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4 July 2018

The changing face of the venture capitalist

Fintech has changed the financial trading and investing landscape. Traditional investors and early stage adopters can take advantage of new technologies that allow global investment opportunities in a tokenized industry. Yet blockchain and distributed ledger technology (DLT), as well as cryptocurrencies, aren’t without their critics.

However, they have the potential to change the face of the venture capitalist (VC) by providing a globalised platform for investment in start-ups and larger companies.

Alexander Tkachenko, founder of Venture Exchange, says there is some serious change afoot in the funding with initial coin offerings (ICOs). “ICOs are the process used by start-up companies to fund blockchain projects to raise significant amounts of money – sometimes into the tens of millions of US dollars.” This funding opportunity wasn’t possible at the early stage of a start-up’s development, where nowadays, project and development funding can now be attained at any stage.

Globalising VC funding

VC funding also tended to be localised to markets. Tkachenko explains the difference: “What differs from the traditional VC early stage funding is that it is global. VCs and early stage investments tend to be local. ICOs offer the opportunity to attract global investments. You are also able to sell them, turning them into cash.

“So someone in Estonia can now raise money from China and any other country”, he claims before adding: “ICOs are a coin offering on blockchain, and anyone can buy such coins to provide funding to the start-up.” He stresses that where the investors are located is no longer important. All they need to have is the cryptocurrencies such as Bitcoin or Ethereum “to get the token”,

He says traditional VC investments can create some barriers that don’t exist with ICOs: “With the traditional VC investment you have a lock-in of up to ten to 12 years.

“Yet there is a significant opportunity because around $6 billion was raised through ICOs last year, and $3.3 billion was invested in ICOs this year. From the top of my head, the amount of money raised by venture capital funds was about $55 billion during the last year, and $160 billion was invested by them.”

ICO traction

The Association of Chartered Certified Accountants (ACCA) highlights an article from the Accounting and Business magazine that finds that ICOs are gaining traction, while admitting that their “regulatory future remains uncertain”. An extract from the article:

“In December 2017, a Swiss-based company called SingularityNET raised $36 million from investors in under 60 seconds. The company, which enables artificial intelligence (AI) as a service (with the intention of creating a decentralised marketplace for AI) holds the record for the fastest capital-raising exercise ever. But this wasn’t an IPO, it was an ICO; SingularityNET’s investors paid in cryptocurrency and received ‘coins’ (also known as tokens) rather than shares in return.”

ICOs: crowdfunding

The article says ICOs are essentially crowdfunding through cryptocurrency: “ICOs began as a niche funding route for tech entrepreneurs developing new blockchain-based cryptocurrencies and connected applications.”

Investors use them to back “new businesses with existing cryptocurrencies, and in return they are given tokens in another, new cryptocurrency that was also based on blockchain”.

In theory if the ventures succeed, the tokens become increasingly valuable and thence they attract the most attention. Beyond this, the key benefits of an ICO are that they promise to open up an avenue for funding that is quicker and less complex than traditional methods of gaining venture capital.

Regulations and uncertainty

Despite these benefits there is an air of nervousness surrounding ICOs, emanating from their sudden growth and their reliance on volatile cryptocurrencies. This uncertainty is created by the fact that most blockchains and cryptocurrencies tend to be largely unregulated – raising questions about how they should be controlled and regulated without stifling innovation.

Krzysztof Wojdylo, creator and head of the New Technologies law practice at Wardyński & Partners, examines in an article for Newtech.law, “How may we regulate the blockchain?” The answer is that it’s not an easy feat to achieve, and so a completely new approach is required to address these issues.

He writes: “Three main challenges mean that blockchain regulation will require a very non-standard approach. First, it is very difficult to attribute what is happening on the blockchain to a particular jurisdiction. No obvious link allows the assignment of a specific proper law to the blockchain.

“Secondly, blockchain is an area that will see increasing numbers of “autonomous actors” appearing in the form of smart contracts and the algorithms behind them. Therefore, events that take place on the blockchain may be attributed only to a certain extent to traditional legal entities. Thirdly, the dispersed architecture of the blockchain means that there is no traditional sovereign power that can take control of what is happening in that space.”

Six ways to regulate

While these issues are certain ones that may often require an answer, Rowland Manthorpe and Akram Hussein offer some advice for governments in their article for the Wired magazine, “Six ways to regulate cryptocurrency without killing it”:

  1. Clear up the tax situation – blockchains don’t work without a token, and tokens needs to be traded in and out of fiat currencies such as the US dollar, offering a chance to profit. So, in the UK, HMRC needs to clarify its stance relating to this.
  2. Regulate the exchanges as foreign exchange mostly flows through the banks or the currency houses, and this should be no different in the “crypto-verse”.
  3. Create a framework for ICOs to discern which ICOs are legitimate or not. People need to know what they’re investing in and where their money is going.
  4. Let exchanges manage ICOs – offering a new business model for the exchanges and a central point of control for illicit activity such as theft and money laundering.
  5. Establish a working group of blockchain and policy experts, and of economists. Too many people think they know everything about blockchains and cryptocurrencies, but in actuality they don’t. So, as it’s a new field it’s crucial to fully understand it, and without leaving investors, developers and banks in the dark.
  6. Don’t innovate yourself – why? Naval Ravikant, CEO and founder of AngelList and CoinList, claims that there are only a few hundred engineers globally whom are qualified to write blockchain protocols.

