There is a silent revolution happening today in the early-stage
investment space. It’s a confluence of
all the various technologies and investment methodologies of the past three decades,
and yes, it is going to be amazing. What am I talking about? Digital securities, or as they have been previously called: security tokens (I will probably use these
two terms interchangeably during this post).
Let’s start from the
beginning. What is a digital security?
A digital security
is essentially a blockchain-based representation of:
- financial assets,
such as stocks, bonds or some other types of monetary collateral
- physical assets
such as gold, real estate, or simple fiat money in the bank
This representation takes the form of a digital
token, that is a set of numbers that securely symbolize a one-to-one relation
with the underlying asset. I will not go into the whole concept of blockchain cryptography,
but to make a long story short, using blockchain tokens for digital securities ensures
that there can be only one copy of each token and that just one individual can own it at any given time. Using blockchain then ensures that fraudulent
transactions (i.e., sending the same token to two different people) are
near-impossible.
But what can you do with a digital security?
A digital security (token) is used therefore to
represent ownership over some underlying asset. This
means that if you hold the token then the underlying asset actually belongs to
you. Much the same as any digital document, you can either keep the token to
yourself or send it to someone else. However, since there can only be a single
copy of the token at any point in time, sending it to someone else means that
you are giving them ownership over the underlying
asset.
This opens up a whole world of potential peer-to-peer
trading possibilities that today are very difficult to perform. For example, if
today I hold equity in a company, and I
wish to sell it to someone else (provided this transaction meets all the
regulatory restrictions), I will need to go through a process (the exact
process is very much jurisdiction dependent) that usually involves some 3rd
party mediation (e.g., a broker), and a slew of paperwork. With tokens, transferring
ownership can be as easy as pressing a button on a mobile app.
Why do we need blockchain for
this?
Distributed ledger technology,
a.k.a. blockchain, is the technology that makes all
this possible. Before blockchain, the information about ownership of assets had
to be held by some company, for example,
a bank, and all transactions had to go through that company. This limited
trading potential and usually helped that holding company make a lot of money.
By using blockchain, we can remove the intermediaries and enable the
owners of the tokens themselves to be in control of their assets.
Ok, I think I understand
now. But why is this so revolutionary for investing?
Investing and blockchain have been getting a bad
rap lately because of the many scandals and frauds related to initial coin
offerings (ICOs). However, digital securities are a new way of merging the old (traditional
investing techniques) with the new (blockchain tokens) to create new and
incredible ways to invest in assets in general, and in companies in particular.
To understand this, we need first to understand
current investment methods.
Today, if you want to invest in a company that isn’t traded publicly, you generally have two ways:
- Invest directly,
or as part of an investment group (e.g., crowdfunding, angel clubs) in exchange
for equity
- Invest
indirectly, for example, through a venture capital firm in exchange for some
promised future returns
Once you have invested,
you are generally locked-in with your investment for a long period of time, usually 8-10 years, before there
is any type of “exit event”, such as an M&A or an IPO, and you can liquidate your investment. If in some point
in the middle, you wish to sell off your investment, you will be met with bureaucratic
obstacles and will probably need to discount the value of your shares on some
secondary market. Selling off your investment in a company may also reflect
badly on the company itself.
As someone who works mainly with early-stage startups, it is not uncommon for me
to see a startup’s CEO having to spend valuable time helping early investors
sell some of their equity to finance a son’s wedding, or for some other financial
emergency.
With digital securities,
all this can be a part of the past.
How? Digital securities enable the digitization
of the investment itself. This means that
the investor can receive a financial asset
from the company (for example equity) in the form of a blockchain token. This
token is essentially tradable from day one on security exchanges, which provide
immediate liquidity to the investor.
Is this really such a big deal?
I think so. Let me tell you why.
