- By SeedInvest
- December 18, 2019
- 6 minute read
The process of raising capital has grown more complex. New paths exist for both the investor and the entrepreneur, but they can be prohibitively expensive to take. In the first article in this series, we describe how “tokenization”—the process of cryptographically securing something of value in digital form—can make new paths to capital more attractive and cost-effective. In short, tokenization moves the paper-based process of private security issuance, trading, and compliance into the digital world by issuing securities as crypto assets. The same cryptographic technology used in bitcoin also allows us to encode into assets the requirements for compliant trading and issuance. Tokenization of private securities will put new options on the table for private investors and privately held companies.
In this article, we will discuss what crypto, blockchain, and tokenization will mean for capital formation on a macro level. We’ll introduce some of the industry trends that make these innovations important for the future of investing.
There is a growing belief that companies will begin to go public earlier, and investors will enjoy expanded opportunities to participate in their growth stages—much as investors did during the public offerings of technology companies in the 1980s and 1990s, investments that offered opportunities to establish generational wealth. We believe we’re on the cusp of another transformation that will further democratize capital formation, putting more tools, opportunity, and value in the hands of investors and entrepreneur alike.
The US hit a peak in the total number of publicly-traded companies in 1997, when 7,509 listed firms vied for investors’ attention and dollars on US stock exchanges. That number was the result of two decades of steady growth. After 1997, the number of US-listed firms fell at first swiftly, and then continued to decline gradually. By the end of 2016, the number of publicly traded firms in the US was half of where it was at its peak, and 25 percent below what it had been 40 years prior, in 1975.
As the number of publicly traded companies has dwindled, private markets have grown. The year 2018 saw private equity amass a record high of $2 trillion in “dry powder,” or liquid assets available for investment by funds ranging from venture capital to buyout categories of the asset class. Companies staying private longer has meant narrower access to growth-stage investments in some of the largest and most highly valued companies operating today. The average age of a company going public today is 11 years. Between 1995 and 2005 the average age was three years. This is not only a troublesome trend for America’s stock markets, it’s a likely culprit, if one that is sometimes overlooked, behind the wealth gap that has been widening in America, despite an unprecedented period of economic expansion.
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Many industry experts believe firms will seek access to broader markets earlier and that today’s individual investors expect to be able to invest earlier too. This is a perspective that we at SeedInvest have gained firsthand while helping innovate capital markets through the JOBS Act, and guiding entrepreneurs and investors on how they can take advantage of these innovations.
Investor demand for such a pendulum swing became apparent in 2017, with a rush of enthusiasm for so-called “initial coin offerings,” or “ICOs.” For a few heady months, it seemed any blockchain project could raise capital from an unlimited, global population of investors: In October 2017, ICO deal activity peaked at more than 100 fundraises closed, according to market data provider Token Data. Investors’ enthusiasm for these offerings points to the extent to which there is pent-up demand to invest at earlier, riskier stages in companies that offer potential for high growth.
However, ICOs were based on a regulatory fallacy. Crypto assets, issued to raise capital, are subject to regulation, much as other debt or equity investment contracts are. We believe that regulation was necessary: most ICO’d tokens are securities, as we pointed out at the time. This regulation is beneficial, both for investors and for fundraising companies. ICO issuers who were successful at raising capital became public companies overnight, many with their businesses still in the idea stage. For a firm, having ownership publicly traded is a responsibility that can change strategy, not something to be undertaken too early or too lightly. For investors, not every project merits access to liquid, public markets.
The future that we see combines the energy and accessibility of the ICO boom, but stays compliant with securities laws: the pendulum falls somewhere in the middle. We believe there is an equilibrium between the 2017 ICO market, and the IPO chill of the past two decades, in which tokenization and financial innovation give firms a variety of ways to reach broader bases of investors, reaching the kinds of backers that are appropriate to each stage of the firm’s growth. We spell out some of those stages and the options that are available in the first post of this series.
What it means today
Tokenization of securities is possible today. Technology platforms are able to provide more options for entrepreneurs and investors, from early-stage issuance, to shares moving on alternative trading systems (ATS). Right now, firms are taking advantage of that to access a global distribution of the right categories of investors at the right stage: JOBS Act exemptions are available to these entrepreneurs in new and more cost-effective ways. Investors are looking to take advantage of blockchain technology to let them sell securities or buy into new investments on the secondary market, in ways that would before have been cost-prohibitive or disadvantageous.
Tokenization doesn’t replace traditional equity or notes, but it offers new opportunities in deal structure and gives investors new advantages on the secondary market—for example, varying degrees of lock-up periods for various categories of investor. We believe these deal structures and these advantages will become an expected part of capital raising for companies. Companies that have made use of these structures, completing broad issuance through regulatory exemptions early in their growth, will be better prepared for public markets. At all levels, investors will begin to demand this kind of capital raising activity.
What it means in the future
Some security token platform providers sketch a future vision in which shares in privately held companies trade with as much liquidity and lack of friction as stocks on the NYSE or the Nasdaq. While that future may be far away, in the near term, deals on the secondary market for tokenized securities may look much like secondary trades in private company shares do today, but with better options for entrepreneurs and investors.
In short, the opportunity and interest in reaching a global investor base with cost-effective compliance is real. The simple progression of more companies accessing these new funding sources available through tokenization, and investors demanding the latitude it gives them, has the potential to remake capital raising for growth companies in the coming decade. Beyond that, there will be new layers of innovation to build on top of these changes, and it is these further innovative steps that we will address in our next blog post in the series.
This post was written by SeedInvest on December 18, 2019