Raising Capital in De-Centralized Finance (DeFi) World
New emerging ecosystem that startups and founders can use to raise capital from investors around the world
Traditionally, the capital raising for the startups or small and medium businesses (SMBs) have been facilitated by investment banks, venture capital funds and very few selected groups of individuals. They leverage their deep expertise to identify, curate and fund startups. These traditional companies raise funds through high net worth individuals and institutional investors to distribute funds to startup in multiple series — a seed round, series A, series B and others.
Wave #1 of De-Centralized Finance: False Positive
With increased connectivity and success of internet startups in 1999–2000, we saw the rise of small venture capital funds and incubators all around the world to bridge the gap between supply and demand. These organizations became a feeder-channel (validators) to more significant venture capital firms for investment rounds beyond seed round or series A. However, the traditional players made most out of feeder-channel arrangements and became stronger with the dot-com bust.
These model are not new for a startup. There is a healthy ecosystem in the San Francisco Bay Area and other clusters around the world to raise capital through Angels’ Network or Venture Capitalists. However, there is a change of winds for some of the successful private companies in their quest for IPOs. They are bypassing the traditional investment banks and raising millions of dollars through a direct listing. Bill Gurley has researched the area and become an authority on the topic @bgurley
Wave #2 of De-Centralized Finance: Rise of crowdfunding platforms and ICO Boom
In the United States, we saw the startup investment declined after 2000. However, at the same time, other parts of the world started their growth trajectory with Increased global connectivity and changing government policies. With open communication channels, consumption behaviors in developing economies changed and fueled a rapid increase in the number of start-ups.
The increased activity has created a wave-2 of de-centralization that has led to the emergence of crowdfunding platforms. In China alone, there were 2000 crowdfunding platforms active in 2018. However, these crowdfunding platforms have challenges in terms of information asymmetry. The CROWDFUNDING lenders on crowdfunding platforms need to take decision based on the near-complete information presented by the crowdfunding lending platform.
Most of the crowdfunding platforms have the somewhat same processes for listing borrowers on their site — They enlist prospectus based on borrowers’ creditworthiness (borrower likelihood to repay the loan, not credit score alone), borrower profile, peer endorsement, debt-income percentage, borrower debt level, and bank account verification or borrower’s mobile phone (in case of unbanked borrower like M-Pesa in Kenya). These crowdfunding platforms started the democratization of funding by aggregating the various startups, providing the global reach, and standardization of deal structure.
While the growth of crowdfunding lending is going on, there was another game-changing technology innovation coming into place — Satoshi Nakamoto introduced virtual currency, Bitcoin, mined first “Genesis Block” in 2009 on top of Blockchain technology. The year 2010 was the beginning of a real de-centralization effort that started more rigorous research and the invention of decentralized finance models those were further fueled by the Ethereum, NEO and other smart contract enabled networks from 2015 and onwards. A large number of startups across the globe leveraged these decentralized platforms to issue tokens to raise funds for their ideas. Within a very short period, the entire ecosystem started mushrooming up right from the agencies that could facilitate pre-sale, token minting, marketing, white paper creation, token listing, advisory, token rating and others. Innovative ideas spin-off such as bounty based contribution, airdrops for registration, multi-currency token purchase and others to bring the required FOMO and network effects. Bancor raising #143 million in 3 hours and EOS mega ICO raise of $4.1 Billion in a year-long effort between 2017 and 2018 are some of the big success stories. By the time the ICO boom had gone mainstream, this procedure was a well-oiled machine.
Wave #3 of decentralized finance: Fundamental changes impacting startup finance
With the early success of many ICOs, scammers were flooding the market. Pizza size team, bogus dApps/tokens, un-explained burning of funds and other factors pushed many investors to pull out from the ICO race. Consumer protection regulators also started intervening to safeguard investors.
During this slowing down ICO period, startups who were still looking towards leveraging the decentralized platform for fundraising started to explore a more regulated approach. This gives rise to growth in Security token offering or STO — a sale of tokens with features comparable to standard securities, i.e., fully regulated and approved within their respective jurisdiction. Following the security, laws not only put a check for regulations compliance but also helped to gain customers the confidence to invest in the STOs.
There are three main categories of players are flocking to capture the growth of the token-based economy. These are:
· Platform Players the providers of technology and platform like Polymath, Securitize and others.
· Traditional investment banks those are considering to use platform players to build services along with their traditional services.
· Marketplace providers and compliance services providers those believe in centralized compliance, but everything else can be decentralized likes of Harbor and traditional clearing agencies.
DeFi space is not just getting crowded by the young startups, but more and more established institutions are trying to play in any of the categories (as mentioned previously) and start issuing a security token. Some of the prominent examples of security token issuance that raised millions to include Austrian government bond by the Austrian government, Syndicated loan by BBVA, Bond by Bank of China, 5-year covered bond by Société Générale and AUD-denominated bond by World Bank. From 2018 onward, STOs continued to establish as pivotal Blockchain-based crowdfunding instrument. With the recent Q3 report from stoblock (https://www.stoblock.io/research/reports/), 16 STOs raised $74.4M in Q3 2019. 75% of deals were structured as debt offerings and Ethereum continues to be the most popular blockchain being adopted in 81% of deals.
Concluding Remarks
As we look forward in the future, a stable/regulated ecosystem layer will further drive the importance and adoption of Security Tokens in financial and investment market landscape. The regulated eco-system with token safe harbor proposition (Securities Act Rule #195) not only make capital raising easy, cheaper and decentralized for the borrower but it will also bring a whole new array of investment instrument within reach of the large population across the globe.
About the authors:
Ravikant Agarwal @xragrawal is Principal Consultant with Infosys Consulting. Ravi is a part of Financial Services and Insurance practice with focus in the areas of Blockchain, FinTech evaluations, Digital Transformation and Data Privacy. He is an active contributor in different Blockchain communities and working groups, and runs one of the top three Blockchain meetup groups in India. He has done post-graduation in Finance Management and Bachelors in Computer Science.
Bharat Gupta (@bayglide) is Senior Principal with Infosys Consulting, a management consulting arm of Infosys. Bharat is a part of Financial Services and Insurance consulting practice and focusing on digital transformation, cloud platforms and Blockchain. Bharat was formerly lead the senior executive positions with Reliance Group and NEC Corporation and post-graduated from the Indian Institute of Technology Delhi (IIT Delhi).
