In 2012, the Kauffman Foundation released a report titled “We Have Met the Enemy… And He is Us.” The report contains research from 20 years of the Kauffman Foundation’s investments in venture capital (VC) Funds. Unfortunately, the report found many issues with the current venture capital system. Although the foundation released the report over seven years ago, the VC landscape remains largely unchanged. Fortunately, blockchain technology can help solve many of these problems.
VC Fund Background
Typically, General partners (GPs) manage VC funds. The GP raises the fund by collecting investments from limited partners (LPs). Then, the GP decides the companies in which the fund will invest. The GP receives a management fee as well as a percentage of the return on investment. The management fee is typically 2% of the fund size. Also, GPs receive 20% of the carry (money made on the investment).
The most significant problem with VC funds is they do not return investments. 93% of Venture Capital Funds do not return 2x capital. In many funds, GPs take large percentages of any early exits. If the rest of the investments in the fund do poorly, the GP must pay the LPs back. Understandably, these claw-back provisions are tough to manage. If the GP has already spent the money or the fund is under new management, LPs can lose their money. Fortunately, smart contracts in blockchain technology can seamlessly transfer money. In addition, this technology ensures LPs and GPs receive the correct returns instantly.
The easiest way to implement blockchain solutions into the VC system is through tokenized funds. A tokenized fund would have LPs buy fund tokens. In addition to utilizing smart contracts to transfer tokens, this model solves other serious problems. The current VC fund model is extremely illiquid. Investors have to wait until a company exits, or the life of the fund is over to cash out. Therefore, many limited partners must wait ten years or longer to determine if they are making the right investment. Many funds also have very high minimum investments, which makes it difficult for limited partners to diversify their holdings.
In addition, this makes VC investing available only to the extremely wealthy and to large endowments. Thankfully, tokenized funds provide a solution. The secondary token market offers early feedback on investments. If people believe in the fund, the token price will go up. Likewise, if the investments look bad, the token price will fall. A secondary market also allows for an early exit. For example, if an investor decides they would rather invest elsewhere, they sell their tokens at the current market price. This allows a limited partner to cash out early. Alternatively, an investor can buy more tokens and increase their share of the fund. When a company exits, the returns go back into the fund. This increases the value of the tokens. Also, a tokenized fund eliminates minimum investments. Likewise, any accredited investor can buy tokens and invest in the fund.
The Future of Venture Capital
Hackfund, Blockchain Capital, and Swarmfund are all successful tokenized funds. Typically, tokenized funds are evergreen funds, meaning they do not have a set life. In addition to providing a history of success, this evergreen system allows companies to mature and scale gradually. Typical 10-15 year funds push startups to scale quickly and exit early. Unfortunately, this system does not support stable growth. Tokenized evergreen funds allow investors to cash out in the secondary token market and support stable growth.
Venture capital investing is problematic and does not return investor capital. Fortunately, tokenized funds and blockchain solutions can solve these issues. Venture capital provides the means for startups to create disruptive solutions. Furthermore, it’s time for blockchain to disrupt the venture capital system. Startups and investors will continue to make positive changes to the industry.