"Venture capital, is it obsolete today? I do not think so.." Author's column of Maxim Gorbachev

29 August 2017

Maxim Gorbachev, Managing Partner of RMI Partners. Author's column.

New technologies make dramatic changes to business. They even reached financing of venture capital companies. Use of crypto-currency has resulted into development of the new mechanism of crowdfunding – Initial Coin Offering (ICO) which is in a way similar to public share placement (IPO). Venture projects utilize blockchain technologies to create and sell digital tokens, thus raising funds from investors. When initially ICO was used as mechanism to develop new crypto-currency instruments such as Ethereum, nowadays ICO serve as a democratic mechanism of fund raising for any project. And this instrument cannot be ignored due to amounts of funds raised this way.   

In order to estimate change in the scale of this instrument utilization let us compare amounts of such offerings with the amount of funds which is raised at public markets by one of the most profitable sectors of global economy – biopharma. Indeed this is a dynamically developing market – 2017 year to date NASDAQ Biotech index advance equals to 19.5% (Source: Factset, Bloomberg).

Back in 2016 amount of funds raised within Initial Coin Offering was insignificant – about $222 mln. (Source: Autonomous Research LLP). For comparison that year almost same amount was raised by only two portfolio companies of RMI Partners - Syndax Pharmaceuticals and Clearside Biomedical – within NASDAQ public offerings. Total amount of Healthcare IPO for NASDAQ in 2016 was $3.52 bln (Source: Dealogic, Renaissance Capital).  

However, as per Autonomous Research LLP beginning with 2017 amount of Initial Coin Offering equaled to $1,27 bln, which is close to cumulative amount of all Healthcare IPO for NASDAQ for the same period - $1,49 bln as per Dealogic.  

It is necessary to note though that quality of such offerings differs significantly. Only companies which represent real interest for investors and bankers and which are ready to meet high standards of corporate management pass through selection process of preparation for IPO. Within ICO there is no any regulation so far and only those projects are successful which managed to persuade as many supporters as possible to invest into them having created a community of supporters around the project. This makes ICO quite attractive for early-stage start-ups and creates an alternative to fund raising from venture foundations.

Some hot-heads are claiming already that due to this factor a venture financing model has worked its days out. For example, Jamie Burke, founder and CEO of Outlier Ventures which specializes in financing of blockchain and other technologic projects, has recently stated: “The day when VCs were the elusive elite and primary source of capital for startups has ended”. This is so much the case that a number of venture foundations are ready to participate in ICO of the companies interesting for them, but they face difficulties with investing significant amounts as far as start-ups themselves limit amounts of financial resources attraction at the stage of ICO preparation. And within the frames of ICO they try to distribute their tokens as wide as possible in order to create a community around their project.    

Brock Pierce, cofounder of Blockchain Capital, in his interview for Reuters has recently stated: “The old business model that gave venture capitalists and founders the lion’s share of a company no longer worked with blockchain firms. Whether VCs like it or not, venture capital will become a very small part of capital formation”.

At that, certainly, venture capitalists cannot just sit and do nothing watching high profitable deals going west. As per (website which monitors Initial Coin Offerings) average current price of tokens which are traded at crypto exchanges are 20 times higher than their initial offerings. This value is certainly upshifted due to several super-successful offerings, however even median multiplier of excess is equal to 3 which cannot but disturb venture foundations.  

Not everyone is pessimistic though. A number of venture capitalists see sale of digital tokens as mechanism which transforms traditional understanding of capital raising, but advocate their role in financing of venture capital companies as well, reasoning this with the fact that foundations provide not just money, but also help with team creation and building of long-term strategy of a company, share their professional competences.

In our practice we had cases when for the further development of a portfolio company interference of a syndicate of investors was required in order to strengthen the management team. For example, in the above mentioned company, Syndax Pharmaceuticals, it was required to change CEO so that the company stops to stagnate and make a significant move forward in researches and market positioning. When industry “veterans” Briggs W. Morrison and Michael A. Metzger joined the team, and this was initiated by the syndicate of investors, it resulted into review of the company strategy and conclusion of a number of partnerships with leading industry players. This allowed Syndax to make offerings for NASDAQ.

In contrast to such opportunities companies which make ICO offerings have almost no mechanism to influence management team membership or change management. And even if majority of token holders express some way their distrust to management and request its change, it is unclear how this can be realized and which way new candidates will be selected.

Moreover, acknowledging their significance for start-ups, venture capitalists point out long-term format of relationship which is accepted in the industry. “The investors who bought your token, like public market investors, may be gone tomorrow, next month, or next year, having moved on to the next big thing”, comments Fred Wilson, cofounder of Union Square Ventures, “VCs, at least the best ones, are there for your company in good times and bad”.  

Industrial expertise which venture foundations possess can also serve as a significant asset for projects in order to attract new investors. Thus, for example, in biotechnologies it is necessary to have deep understanding of this industry, its peculiarities and scientific specific features in order to invest successfully. This is why new investors are often ready to join syndicates of other venture foundations which already have reputation of successful investors. What is more, high capital intensity of such projects requires a syndicate of investors which could finance a company even in the case when due to any reason they did not manage to get investments from other sources, and venture foundations with their significant reserves can provide such support.    

I assume that these factors influence, among other, the fact that we do not see so far quite a number of biotechnological projects which consider ICO as mechanism to attract investments.

Meanwhile RMI Partners as well as other venture foundations carefully study experience of raising funds with the help of ICO evaluating possibility and reasonability of using this new instrument of financing. Surely “tokenomania” has already made this mechanism of fund raising for venture projects rather significant, although on the world-wide scale it is still insignificant, about 1.5% of the total venture financing globally, which beginning with 2017 has made $83.6 bln, as per Prequin.

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