By Hatu Sheikh, co-founder and CSO of DAO Maker
We are currently living through one of the most uncertain times of this millennium. From COVID-19 to U.S.-China trade wars to high-voltage U.S. elections to Brexit-related trading negotiations with the EU, several upheavals have caused ripples in global markets. But despite all that, there have been record-breaking venture capital funding in 2020, surpassing $300 billion. Second only to 2018, when the total funding was $330 billion, 2020 was, therefore, a landmark year in the history of the venture capital industry.
Strengthening the industry’s upward trajectory, however, 2021 is turning out to be even better. Investments by venture capitalists have already crossed $268 billion this year, distributed primarily among sectors like FinTech, Healthcare, and e-Commerce. Notwithstanding, though, institutional investors and the ultra-rich presently dominate the entire domain of venture capital funding. And this monopoly of giants has become tremendously detrimental for the industry’s long-term prospects.
On the bright side of things, the industry is gradually opening up for fairer competition and greater participation of retail investors. Such a phenomenon is especially in courtesy of recent technological innovations in blockchain and cryptography. Analyzing how it is so shall be the attempt and focus of this article.
Retail investors in venture capital (VC): Where do they stand?
According to several estimates, retail investors contribute less than 1% of all VC funding. For example, out of the $300 billion invested in 2020, retail investment was a mere $2 billion. And concerningly, the situation is not due to any fault or limitation on the part of retailers. Rather, some of the industry’s most persistent and structural problems are responsible for the ever-widening gap between retailers and behemoths.
For one, individual investors have limited access to capital for funding, and thus tend to avoid risky investments. Hiring brokers or participating in pay-per-trade and e-broker setups are often their only options. Because these methods involve multiple intermediaries or middlemen, they introduce significant bottlenecks in security trading. Costs go up, while efficiency takes a backseat. And although certain online alternatives are available, they usually lack robust security features and are not user-friendly.
In addition, VC funding is innately complicated, which further raises the entry barriers for retailers and small investors. For example, startups may falter on their promises and fail to deliver the products. Both the company and its investors may incur losses over ninety percent in such a scenario. Naturally, individuals with limited access to funds do not have the buffer necessary to withstand such a loss. The risks, therefore, are too great for retail participation. And so, better opportunities for managing and limiting risk exposure are necessary to create a safer investment space for retailers.
The cost of due diligence and background verification is also massive, both in terms of time and resources. Before making an investment, the investor needs to assess the startup’s potential for success. From assessing the roadmap and revenue collection infrastructure to predicting a growth trajectory, this entails manifold complications. And in turn, this phase determines the scope and efficacy of the investor’s risk assessment and mitigation strategy. Retailers are thus stuck in a vicious cycle of inadequate resources, capital losses and non-optimal ROIs. Outsourcing is also not possible and for similar reasons.
Furthermore, because most retail investors rely heavily upon brokerage firms and 401(k) bank accounts, they are essentially barred from making cross-border investments. Institutional investors, on the contrary, have a global outreach, enabling them to bypass several limitations to trade. They can also wield power to negotiate for minimum buy-ins and better fees, which isn’t possible for retailers.
Lowering barriers for retailers: The role of blockchain technology
Blockchain has been at the forefront of technological innovations to reimagine global finance and inaugurate equitable economies. Despite its nascency, the blockchain-cryptocurrency sector already has a market capitalization of $2.84 trillion, growing steadily every quarter. And thanks to the secure, transparent and borderless systems that it enables, blockchain technology has the potential to usher in a new class of retail investors.
In combination with peer-to-peer network architectures, the use of distributed ledgers allows blockchain-based systems to function independently of banks and other such intermediaries. As a result, they are significantly more economical and efficient than their centralized counterparts.
Theoretically, blockchain ecosystems may also involve varying degrees of centralization. But in practice, the majority of these have adopted the principles of decentralized finance (DeFi). In this regard, the essential features include decentralized decision-making, community-oriented governance and user-controlled access to information. DeFi thus provides a level playing field for retailers, besides being more receptive to their interests. Blockchain-based funding curtails the scope of monopolizing information, ensuring retail investors’ access to data and resources in a transparent manner. Empowered thus, retailers can make well-informed and risk-minimized investment choices.
Asset tokenization is another significant enabler for retail venture capitalists — the possibility of fractional ownership minimizes risks and broadens the scope. Pooling enables retailers to contribute a part of the overall funding, rather than imposing the compulsion of bulk investments and high capital obligations. And furthermore, crypto-based instruments are genuinely borderless, that too for no extra cost. Therefore, retailers can access cross-border opportunities equally as institutional investors, which opens the door for low-threshold investments among deprived populations.
As an example of the above-mentioned benefits, consider DAO Maker, a blockchain-based venture capital platform, among several others. The ecosystem offers tiered investment opportunities to retail investors, with varying degrees of risk levels. Retailers can thus participate in VC markets through various means: Dynamic Coin Offerings (DYCO), Venture Bonds, Refundable Strong Holder Offerings and so on. And because of these innovations, not just retail investors but also startups benefit greatly.
Liberating startups: The future lies in retail VC funding
Institutional investors often infringe on the liberty of startups through unethical acquisitions, forced scalability operations and unsustainable trade practices. Having reached the tipping point with venture capital oligarchs, new-age entrepreneurs are increasingly preferring retail investments. And DeFi effectively caters to this shift in the demand-supply metrics of VC markets. The industry thus breaks free from its traditional shackles, envisioning the future in a new light. Financial inclusion emerges as the standard, manifest in the adoption of the principles like decentralization and community orientation. Instead of a few, startups can now reach out to the many.
By ensuring fair competition, blockchain-based venture capital funding promotes sustainable growth for businesses and investors alike. The traditional exclusion of retail investors is quite ironic, as they are in fact the majority — their power is the power of numbers. Institutional players may dwarf retailers in terms of capital accumulation, but the latter is inevitably superior in terms of vastness. Excluding them has been a historic stupidity and injustice, which technological progress thankfully rectifies.
Finally, thus, we may hope for proper utilization of the immense liquidity that hitherto remained locked out of reach. The road to an equitable world begins here and now.
About the author:
Hatu Sheikh is the Co-Founder and CSO of DAO Maker, building the future of venture capital. DAO Maker creates growth technologies and funding frameworks for startups, while simultaneously reducing risks for investors. You can follow him on Twitter at @TheHatuSS
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.