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Venture-funded technology startups could be the next big market for security token offerings

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Hope springs eternal.  Each year a new crop companies are being funded by venture capital and private equity, but – according to Pitchbook – each year many fewer startups are being acquired and far fewer are going public.  

Worst of all, most venture-funded, private tech startups have no chance of issuing an initial public offering (IPO) or getting acquired by a larger company any time soon.  Many post-Series B startups exist in a form of purgatory (some still growing), occasionally raising money to fund operations by dilutive equity sales or cutting costs to become profitable to improve operating margins enough to attract a strategic buyer or attempt a merger.  

The number of VC-backed exits around the world reached a peak in 2014, nearly matched it in 2015, but then dropped in 2016 and again in 2017 to about 1,400 exits. And 2018 doesn’t appear to be reversing the trend that fewer and fewer venture-funded companies are finding M&A or IPO exits.

The companies that make it to an IPO are taking even longer to do so.  According to Pitchbook, a definitive source for deals about venture and private equity funding, companies exiting via IPO in 2006 took an average of 4.9 years.  By 2016, the time-to-IPO average was 8.3 years.  That means early investors are often waiting 10 years to exit from a position, a duration longer than most funds.

And it’s already rare companies actually reach the IPO milestone.  After hitting a peak of 200 IPOs in 2014, levels have dropped to double-digits in subsequent years.  In 2017, in a year when fewer than 100 IPOs came to market, VCs put $148 billion dollars to work in 19,000 deals.  

If more startups companies are receiving venture funding, but fewer are exiting via M&A, and it’s taking longer for a select few to exit via IPO, what other exit options exist for founders and early investors of the forgotten tech companies that occupy purgatory?

The “third way” to liquidity and a form of exit for VC-funded startups is an asset-backed security token offering (STO).

Yes, blockchain to the rescue.  With buy-outs increasingly scarce, and selling options limited to higher-valuation businesses, the best alternative liquidity event for most venture-funded tech startups might be through an STO.

STOs are different than ICOs.  Unlike ICOs, STOs are intended to be compliant offerings, usually under an exemption like Reg D, that confer ownership of an underlying asset (the startup’s revenue and IP) to their buyer, just like a traditional equity or debt deal, just in the form of a token governed by a smart contract.

Why are VC-funded tech startups ideal for STOs?  Because startups that have been through multiple funding rounds have a quantifiable and comparable track record.  

Five or seven years after their initial funding, venture-funded startups have clients, revenues, product, and financial history on which to base a valuation, otherwise known as a fair market valuation.  Series C startups – typically well-established businesses that are scaling – have proven teams, supporters, and a ledger of investors, some likely willing or eager to sell their shares after investing early at much lower prices.  After several rounds of fundraising, tech startups have gone through repeated diligence, audits, and have had proper valuations.  There are very few private companies that are easier to value than a tech startup that raised a C or D round of funding.

Tokenizing a venture-funded startup solves the main obstacle to liquidity events: valuation range.  Not small enough, but not quite big enough to afford the onerous registration and road show process required to IPO, startups in the wrong valuation range often languish.  What is the right valuation range when considering a token offering for your venture-funded startup?

The acceptable range for tokenizing a VC-funded startup is surprisingly wide.  It starts right at about $100 million – where the choice remains to get bought – and rises until you reach about $1 billion where the choice increasingly includes sell to Wall Street.  In between those two outcomes there is another choice:  a semi-private token offering of any size utilizing SEC’s Reg D exemption that can be sold to (mostly) accredited investors, or a semi-public offering utilizing the more recent JOBS Act crowdfund raise Reg A+ exemption, limited to $50 million a year, but can be advertised and sold to non-accredited investors.

Why should VC-funded companies investigate tokenizing? Because tech founders, early investors, and early employees are stuck with golden handcuffs, and those handcuffs often hold back the business from fulfilling its destiny.  Tax laws in the USA discourage the exercise of stock options (exercising options requires paying tax on the appreciation based on current valuation) and because of a nearly non-existent secondary market for restricted VC-funded private shares, many early employees are faced with several not-so-good choices:  a) Stay and hope the company is sold, B) leave and forfeit potentially valuable stock options, or – most risky – C) exercise stock options with the hopes that the company will sell for the right price exactly a year and a day after exercise. 

It’s not like VCs have a problem with secondary sales.  According to PitchBook there has been an increase in secondary sales in 2018. Secondary sales produce many outcomes, but importantly they can also help a later stage company price its shares more accurately.  That is something that an open market in security tokens can accomplish as well.

By tokenizing venture funded startups, we have an opportunity to unleash a tsunami of talent and capital and revitalize the tech startup ecosystem.  Why are startups the right kind of asset to tokenize? Diligence is the key to viable security token offerings.

Tech startups that have the right financials (and are properly valued) are ripe for tokenization that can take them semi-public.  Utilizing asset-backed security tokens, tech startups can convert shares tendered by founders, early investors, and employees to tokens that can be sold to later stage investors, pension funds, strategics, or back to the company.  If a company opens up share purchases to the public (not via a Reg D exemption), a board can choose to float its shares in token form on a broker-dealer’s ATS or exchanges like tZero or Open Finance.  

Why should the investors and boards of private tech companies support token sales?  Reducing pressure on founders to sell low and continue to grow is a strong incentive.  Founders who have been underpaid for years should not be blamed for accepting low-ball offers to gain liquidity.  By allowing founders to sell a portion of their shares in a token-based secondary, the company reduces an urgency to sell to the first acquirer that comes along.

A token offering enables VC-funded companies to refresh some of its staff and supporters too. By allowing early-stage employees and investors to sell out of their positions, the company can free up space for new blood to replace rest-and-vest employees who can’t afford the taxes to purchase their shares.  Not limited just to founders and early employees, a secondary offering powered by tokenization might also allow angel and seed investors to sell – letting them declare victory and redeploy funds to other enterprising entrepreneurs.

ICOs might have been a revolution in non-dilutive capital formation.  But most ICOs have not been successful in producing any general business benefits.

STOs can unlock latent wealth, revitalize moribund companies, and enable mid-size venture-funded companies to reinvent themselves while unleashing entrepreneurs and early-stage VCs to solve new problems.  It’s time to #tokenizetheworld – of venture-funded startups.

 

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