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Starta Ventures issues the first VC/ICO market report Hybrid Capital: The Future of Venture in the ICO Era


Starta Ventures present the first VC/ICO market report: “Hybrid Capital: The Future of Venture in the ICO Era”. 2017 has been an exciting and interesting year for everyone in venture capital and the crypto-community. As blockchain unfolded from a narrow niche to global adoption, and volumes of Initial Coin Offerings shook up traditional venture funding, it became obvious that this technology has the potential to disrupt traditional venture capital.






Starta Accelerator with its ICO in July were the first accelerator to tokenize a part of its portfolio and secure funding through token sales. Moreover, four of Starta’s portfolio companies raised over $22M in their successful ICO campaigns in which Starta Ventures’ executives took part as advisors and mentors. On the other side, as an early stage VC fund and startup accelerator Starta Ventures also faced “competition” from ICOs in 2017 as it became popular among many companies in our pipeline as an alternative to VC funding. This gave a unique perspective on developing the vision of this process and where it will lead VC firms in the future.

In this report Strarta analysts conduct an ICO market overview, as well as analyze the current trends and present the vision on how they are triggering a fundamental shift in the traditional VC funding model.

“We saw a very curious trend emerge in the world of tech investing in 2017. Various seed and angel stage projects found an alternative to the classic funding model and raised more than $3 billion through ICOs. This number is comparable to the volume of traditional venture funding during the same period.Since the summer peak of this ICO trend, several articles have been written with the thesis that ICO's will be the end of venture funding as we know it. In this report Starta Ventures gives its own opinion on the matter”, - it's said in the report.

Key trends:

ICO MARKET OVERVIEW

ICO Profitability is Going Down for Investors / ICO Market is Overloaded with Capital in 2017

ICO maturing market shifts
Although the total volume of ICO funding keeps rising, we can see a major shift in market trends and the quality of ICOs on the market over the last few months. In this report we distinguish two types of ICOs:
The first is the fundamental blockchain infrastructure and protocol ICOs that are native to the blockchain community. These types of ICOs were here before the ICO hype in 2017 and are here to stay. We expect upward trends in ICO fundraising for infrastructure projects as blockchain technology matures and gains deeper adoption in the “real world”.
The second type of ICOs are niche product ICOs, non-native to blockchain and utilized by companies as a fundraising vehicle instead of giving up equity to the VC. These type of ICOs peaked in Q3, 2017 with an obscene amount of funding raised by early stage companies. However as the market matures these types of ICOs are gradually disappearing as they are not competitive and not rooted in the blockchain community.

We see it already because a significant portion of such projects in October- November 2017 failed to raise minimal projected funding. We expect such product-ICOs to die out in the current model unless they are somehow integrated into traditional VC funding model in a regulatory-compliant infrastructure.

ICO is becoming too expensive for startups
The days when a startup could raise millions with only a whitepaper and a fancy website are over – the average cost of running a successful ICO has skyrocketed in recent months due to a high volume of new coin offerings. The experience of running our own ICO, as well as advising our portfolio companies, indicates that the costs of conducting a successful ICO are not only directly correlated with the final goal, but are rising exponentially as the number of competing ICOs increases on a daily basis.

The cost of running a successful ICO has reached $500K-$700K, which is equal to the amount collected at a decent seed round. Taking into account the various regulatory complexities, as well as the changes in the ICO environment over the past few months, the average start-up company will now find the ICO to be a less attractive means to raise capital compared to traditional fundraising.

ICO fundraising is going offline
The process of ICO fundraising is becoming less and less distinguishable from a typical VC round. Nowadays, running an ICO is increasingly more about offline meetings with funds, attending blockchain conferences and trying to associate the project with the names of a few select Bitcoin godfathers. Digital marketing instruments that were an easy way to promote an ICO only a few months ago became obsolete as potential investors were swarmed by advertisements of yet another project.

Given the number of new ICOs, crowd investors increasingly rely on the reputation of a particular project’s founders and advisors, rather than pay attention to the whitepaper. Thus, the focus is shifting from digital marketing towards offline engagement and trying to affiliate with big names.

Too much noise in the market

The ICO market at the moment is extremely noisy, which means that the sheer amount of ICOs rolling out makes it almost impossible to thoroughly analyze each and every project. Right now there are over 350 active ICO's going on as per www.smithandcrown.com. Inexperienced investors, who comprise a large portion of the market, are looking for reference points and often rely on third party expertise when choosing a particular project to invest in.
A typical ICO is often used to demonstrate extremely high returns, which led to an an influx of investors and capital in the short term. However, the market has already structurally changed and upside potential has greatly decreased.

