The last weeks have been tough for the crypto-currency market and its investors: Bitcoin dropped by more than 50% since November 2021 and the world has witnessed the crash of the Luna coin and its blockchain Terra in May. In the last twelve months, despite uncertainty inherent to the crypto world, successive venture funds dedicated to cryptos have continuously increased in size. Andreessen Horowitz (a16z), a venture capital house known to be one of the early crypto investors, is topping the charts after raising 4.5Bn USD for two new funds.
Crypto funds are more about technology than currency
Investors may be familiar with cryptocurrencies but volatility and uncontrolled changes in prices that have been observed on the crypto market look incompatible with a normal private equity or venture capital investment approach. However, cryptocurrencies alone are only the tip of the iceberg: the blockchain technology, being the backbone behind all cryptocurrency mechanisms and known to be a real game changer for years, turns out to have applications outside of the currencies’ world.
For example, the Web3, the successor of the good old Web 2.0 commonly used by millions, is based on blockchain, and gives rise to the creation of hundreds of start-up companies. Therefore, the appetite of venture capitalists appears more clearly, as they would like to reiterate Web 1.0 and 2.0 success stories.
Another example is decentralized finance (DeFi), a new financial technology also based on blockchain removing financial institutions from the equation when it comes to financial instruments and services, such as lending or trading by introducing a new online-based decentralized model with reduced dependance on centralized financial intermediaries.
In 2021, blockchain is gained investors’ confidence worldwide. Enormous growth in the number of NFT transactions and funding for crypto exchanges made headlines; notably, Coinbase has been publicly listed and FTX raised nearly 1.5Bn USD in deal value last year.
In Europe, venture capital funds investing in Web3 and DeFi are backed by major institutions such as the European Investment Fund, showing that the crypto and blockchain world is not a niche anymore.
Blockchain at the heart of new ways of investing
Following the growth of Web3, NFTs and DeFi, investors are also starting to look around for new ways of investing aside from debt and equity deals. When investing in companies developing business around decentralized technologies, why are they not also investing in a decentralized manner through blockchain?
Over the past years, tokenization using blockchain technology to create fractional digital shares of assets has started to become popular. For example, RealT, a US-based real estate company, offers fractional real estate investment in tokenized assets. Token-owners collect their revenue portion from the total income generated by the asset.
The last months have seen the rise of non-traditional investments approaches and among others Decentralized Autonomous Organizations (“DAOs”). DAOs are to some extent similar to partnerships but ruled by blockchain-based smart contracts rather than by a Limited Partnership Agreement (“LPA”). Instead of shares, tokens with various governance rights can be issued to the investors through security token offerings (“STOs”). The blockchain source code is the equivalent of the Articles of Incorporation or the LPA of the traditional world defining the rules of the game. The code of the blockchain also becomes the central organization tracking each investor’s contribution and allocating governance rights proportionally or based on the rules defined when setting up the code of the DAO.
The main objective of an investment DAO is to raise money from investors without intermediary to finance projects. Many early-stage companies are launching their own DAO to attract investors in supporting their growth outside of the traditional venture capital channel. Aurora, a European-based company developing solutions around blockchain is established as a regular corporation and launched a DAO that is used to raise money but also for governance purposes with voting committees such as boards of directors or meeting of shareholders of the traditional world.
Despite being very new, DAOs appear to have the potential to become an effective tool for the venture capital industry or even an alternative to it to finance innovative projects thanks to the flexibility of the model and limited administrative burden.
How would DAOs impact alternatives and venture capital?
Investing in disruptive businesses in a disruptive way using blockchain technologies is tempting and raises the question of how DAOs will impact the well-established world of investment funds specialized in alternatives and more particularly in venture capital.
As for the example of Aurora, more and more early-stage companies are being created using a well-known corporate form and once set up launch their DAOs in parallel. Initial investors can enter into a shared purchase agreement in the corporation with options to receive a pre-determined number of security tokens once the DAO is up and running. The legacy corporate entities remain but the intrinsic value is in the DAO. These hybrid strategies consisting of mixing equity and security tokens are becoming progressively more common in the venture capital industry. It is also worth mentioning that tokens can be exchanged or traded through online platforms, thereby increasing the liquidity for private assets that are usually seen as an illiquid asset class. In this context, it is likely that companies in the future will have less equity and more tokens to offer to investors. Maybe the next successful startup will be established as a DAO rather than a regular corporation.
In addition to being considered at investment level only, the door might also open to use DAOs as investment vehicles. As a matter of fact, an investment fund could be considered as an example of a DAO: investors collectively enter a fund that collects capital from them to invest in target companies following an investment policy for the purpose of generating a financial return for these investors. Due to the broad definition of what an Alternative Investment Fund (“AIF”) is under the Alternative Investment Fund Managers Directive (“AIFMD”), it cannot be excluded that DAO themselves could even be qualified as AIFs one day.
Despite the trend being positive, with DAOs gaining presence in the capitalization tables of start-ups’ financing rounds, only 3% of the largest alternative investment’s firms have invested in crypto-related or digital assets as per EY’s 2022 Global Private Equity Survey. However, digital assets and therefore DAOs will continue to be an area that many alternative investment firms will consider going forward to the extent that these assets are becoming more and more mainstream. The survey’s results also show that most firms remain cautious as they monitor how regulators treat digital assets from a legal and regulatory standpoint.
Regulatory challenges and risks remain
The regulatory framework surrounding cryptos and digital assets is being built with ongoing efforts worldwide. Many challenges remain on how these assets are dealt with by traditional AIFs custodians or simply in terms of legal recognition.
In late 2021, the European Securities and Markets Authority (“ESMA”) added in its Alternative Investment Funds Management Directive (“AIFMD”) Q&A that funds investing into crypto assets are to be considered as AIFs as long they are following their investment policy and comply with the AIFMD. Still at European level, the European Commission's forthcoming Markets in Crypto Assets (MiCA) regulation, which aims to create a framework for all digital assets not yet covered by European directives or regulations, is expected to see its first application in 2024.
In Luxembourg, the CSSF recently issued whitepapers and guidance on virtual assets providing clarifications on the expected level of due diligence, related internal especially for banks and for funds and their managers falling into the scope of the AIFMD. Unfortunately, there is no explicit mention of DAOs neither in the European nor CSSF’s publications yet. Currently, only two US States (Vermont and Wyoming) give DAOs official recognition with the possibility incorporate and register as a regular company or corporation.
All in all, notwithstanding their increasing popularity, the road still seems very long for DAOs to become mainstream. The main issue is the lack of clear regulatory framework. Although security tokens are governed by regulatory frameworks applicable to securities as these are qualifying as financial instruments, many gray zones remain on the legal status of DAOs. Andreessen Horowitz (a16z) as one of the largest investors in the crypto world issued a publication on the challenge related to the legal framework of DAOs. It highlights the critical legal matters related to DAOs, mainly the absence of country of jurisdiction, uncertainty on the status of the legal personality and tax reporting or potential liability for DAOs’ members. Currently, none of these points are yet regulated as many others in the crypto-assets world.
Finally, one cannot underestimate the cybersecurity risk and must bear in mind what happened in 2016 with “The DAO” which was the first DAO to act as a venture capital fund and raised more than 150Mn USD – but 50Mn USD got stolen by a group of hackers.
Currently, uncertainty remains, and the DAO environment is far from perfect. Nonetheless this new form of organizations is one of the most innovative concepts that have been designed with the blockchain. It has clearly the potential of disrupting many well-established businesses. The question is therefore not whether DAOs will have an impact on business, but how to safely navigate this coming revolution while seizing the opportunities.