it has gained more traction globally and represents a growth opportunity for early stage equity funding.
Regulation Crowdfunding allows any American startup or small business to raise up to $1 million from friends, family, and followers on debt and equity crowdfunding platforms registered with the Securities & Exchange Commission (SEC).
There are currently about thirty major platforms in the United States providing portals and services for Reg CF crowdfunding.
But the process is still complicated for startups to register with the Securities & Exchange Commission by filing their project in EDGAR (the SEC’s public information database). It’s expensive to retain good legal counsel — which is a must even if the portal says they’ll handle it. The portal always disclaims any errors or omissions, so it’s a huge liability for the startup to wander into the deep end of the pool without a good attorney.
It’s also expensive for startups to market and sell their deal. Paid advertising, social media interns, etc… they all still cost a lot of money.
That’s money the startup already doesn’t have, which is why they’re raising money.
Again, quite the irony.
Furthermore, the investing process is cumbersome. Just the basic function of providing the documentation proof of investor status places a lot of burden on the investor.
Time costs money, and one thing I’ve learned over the years is that the perception of value in anything radically drops when it requires more time and involvement by any prospective investor or customer.
Lack of Liquidity
Liquidity is the degree to which an asset or security can be quickly bought or sold in a given market without affecting the asset’s price.
Market liquidity refers to the extent to which a market, such as a country’s stock market or a city’s real estate market, allows assets to be bought and sold at stable prices. Of course, cash is the most liquid asset, whereas real estate, fine art and collectibles, and particularly, early stage private equities are all relatively illiquid.
If an exchange has a high volume of trade that is not dominated by selling, the price a buyer offers per share (the bid price) and the price the seller is willing to accept (the ask price) will be fairly close to each other. Investors will not have to give up unrealized gains just for the purpose of obtaining a quick sale. When the spread between the bid and ask prices grows, the market becomes more illiquid.
Higher liquidity alleviates the trade-off between the price of an asset it can be sold/bought for and the speed of its sale. People have preference for liquidity as demonstrated by the theory first introduced by John Maynard Keynes. Many theories and empirical studies suggest that lower liquidity results in underrated value stored in assets.
Making securities and assets more liquid helps preserve their underlying value. A share of stock that’s traded on an exchange is of higher value than a share of stock in an identical private company because there is less friction to trade the public stock. Less friction often means more market participants, more volume, smaller spreads, and less price impact.
How big is the illiquidity discount? Financial economists have attempted to measure this discount in a variety of ways. A common rule of thumb is 20–30%. This represents a huge amount of value shaved off of any asset.
The current numbers show that the average time for a startup exit (the company sells or goes public to create liquidity for the shares of stock) is between 5 and 8 years. That’s just to get your money back out — not whether you’ve actually gotten any profit at all.
This is pretty abysmal, especially considering the later venture capital market dollars available to companies continues to grow to unfathomable amounts.
Being able to raise an H round of investment for hundreds of millions of dollars allows companies to stay private much longer.
But this comes with a terrible side effect of continuing the illiquidity of the investment. The most impacted are the earliest stage investors who must take the entire ride with their $25-$100k average. It also hurts employees, who have stock options in their business, but can’t actually get their money out.
When examining the spectrum of asset classes available to investors from a time between transactions, startup equity is one of the longest to lock up the money.
Even among high net worth individuals, the percentage of potential investors who are willing to lock up their money for nearly a decade is a lot of risk. Especially considering the general failure rate of startups.
Contrast this with the liquidity of the cryptocurrency markets, it’s easy to understand the popularity and willingness to speculate on something that may be a risky venture, but you can press the eject button at any time to recover.
Fragmented Primary & Secondary Markets
The early stage and venture capital markets are highly fragmented. Venture capital firms create limited partnerships with individual investors to pool capital, which they deploy into investments on behalf as general partners. They provide due diligence (research about the companies) and analysis about the potential market and the company’s ability to grow and create a return.
The pooled funds by limited partners typically have a lifespan of 10 years. The first few years are spent building the portfolio by deploying capital in investments. Then there’s typically a few years of maturation. And ultimately each individual investment either implodes, returns some capital, or creates a runaway success that amortizes the other non-performers.
I often joke with my VC friends that only in the venture capital industry is a .100 batting average considered the successful baseline when portfolios are seeing 1 in 10 as success rates. It’s really tantamount to a record label signing a bunch of bands hoping that a Taylor Swift amortizes the losses of the other 9 dogs in the catalog.
At the earliest of stages, angel and seed investors typically pool their money through highly localized and fragmented angel capital investing groups. Even when operating under a bigger umbrella association like the Angel Capital Association or Keiretsu Forum, the individual chapters are very regional. This means deal flow (potential candidates for investment) for each of these localized groups is mostly limited to the region as well.