Structural shift
In its early days (before 2017), an ICO was a niche instrument primarily used by blockchain infrastructure projects to launch their networks. With the hype expanding in 2017, the share of infrastructure projects among the total number of ICOs has declined while a wave of niche product startups using ICO as a fundraising vehicle similar to VC has greatly increased. Therefore, potential returns for most ICOs launched in 2017 are much less compared to pre-2017.

The ICO hype of 2017 has attracted a huge influx of capital into the market. Meanwhile, the investment infrastructure of this new instrument has remained rudimentary. The lack of a concise a bubble, with companies raising as much money as they could rather than what they really need. Disproportionate, bloated investment rounds significantly decrease the effectiveness of investment capital, which in turn is reflected by lower upside potential for investors.

Average fundraising size has increased 15x times in 2017 compared to 2016. The market is overloaded with capital, which inevitably leads to smaller upside potential for investors.

STATE OF VC IN THE OF ICO ERA

ICO is a Base for VC transformation / VC Inefficiencies: Liquidity Problem

New trends in the ICO market are indicative of the fact that early stage investment mechanisms are ready for a structural shift. The first wave of crowdfunding platforms indicated a strong interest in attracting funding from small investors. However, it also exposed a number of inefficiencies that hindered the prospects of this niche type of investment. Technical difficulties associated with using debit/credit cards, unclear liquidity mechanisms, lack of control and regulatory complications have foretold the decline of crowdfunding.

The new wave of ICOs is a logical progression of crowdfunding, with blockchain technology solving most of the previous complications. This new technological base has allowed for the second phase of crowdfunding hype – namely the institutionalization of the ICO. However, data indicates that this new wave is following the exact same trend as the previous one. What is important here is the fact that tokenization and blockchain could be a novelty solution to venture capital's inherent problems.

The existing VC funding model was formed in the mid 20th century and remains almost unchanged to this day. Not surprisingly, it is characterized by a number of inefficiencies. With new technologies, such as blockchain and its ICO offspring, the pressure on this model is increasing and its drawbacks are becoming even more exposed. This makes us believe that with new technology and disruptive powers in place, the traditional venture model has to undergo significant structural shifts.

We believe that this structural shift will be triggered by the wave of product ICOs that we observed in 2017. Companies using ICO primarily for fundraising purposes will eventually be integrated back into the equity fundraising VC model. However, we forecast that in the future, VC will undergo significant transformation based on the principles of tokenization and crowdinvesting.

The process of VC transformation with blockchain technology has already started. The advantages of investing in tokenized assets are obvious – the liquidity and transparency that blockchain technology has enabled is unrivaled. What is more important here is the publicity factor that comes hand-in-hand with the ICO mechanism. By publicity, we refer to the fact that most of the projects going through an ICO are relying on the team’s reputation as the primary factor of their validity. The crypto-community is all about transparency, thus each project that decides to fundraise via an ICO puts the reputation of the team on the table. This means that the team behind a particular failed project will face a significantly more hostile investment climate around their next project compared to the traditional VC ecosystem, where the team is less exposed.

Traditional VC limitations on ICO investing
Although a number of top-tier VC funds have already gotten involved in the ICO market, there are some limitations for a typical VC fund that chooses to invest in crypto tokens.
The majority of venture capital firms can’t speculate on digital currency according to their investment mandates. Potential exposure to non-private equities grows beyond 80% of the fund’s holdings.
There's also the security risk of buying cryptocurrencies. Theft is a common problem inherent to the market, and due to the nature of cryptocurrencies it is almost irreverisble. Another issue is lack of the ecosystem around crypto investments. Unlike regular equity investing, venture investors take custody of tokens they purchase.


Traditional VC should utilize ICO to evolve
We believe that ICO principles and foundations have a transformative potential for traditional VCs and act as a stimulus for it to overcome its own barriers. In the following slides we will review core VC model inefficiencies and discuss how they can be solved through utilizing an ICO vehicle.

Liquidity problem
Especially significant is the problem of liquidity associated with traditional VC funding. Essentially, venture funds have no control over portfolio liquidity from the moment
of investment until the exit. There are three exit strategies in the startup industry today – M&A, PE buyout and an IPO.
ll of these strategies are completely out of the investor’s control and depend mostly on the project team's decision-making, execution and market conditions.
Therefore, during the post-investment period, a venture fund’s portfolio is essentially a black hole, with its dynamics and performance practically untraceable until the exit moment. This allows for hiding zombie-projects inside the portfolio and becomes a source of uncertainty for LPs since the previous success of GPs does not guarantee positive future performance.

