Smart contracts, structured funding and the future of private capital markets
No part of the economy will feel the effects of tightening monetary conditions more than the start-up ecosystem. The founders, VCs and private equity investors who populate it are braced for a dramatic change in terms of how funding rounds are conducted and on what terms.
Within this broad universe, tech companies are by some margin the most exposed. Whilst all new enterprises are fragile by nature, new entrants into technology-intensive sectors are often years and even decades away from profitability, rendering them highly vulnerable to changing monetary conditions. With all major central banks except the ever-contrarian Bank of Japan now firmly on the path of pushing rates up fast and high, changes are already emerging in the way start-ups access funding and how VCs are running their deals.
We explain what a structured funding round is, why they’re becoming more common, and what they mean for the economy going forward. The operational importance of smart contracts to optimise the management of structured funding rounds is also considered, and we reflect on how these developments are likely to change the early-stage investment landscape.
What are structured funding rounds?
Entrepreneurs with an idea but little or no funding have traditionally relied on VC investors to get the ball rolling with a seed capital funding round, with PE firms likely to invest only at later stages of growth due to the volume of capital they must deploy. Given that tech companies from mega-caps down to start-ups have enjoyed over a decade of growth which saw valuations balloon well above historical averages, these VC-founder interactions very often ended with the later party getting the funding they wanted, without too much trouble.
Today, the abrupt ushering in of a new market regime characterised by rising rates and the winding-down of the extraordinary bond buying programmes run by central banks since 2008 has radically altered this dynamic. VC investors are no longer so happy to throw capital at loss-making tech companies on the premise that rapid growth will eventually lead to profitability.
These macro factors help to explain the sharp rise in the popularity of so-called structured funding rounds.
This is all the more significant given that private markets investors are sitting on an estimate $1.8 trillion in dry powder, capital raised but not yet deployed. The combination of abundant but unused cash with an increase in structured funding suggests a fundamental shift in how private capital markets will working moving forward.
The conditions structured into the funding can be anything perceived by the investing firm to give them some protection against the risk of underperformance and are larger slices of the upside than they would have obtained previously. Commonly built-in terms include specifying the exact conditions under which future tranches of funding will be released,
– for example , if, and only if, certain metrics for revenue growth or other financial indicators are met, as well as demands for preference shares over ordinary shares, or for debt that is convertible on especially favourable terms.
Who wins and who loses from structured funding?
With start-up valuations today typically much lower than 12 months ago, and an increasing amount of the funding that is available being heavily caveated with conditions and demands, it seems like VC and PE investors are asserting their dominance over founders.
This is, as so often in business, something of an artful simplification. Whilst it could appear that the addition of tough conditions to funding punishes founders and rewards investors, the truth is that some sort of rationalisation of seed and Series A funding has been inevitable for quite a while, and ultimately is good for the economy.
The fact that rates were held abnormally low for so long has led to an enormous and problematic under-pricing of risk.
The Bank of International Settlements, the so-called central bank for central banks, is credited with originally coining the term ‘zombie firms’ in the 1980s. A zombie is a business that has failed to earn enough profit over the past three years to meet the interest payments due on its debt. As such, zombies are companies that can only live in the atmosphere of low-interest rates, and will likely perish as soon as there is a rise to the cost of financing their debt. As the graph below shows, there has been something of a zombie invasion of the US public markets over the past two decades. As such, the ultra-loose monetary conditions of the past decade and a half have merely exacerbated a pre-existing problem.
As Edward Chancellor argues , the hyperactive monetary policy of the past decade has caused an epidemic of mispricing in capital markets. With borrowing costs and yields hovering just above zero for so long, overinvestment and bloated valuations were always going to be the result.
The return of monetary normality is in the long-term advantage of both private markets investors and young companies confident they can attract investment in a context where there is a meaningful cost to capital.
Smart contracts and structured funding rounds
Structured funding rounds can be expected to feature prominently for the next few years as monetary conditions normalise and VC and PE investors continue to drive tougher deals.
Recent reports that JP Morgan is planning to a launch fund with the specific remit to make structured equity investments in both private and potentially public companies, further underlines the significance of this development.
The complex contractual requirements inherent to raising capital through a structured funding round have, and will, continue to strain the operational capacity of VCs and later stage investors like JP Morgan, just as their stringent conditions will weight on the founders that are compelled to accept them.
This is where blockchain-powered automation can contribute to greasing the wheels of the investment cycle, with the use of smart contracts. In this way, they serve to automate processes which can be extremely time and labour-intensive when performed manually.
Structured funding, therefore, represents a new phase in the evolution of private capital markets, one where capital flows are more conditional and adjustable than before. Smart contracts will be needed to simplify the operational processes to manage such funding rounds, and we expect to see increasing investment from VC and PE firms into technology that can streamline these complex processes.