The Elephant In The Room — Venture Capital, Startups, And The Problem Of Liquidity Immobility
Common Wealth
Imagine if retail investors over the world had access to the same private sale crypto deals that VCs have access to?
The Elephant In The Room — Venture Capital, Startups, And The Problem Of Liquidity Immobility
Imagine if there was a solution to the problem of liquidity immobility for early-stage venture capital providers. One that dissolved the tension between startup funders and startup founders’ goals to better align their interests and actions? That would be a game changer.
A significant challenge for venture capitalists (VCs) in early-stage project funding is liquidity immobility–the period when their money (liquidity) is locked up (immobile) until their initial investment is recouped and they can access capital. Tension arises between investors seeking profits, and project founders and community members seeking to safeguard the project’s value from instability caused by investors cashing out early investments.
This is the elephant in the room of every VC/project relationship.
VCs struggle with liquidity immobility. They must risk-manage their investment (e.g. sell tokens to recoup their initial investment), but they also want to support the projects they invest time and mentorship into by not selling early and damaging the token price. On the other hand projects require investment and understand the fund needs to recoup their investment, but they also want to avoid the volatility of early investor tokens hitting the market.
Let’s address “the elephant in the room” and analyze liquidity immobility by looking at:
Is there a better way to align VCs’ interests with the projects in which they invest? Read on and learn more about the lucrative world of investing in startups.
The current structure of early-stage investing has problems
Venture capital providers (VCs) are indispensable to early-stage startups. Their true value extends well beyond the value of the initial capital they invest to get young projects up and running. While it’s easy to imagine VCs effortlessly turning millions into billions from the decks of their super yachts, the reality is usually less glamorous.
A regular non-accredited investor would jump at the chance to make the kind of investment return multiples that early-stage investors can, but?as we have explored previously,?gaining access is a real problem.
Even if a retail investor somehow gets access to an early-stage investment opportunity, are they in a position to wait out the 5 to possibly 10 years it can take for these investments to mature? Because once you commit there’s no backing out.
Aside from a general access issue, most of us are excluded from participating in startup VC investing by virtue of liquidity immobility.
So the question is, how can ALL investors — accredited VCs as well as anyone else — enjoy entry into this profitable sector without fear of liquidity immobility?
Not all VC opportunities are created equal: early-stage outperforms later stage VC funding
According to?JP Morgan research, early-stage venture capital (the seed and angel rounds) outperforms later-stage (labeled “late” and “generalist” funds). Later stage funds are typically provided by hedge, mutual, or sovereign wealth funds.
Hedge fund style investors typically prefer a later entry for shorter time frames to liquidity. In contrast, an early-stage VC is willing to tolerate a longer period of liquidity immobility for higher gains 2. They have a longer term view than hedge fund VCs, who are “motivated primarily by profit-making and a quick exit”?3.
But.. what if you had a choice to stay the long term or exit early without disrupting the token value? Wouldn’t that be a game changer?
The truth is, the startup lifecycle wouldn’t ever start if all investors waited until later investing rounds to reduce exposure to periods of liquidity immobility. VCs willing to financially participate in the earliest stages of a new business play an invaluable role. Later-stage VCs rely on the underlying due diligence and work of early-stage VCs for prospects as well.
But it’s not only the conviction of cash from early investors that startups and downstream VCs benefit from.
Much more than cash: the real value of early VCs to a startup
Early-stage crypto startups are innovative ideas needing real development funds to bankroll themselves, but they can’t approach banks. They need specialist venture capital providers.
Great projects are discerning about who they take investment from, so VCs compete by offering “beyond cash” value-adds like expertise, strategic mentorship, niche network introductions, and founder/team incubation. Savvy VCs protect their startup investment by rolling up their sleeves and assembling a team to work within the project and stay committed for the long haul.
While the JP Morgan data highlights the payoff is bigger profits, early-stage venture capitalists risk more than money to make money, and the true costs also include:
The double-edged sword of vesting schedules
Liquidity lock-ups (a ‘vesting schedule’) is used to balance early VCs’ profit goals with a startup’s need to attract long-term investors and sustain token value. Liquidity is defined as the?ease with which an asset or security can be converted into ready cash without affecting [the projects] market price ?, and vesting schedules exist to protect the projects’ price.
A?smart contract?administers the vesting schedule. After the public sale, it gradually unlocks early backers’ tokens, restricting the number of tokens for sale. This prevents early investors from?dumping?tokens on the market and potentially causing the price to suffer.
A well-designed schedule arranges token unlocks when new buyer demand (e.g., from positive announcements or successful milestone achievements) neutralizes unlocked token sell pressure??. Expect a 1-year “cliff” (no-sell period) followed by several years of incremental unlocking until early investor tokens are fully distributed.
The strategic benefit of investing early is that VCs pay much less than retail investors but are bound by a vesting schedule. Retail investors pay much more for post-launch tokens, but have no lock-up or vesting period and can sell their holdings instantly.
And here’s the catch: a responsible VC will actively encourage longer lock-up periods to protect a project’s?tokenomics?and token value, at the expense of making profits faster. This inherent tension — profit versus responsible vesting schedules — can in some cases prevent promising projects from getting funded, particularly in bear markets.
Finding a better way for early-stage investors to access liquidity could boost innovation and make it easier for smart investors to step in when their value-adds are most needed.
ALL investors would benefit from a new way to invest in startups
Solving the problem of early-stage VC liquidity immobility demands rethinking the existing architecture of startup funding.
Can the emergence of web3 technologies address the elephant in the room and dissolve the tension between startup funders and startup founders who otherwise have aligned goals?
What if the next generation of unicorn entrepreneurs could attract innovation funding (even during bear markets) without investors being put off by liquidity immobility? Now that would be a game-changer.
For a jumpstart on solutions to liquidity immobility join the Common Wealth announcement?Telegram channel?or follow us on?Twitter.
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References
1. AVC |?Half Of All VCs Beat The Stock Market?| Fred Wilson | May 5, 2021
2. JP Morgan Asset Management |?Searching for returns: Why early-stage venture outperforms?| Sourced Dec 13, 2022
3. Magazine by Cointelegraph |?The risks and benefits of VCs for crypto communities?| Max Parasol | July 8, 2022
4. Entrepreneur |?Startups Need More Than Money to Succeed?| Max Lyadvinsky | Nov 16, 2018
5. CoinMarketCap |?What Does Vesting Mean in Crypto??| Daniel Phillips | sourced Nov 25, 2022
6. Investopedia |?Understanding Liquidity and How to Measure It?| Adam Hayes | Updated Mar 29, 2022