Tokenization is a solution

The most powerful tool that an ICO brings is the tokenization of the underlying assets. This solves the classic liquidity problem of venture capital. Tokenization allows for flexibility in terms of a manager having discretion of when to exit a particular investment. The general partner is back in control over the fund’s liquidity while allowing limited partners to monitor the financial performance of the fund in real time, just like with hedge funds or mutual funds (NAV).

Another problem that might be less obvious, but is just as important, is the deep contradiction of the classic GP-LP relationship. According to this model, the general partners of the fund get a 2% management fee yearly to cover operational costs along with 20% carried interest (success fee) after the limited partner investment payout. This situation has a number of curious implications.

Usually, a fund of this size has at least 3 GPs and an investment period of 3 years throughout which it has to be fully funded. Such resource limitations dictate the investment strategy of $1 million minimal investment which by default eliminates seed round financing. At the same time, raising a smaller fund is not economically sound due to the insufficient management.

Bloating of the funds
By definition, the primary motivating factor for the GP – the management fee – is directly correlated with the size of the fund and not it’s overall performance. As for the second component of the GP’s reward – carried interest based on successful exit – it takes a regular GP anywhere from 5 to 10 years to get to the point of an exit event. With the current pace of technological advancement, this time span is extremely lingering for a rational individual. This explains the situation when it is in GP’s best interest to bloat the fund as much as possible in order to maximize the profit off the 2% management fee

Focus on later stages

As a logical conclusion, the investment focus of an average fund is shifted higher along the round chain towards A, B and C rounds. A theoretical fund of $100 million is not economically stimulated to invest in early stage startups with an average check size of $500k.

Later stage tilt problem

Professional venture investing is tilted towards the financing of later stage companies. This indicates an opportunity for early stage investments. Seed and early stage investing is mostly covered by angel investors which often times fail to provide the startup with the same set of benefits that a traditional fund offers (expertise, connections etc.)

Invested capital ratio
A closer look at the LP/ GP economic relationship reveals that a 2% management fee, throughout a lifespan of a typical VC fund, ends up being around 16-20% of the overall funds. A significant portion of the fund is not being invested therefore lowering the VC's efficiency for its investors. Over a ten year life span, that 2% management fee can wind up growing to 20% of the total funds raised. One can say that the GP essentially takes a 20% commission fee out of each deal and loses 20% of potential income for their LPs.

In further slides we will present our vision on how the ICO vehicle can be integrated into a VC fund to create performance-driven incentive for GPs, discourage bloating of the funds and achieve higher capital efficiency for fund investors (LPs).

One more barrier to entry for VCs is the average check size from the GP's own investors - the LP's. The typical check for an LP investor is around $500k due to high transactional costs of creating the fund. This means that a person who has less than $10 million at disposal is not considered as a potential venture capital investor. People who can invest only in the range of $100k-$500k, are in fact detached from the general investment market unless its through angel investing, which is much riskier due to the lack of expertise and infrastructure to nourish the project.

The number of people who are willing to spend money via technology investing is huge, but until very recently, all these potential investors had no access to the venture funding infrastructure. Thus, an important implication of the rise of ICOs is a breakdown of the barriers to entry of venture investing for smaller investors due to greatly decreased transactional costs.

Conclusion
Low returns of venture capital, shifting of professional VCs’ investment focus towards latter stage companies and lack of access to investment markets for smaller investors – these are just some of the problems that will inevitably bring structural change to the traditional model.

HYBRID INVESTMENTS

Hybrid Investment Model: future of ICOs in traditional venture capital funding infrastructure

Current ICO market conditions show us that there is a trend towards convergence of players amongst active participants - namely venture funds, crowd investors and startups.

GPs will serve the same function that they do today – selection of investment opportunities, due diligence, investment terms negotiation, guidance and mentorship at growth stage, help with further rounds fundraising and exiting during later stages.
However, resources that will be available for GPs will not be limited to traditional LP-GP structures and the size of the fund. GP will get access to leveraging their competence, expertise and infrastructure by working with crowd investors, which makes them less dependent on traditional relations with LPs.

Crowd investors will be willing to pay GPs a fee in order to participate in deals initiated by the GP since they understand that GPs have professional competence and infrastructure that is able to minimize their investment risks.

We expect the emergence of investment platforms where the concept of the Hybrid Investment model can be realized. Such platforms will represent the classic functional structure of VC markets on the blockchain, taking on the functions of regulator of transactions between market participants.

We predict that regulatory compliance for such platforms will be developed in the near future allowing equity investment tokens within the platform infrastructure and free float of security tokens on the internal exchange.

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Thursday, January 11th 2018
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