How to Manage Your Startup Equity with eShares
Regular readers will recall the article we published on Paragon’s Cannabis Themed Initial Coin Offering in which we unpacked just how bad of an “investment opportunity” this ICO actually is (or any ICO for that matter), much to the chagrin of the founders who did manage to put together a comprehensive response to our article. Said response, while much appreciated, did nothing to alleviate our concerns. In fact, we’re becoming even more concerned when we receive emails like this one which (for no rhythm or reason) just discounts their ICO tokens by 55%:
If you stop and think for a second about what these tokens actually represent, the lack of logic here by people who buy these tokens is simply unfathomable. These people are not buying equity in this “business” that consists of a white paper. They’re essentially spending money on a product that doesn’t exist yet – which sounds a whole lot like crowdfunding, something prudent people should avoid at all costs.
In the case of crowdfunding, you buy a product before it is produced. While it sounds like a great idea, in most cases it ends in disaster because the teams putting these things together cannot execute on their plan. In the case of ICOs, you are not buying equity in a startup. It’s so much worse than that. You’re actually buying tokens that you can use to spend on a software platform that hasn’t even been developed yet with the exception of something called a white paper. These tokens are not even worth the “paper” they are printed on, yet people seem to think that somehow these ICOs are going to “replace the traditional venture capital model”. Until an ICO token represents an actual piece of the company (as in equity), there’s no danger of that happening anytime soon.
Blockchain technology in its simplest form is the digitization of transactions so that they can be tracked in a manner that cannot be disputed by any party involved in the transaction. Everyone knows the rules and there is only one interpretation of ownership. The transformation of the traditional venture capital model will not be the current manifestation of the “ICO” but rather a gradual transition where startup shares are first digitized and then complimented by blockchain technology. One company that promises to herald in this new era for startups around the globe is called eShares.
Founded in 2012, Silicon Valley startup eShares has taken in $67.8 million in funding so far with $42 million of that coming in the form of a Series C round that closed about a week ago. The business model is quite simple in that they offer “startup equity tracking as a service” which eliminates all the paperwork and aggregation that is required for startups that issue shares of equity in exchange for funding. You may have heard the term “cap table” to describe how a startup manages their equity so let’s talk about that.
Most people think that the most difficult part of having a great idea is executing on it. That’s just not true. The most difficult part is trying to figure out how to spend all that money you’re going to make from your brilliant idea. That’s the sort of mindset you will often see in startups where the founder suddenly starts giving all his mates equity in the business for no other reason than “well, Bob can write some code and he’s my mate“. That’s unfortunately how things start off at startups, so these distributions of equity need to be tracked and then “diluted” when more equity is sold to venture capitalists in the form of newly issued shares. The price that those shares are sold at is how we determine valuation (it’s where unicorns come from) and it’s often reflected in something called a “cap table”. Here’s an example of one:
Just based on the above summary table, you would immediately have some questions about who currently holds the “shares issued”, in other words, who have you sold (or granted) shares to over time? Once you have a record of that you can begin issuing digital stock certificates, giving each stakeholder a place to login to see their holdings, enforcing compliance rules, and running valuable reports that provide insights into the state of your business. When we talk about “stakeholders” in a startup, we’re generally talking about the below people:
You can see the various services that eShares can provide each stakeholder above and can probably imagine how much little time and desire founders have to deal with this stuff while they’re busy executing with a laser focus. It’s no surprise that over 6,000 startups use the eShares service including names like Kickstarter, Squarespace, and Cylance. The product is sold as a SaaS offering, so expect a subscription model. You’ll need to ask them about pricing because it’s only available upon request.
When it comes time to conduct an IPO, you can see how all this digital data will make the whole process so simpler, especially when it comes to boring things like compliance. It should be really obvious by now that using blockchain to track these transactions would be the next step for eShares (if they haven’t already taken it). Contrast that to some ICO (probably a dozen ICOs) that have a white paper claiming to do the same thing and want you to buy their tokens. That doesn’t mean that there isn’t some legitimate competition though. Our past article on 3 Blockchain Companies Targeting Financial Services talked about a company called Chain which is working with Nasdaq to manage transactions for shares of startups that are traded on private secondary markets.
Another obvious step here would be to make investment participation accessible to retail investors – in other words, equity crowdfunding. The problem with that idea however, is that the regulations require companies to raise about a $1 million or less:
For any startup with even a modicum of potential, the additional paperwork needed to raise $1 million is not worth the hassle, not to mention all the questions you’re going to start getting because you will need quite a few investors to pitch in based on the limits – questions which if you don’t answer promptly, will result in some serious Twitter outrage. Nobody has time for that. eShares will be in a much better position if the rules change to allow participation at any size raise.
When we get down to brass tacks, the vision of the ICO replacing the venture capital model is the promise of everyone having the same ability to invest in startups that all those rich billionaires do (65% of who made their money from building their own incredibly successful startups). The eShares model could offer that same promise, except to keep the VCs on board so that they can help weed out the businesses that will never get off the ground. Maybe the founder isn’t committed to the work it takes to succeed, maybe it’s a bad idea, or maybe there is too much competition the founder isn’t aware of. These are all red flags that VCs can easily spot. However, even after looking at 1000s of business ideas a year, VCs still can’t do better than a 1 in 10 success rate. VCs serve a unique function that ensures the capital flows to those disruptive technologies that will change the world. The free-for-all we see today with ICOs is far from that, but startups like eShares give us some hope.
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