Once investing through digital securities becomes
more commonplace several things will make this market really stand out. Here are the key reasons that digital securities
investing is a real breakthrough for investors:
- Liquidity – as I stated before, the main advantage
that digital securities provide is the possibility of trading your tokens at
any point in time. For early-stage investors, this means that they can invest in
companies during their initial stage and sell off their investment (hopefully at
a substantial profit) after a year or two and/or once that company hits a major
milestone, instead of having to wait for an exit event. For later stage investors,
this means that they can purchase
investments in a company at any stage without having to commit to being part of
a large investment round, thereby diversifying
their investment portfolio
- Valuation – one of the main problems with early-stage
companies is the ability to evaluate their worth. Many of these companies are
losing money, and yet are worth many millions/billions
of dollars. Today the only real way to get valuated is by having someone invest
at that valuation (which is kind of reverse
logic). The real result of this thinking is that venture-backed companies keep chasing
investments just to increase their
valuation for the earlier investors. Since digital securities are tradable on a
securities exchange from day one, they are, for better or worse, valued by the market. This is the exact mechanism that works for the stock exchange and is
dependent on the investor’s belief in the potential of the company as well as
its ongoing performance
- Versatility – traditional investors put in
capital and receive equity in trade. However, digital securities enable
companies to compensate investors in additional ways, ways which may be more
lucrative for the investor. For example, a real estate company can award
investors in a commercial project with a share of all the rent generated by that
project, or a services company can provide its investors (e.g., its token
holders) with a lifetime discount on
services. The only limit here is the imagination
- Transparency – one of the guiding principles of
blockchain is its openness to everyone. An investment in a blockchain-based
token is no different. A company issuing tokens for investors must provide full
transparency to its operations (within commercial limitations) in much the same
way that a public company must. This
means periodical reports as well as connecting as much of the company’s financial
activities to the blockchain itself
- Globalism – one of the main problems for investors
is investing in opportunities outside of their own country. This is due to many reasons, but some of them
can be easily addressed by digital securities,
which enable easy cross-border transfer of value. This means that investors can easily invest outside of their
country as well as trade in their investments internationally
- Compliance – each jurisdiction has its own
rules and regulations regarding investments and keeping track of those rules is
no small headache. Using blockchain-based smart
contracts, the per-jurisdiction rules can be coded into the digital security itself which makes it self-compliant,
i.e., no transaction that is not compliant can be
performed on it. Headache – gone!
- Control – when investing in publicly traded
companies the investment and exchange platform must be decided in advance and
from that moment on the company is subject to its rules and whims. Does a company want to be traded on the NYSE? They must pay anywhere from $35,000 a year
and more for the listing. Does an investor want
to trade the NYSE issued stock? Just the list of fees is
enough to make you rethink it. However, in digital securities, there is a complete separation between the tokenization
platform (i.e., the company that will create the digital securities) and the
trading platform (i.e., the digital securities exchange). This also means that digital securities can be
traded on several exchanges simultaneously and that you can sell a digital
security you purchased on one exchange to someone else on a different exchange.
You control where and how much you are willing to pay for any trade
- Robots away – a major issue with today’s stock
market is the manipulation by high-frequency trading algorithms. Blockchain-based exchanges make this essentially impossible. Initially due
to the actual limitations on the number of transactions that a blockchain can
perform every second (known as TPS – transactions per second), but once that is
solved, these manipulations will be blocked by smart contracts that will be
built directly into the token itself
So, as you can see, there are major
advantages for investors in using digital securities as their investment
vehicle.
For companies too, digital securities offer a great
way of raising capital, for a specific project or for the company in general, but I think I will address this in a
future blog entry.
One final
point which must be stressed: be careful
The fact that digital securities are an amazing
investment vehicle does not mean that it is without its risk, as any
early-stage investment is. Digital securities are just the form of investment. And
like with any investment, it is the job of the investors to do a thorough due diligence on their investment – make sure
that the company is legit, the team is serious, the business model is
sustainable, the strategy is viable, and the opportunity is as good as it
seems.
In my next blog entry (which hopefully will not
be a year from now) I will discuss how digital securities investments impact early-stage
companies that are seeking funding.