Regulators: head of the party

Tkachenko agrees that blockchains and cryptocurrencies would benefit from being regulated and thinks that regulators are at the head of the party – able to play a very important role by addressing some of the risks that come with cryptocurrencies, such as anti-money laundering (AML) and know your customer (KYC).

However, he claims that “these issues don’t largely exist because with blockchain it’s easy to track the history, and it’s vital to note that the role of the regulator is not to stifle regulation with a heavy-handed approach. They need to see the advantages of the technology.”

While regulators should stifle technology, he believes “It’s difficult to say whether most regulators are embracing the new technology”. However, he says that it is legal to transact in cryptocurrencies in most countries, and he argues that this will soon be backed by a more structured approach to regulation in this market. So, from his perspective, it is possible to address many of the concerns and issues that may concern VCs and investors about blockchains and cryptocurrencies. This includes the belief that many cryptocurrencies are nothing but a scam.

VC due diligence

He therefore explains how to reassure venture capitalists that all is above board: “We need to differentiate between the major cryptocurrencies such as Bitcoin and Ethereum, and the tokens that are issued by start-ups. The difference is in the audience. It’s difficult to explain to an Ethereum investor who bought, for example, in at $20 that now is valued at $685, that this is all a scam because this an instrument that is trading on the regulated exchanges.

“In some countries you can withdraw the money to your bank account. You can make some money, and you can lose some money on it. So, it is difficult to see why Ethereum is a scam. It is an instrument that has gained in value, and it has grown with its use. Bitcoin and Ethereum aren’t offering a return, and so they are seen as a transactional payment.”

While this may be the case, he believes that some of the offerings created by start-ups can be classified as a scam. To avoid being portrayed in this way, he advises venture capitalists and other ICO investors to read the whitepapers to make sure that the product makes sense. They should also note that view of the Bank of Japan. It believes that if one person is prepared to transact in cryptocurrencies, then it’s up to both parties to ensure that it’s okay. Yet there is a need for VCs and other types of investors to undertake their own due diligence when investing in an ICO.

In many cases there is not much difference between the due diligence of traditional VC and start-up investments and ICOs. It’s nevertheless worth considering Tkachenko’s advice for VC and investors generally whenever they are thinking about investing in an ICO:

  • Invest in a company and in a team – look at the same fundamentals that he or she would have done in the past, and to consider an ICO as an additional track rather than a replacement.
  • Research the company and the market thoroughly. By thoroughly researching the market you will be able to ask the right questions to ensure that a sound investment in an ICO is made.
  • Examine the regulatory risks – have they been properly assessed? If they’ve not been properly assessed, the chances of gaining a return on your investment could be reduced. It’s advisable, for example, to ensure compliance with AML and KYC legislation too. 
  • Think about how you can innovate to gain a competitive advantage. While the venture capital industry has developed rapidly over the last 40 years, he says it hasn’t seen much innovation. Not much has changed since the 1970s, and yet ICOs are disruptive to the traditional VC and investment industry.
  • Develop an understanding of blockchain technology and cryptocurrencies. Work with partners who can advise you appropriately to ensure that you actually understand what it’s all about – including the pitfalls to avoid and the benefits you could gain.

Tkachenko adds: “I am not 100% sure that I am in favour of encouraging traditional investors to participate in ICOs, but I am in favour of attracting capital to the companies that are backed by professional investors, or to use the mechanism of the ICO to attract capital to the professional investors, or to allow early equity release for professional investors. So, I support using ICOs for supporting professional investors as it’s a better use for using the technology.”

Changing faces

“As far as I can see, last year’s ICOs were mainly for the people in the crypto industry and early adopters – technical guys. You don’t have to be a technological geek to participate in ICOs, and many are registering with cryptocurrencies to test them out. The shift is now towards mainstream early adopters, and traditional VCs are on the other side of the table. Not too many traditional VCs are only investing in the tokens, but I have some across some investment funds that do invest in ICOs.”

So, what will the changing face of venture capitalists look like over the next ten years? In response Tkachenko says “it’s difficult to see the future of the venture capital industry. At the moment, we are developing a platform on blockchain that allows VC funds or accelerators to issue tokens that are linked to the income of their portfolios.”

He also wants to afford institutional investors the opportunity to invest in the new asset class, which he claims can be liquid. His aim is to take the best from the ICO and blockchain space to use it to the advantage of the VC or accelerator industry. So, even if it doesn’t change the individual faces of each VC, it could change how the industry works by making access to start-up and growth funds more readily available without the complexity and restrictions of traditional VC investments.

Click here to read the entire article on BankingTech