With angel investing and venture capital being so highly specialized and fragmented, it isn’t easily accessible through more traditional investing channels like broker dealers and investment firms. You simply cannot log into your Fidelity or TD Ameritrade account and buy and sell shares and securities in early stage companies as an alternative investment class.
Yes, there are some specialized secondary market listing services like SharesPost and NASDAQ Private Market. But these are still very specialized and the pool of buyers and sellers are still small due to each operating in silos.
So long and sort — getting money into early stage investments isn’t necessarily easy. It takes a long time to see a return. And getting money out is also not easy, if it can happen at all.
Poor Due Diligence & Inefficient Information Access
Investors need to vet the companies they want to invest in by going through a due diligence process. Due diligence can be described as the activities undertaken to research the company and the market to come up with the viability potential of the deal.
This involves validating the plan, uncovering the missing pieces and defining the unknown to contain and define the risk of an investment. Having an inherent good feel for the entrepreneur and team, as well as the market, can help with due diligence.
So why does due diligence need to be done?
A Kauffman Foundation study on angel group returns showed that the returns for deals increased with the hours of due diligence invested. The mean time spent on due diligence was around 20 hours and the returns for deals with less than 20 hours of diligence was around 1.1X on average. Deals with more than 20 hours diligence had a 5.9X return and for more than 60 hours spent on diligence the return was strikingly higher – 7.1X.
The process is heavily dependent on the type of deal (industry, stage and amount), potential and/or existing investors in the deal, and industry knowledge or expertise by the angel(s), along with their individual skills.
Clearly, more information access and analysis contribute to better decision-making and subsequent returns.
Inability of Investors to Properly Define the Risk of the Investment
It is extremely important to identify the risks of any venture because even in optimal conditions, many elements are required for success. The greatest barrier to expanded investing in micro capital markets is the relatively high cost of rigorous evaluation.
If even one of these risks is not assessed correctly, and the chance of success is 50 percent, the overall probability of success is reduced to 27 percent. Clearly every risk must be kept to a minimum. These issues are even more important to angel investors than to venture capitalists, because of the early nature of the ventures. While most deals that VCs see are farther along, seed stage investors, angels and angel groups bear a much greater risk of catastrophe.
Any efficient approach to the diligence process will involve quickly identifying the most serious threats to the business plan, such as: what assumptions are being built into the plan and what are the sensitivities of the plan should an assumption prove faulty?
The “what if” outcomes that would prove devastating should be tested first. The “deal killers” are usually easy to identify but hard to fully evaluate. The seed investors simply don’t understand or underestimate these issues.
The origin of 10XTS and our hypothesis for launching XDEX was rooted in solving these problems. By creating a blockchain-based early stage alternative investment ecosystem, we are working to connect the fragmented participants, investment securities, and corresponding information across the entire ecosystem.
Tokenizing Company Shares and Securities
The process starts with the company founders as asset issuers. They’re creating new corporations and issuing traditional shares in their companies. These shares are all “invisible” because we’ve been using “uncertificated shares” now for quite some time. Uncertificated shares are shares that aren’t evidenced by a paper stock certificate — an antiquated, inefficient practice that was largely replaced by Excel spreadsheets.
Instead of keeping the share and shareholder information locked up in a silo on the law firm’s hard drive, we’re moving them to the XDEX distributed ledger as share tokens. Also called securities tokens, these are blockchain tokens that represent the real world asset of the share or security in the company.
Tracking Company Information
The next stage of listing on XDEX is packaging up all of the documents about the company into a secured document repository that is accessible by authorized individuals via blockchain authentication.
This provides access by investors, law firms, accountants/auditors, and even the regulators to a single “source of truth” of information about the company.
When it comes to conducting due diligence, the process is broken and inefficient. Many “deal room” platforms like Proseeder and Gust exist to help facilitate the evaluation of deals. But here’s the reality — if I am a company founder wanting to be considered for investment by a localized angel group, I am generally asked to upload all the information into that club’s account on one of these platforms. They review and either put money into my company or not.
Then I have to wander down the road to the next group, who asks me to upload all my documentation into their own account ON THE SAME PLATFORM. This creates a significant redundancy of information — and potentially incorrect document versions out of sync with the previous or next group.
10XTS seeks to solve this problem with XDEX.
By becoming the go-to platform for information and investments, consolidating the otherwise fragmented market creates a greater opportunity for liquidity between buyers and sellers of securities. Over time, the inventory of assets listed on XDEX will grow, which creates the opportunity to evolve into an actual trading market.
By connecting to licensed broker-dealers and even Alternative Trading Systems (ATS), XDEX can provide a much broader access to investment opportunities that aren’t convenient or efficient to find. Broker-dealers now have products to offer to their existing customers.
We hope this will grow the potential capital investment pool for early stage capital as a viable alternative investment class by connecting the market, reducing the risks, providing more transparency, giving better access to documentation for decision-making, and ultimately creating higher returns and better outcomes.
Learn more about XDEX and become a partner. Contact us today.
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