Jesse Walden: Fundraising and Deal Structure

[Music] hi everyone I'm Jessie Walden I'm on the team at Andreessen Horowitz program managing crypto startup school and prior was a founder of media chain a project in the space and so today I'm going to talk about considerations that crypto startups need to think through with regard to fundraising and deal structure and there's going to be a lot here that that riffs on Brian's presentation first off what is what is startup financing all about and this is not just crypto this is just startup financing in general it's all about converting financial capital into production capital and what that means is financial capital is an investment of money use to hire people and to build products and services and production capital is the value of those products and services once built and so again this is true of both crypto startups and traditional ones but a key difference between crypto and traditional startups is that the productive kept the production capital in crypto networks comes from a community of contributors not only the core team and that has some pretty big implications so in my earlier talk in the program on progressive decentralization you guys heard about the three sequential objectives for crypto startups the first is to build a product people want the second is to build a community around that product and hopefully some one with some network effects and the third is to give ownership to the community and in that talk I saw it stated that the first two objectives are the same for crypto projects and traditional startups both need to build a product that people want they need to get users and hopefully build the community around it but it's the third objective giving ownership to the community where crypto starts to diverge a little bit by giving ownership to the community community members have a strong incentive to participate in generating the production capital of a network Bitcoin and aetherium for example of both built very vibrant communities of miners that operate the network in exchange for Bitcoin and youth respectively and this has obviously been a very effective way to bootstrap those networks what's different about fundraising in crypto so as you can see on the top here traditional startups grow by raising funding through a series of financing rounds this enables them to hire more people to expand their products and services and effectively transform financial capital into production capital and ultimately revenues that drive investment returns and crypto startups being community owned follow a slightly different trajectory so the early stages again they look similar build a product build a community but at the point you've done that you you start to move into community ownership and operation mode and so how this plays out in fundraising could be that you know a crypto startup raises financial capital in a seed or subsequent early rounds hires a great team builds a great product builds a community around that product product and then once there's sufficient community involvement starts to invite the community to participate in ownership and operation and so what that means is that subsequent growth for a crypto startup both in the form of financial and production capital comes from the community itself who has a direct economic incentive to ensure that growth of the network over time now the fact that crypto startups aim for community ownership has further implications for deal structure so so let's get into that how should crypto founder founders structure deals well again given that the early stages of a crypto startup tend to be pretty similar to a traditional one at a 16 Z we tend to think that the the best instrument to fundraise is still equity in a company and and I know in Brian's talk we talked about this exciting new membership model and we think that has a lot of promise but what's what's tested and true is equity in a company and so first off why is equity the choice instrument for first startup fundraising in general well it's because equity facilitates long term alignment between the founders that and investors so you know whatever the company ends up doing whether it needs to pivot investors are aligned for that long haul by owning equity in the company and and crucially this means that there's no obligation for a crypto company to produce a token and that just wasn't true for icos or token pre-sales that we saw in in some in the earlier days in the space where the promise very much was to deliver a token and as we know now committing to a token upfront can be a distraction from finding the perfect way to achieve product market fit so where flexibility is critical especially in the early stages of a startup equity is is the best way to achieve that alignment and flexibility that founders need but if the goal of a crypto startup is to produce a network that's owned and operated by a large community of users all over the world then a token being natively digital is likely the best instrument to coordinate it once a team is ready because it's a lot harder to do as a security as you heard in Brian's talk so when it comes to deal structure it's critical to figure out what happens to tokens if and when the founding team builds a network that generates them and so the way that we've structured many deals is as an equity purchase in a company but one that comes with rights to tokens so that as if the team builds a product or network that produces token a token then the the investors will receive some of those tokens in proportion to their ownership stake in the company and just like equity aligns investors with founders in a company this token right aligns investors with founders and teams if the company builds a decentralized network coordinated by a token and again the key stone here is that investors will receive their proportional share relative to what the founders and the core team received at the time of distribution now remember crypto networks was meant to be community owned and operated so it can't be the case that founders and investors on all of the tokens so what about them where does the community's ownership stake come in well this brings up the question of dilution so to understand dilation let's let's go back to our slide on fundraising trajectories in a traditional startup early founders employees and investors are diluted as the company takes on subsequent rounds of financing and what I mean by that is that as as the company goes through these rounds of fundraising from seed to A to B to see new shares in the company are actually created they're inflating and those new shares are sold to new investors so this means the ownership percentages of founders early team members and early investors gets smaller as subsequent rounds of financing are raised so that's dilution but why do teens and investors agree to that well the reason is that more financial capital coming into the company allows the company to grow its production capital so to expand its products and services hire more people and as the production capital grows the pie gets bigger for everyone so while the early team and investors may own less in percentage terms their ownership stake can be more valuable and that's why they agree to dilution so the same logic holds for crypto networks crypto networks raise financial capital to build production capital in the form of a product or network that they plan to hopefully progressively decentralize and by giving community members a stake in the network early founders and investors have a new tool to fuel growth and network effects that grow the pipe so community members contribute to the ongoing operation and success and so it follows that it's in the interest of roli founders and investors to take on some dilution from the community in order to grow the size of the pie overall so to make this more concrete let's walk through a specific example so here's a very simple example of a seed round let's say $1,000,000 is in tested in exchange for 20% of the equity in a company and this values the company at five million dollars now let's say the company plans to launch a network and the goal of this network is to be decentralized or community owned and operated so an allocation to the community needs to be considered and decided upon now just for illustration let's say the core team decides that the community will receive 50% of all the tokens in this network which leaves the company and investors with the other 50% of tokens while deciding on that specific distribution is important because it has an implications for the valuation of the network and here's how so remember that 1 million into the company gives investors 20% of equity in that company and when the company goes on to build this network the community will get 50% of its tokens and the investors will get the other 50% so that means that the investors pro rata or proportional share of the network is 10% that's 50% of their 20% in the company so where 1 million dollars buys 20% of equity at a 5 million dollar valuation for the company that same 1 million dollars buys only 10% of tokens which implies a network valuation of double that of the company or 10 million and to make that even more clear let's see what happens to your network valuation when founders decide they're going to give 75 percent of network tokens to the community so as you can see here now the the core team and early investors would again be cut in half the same 1 million dollars that bought 20% of the company is now only buying 5 percent of the tokens because the community has the other 75% so hopefully you can see and build an intuition now that the valuation for the network is dependent upon the amount of dilution penciled in for the community which again is a function of the total supply of tokens and how they get distributed over time so given that you know you probably can tell that the future token distribution to community members is closely related to ownership dilution for the core team and early investors and accordingly it's really important to have a good plan for how that token distribution to the community is going to work and who the the stakeholders are so a few key takeaways to note about do structure first is that equity with rights for tokens is a great way to align founders and investors for the long term that it takes to build a product build a community and eventually turn ownership over to that community via tokens and again this this structure it adds a lot of flexibility to founders to figure out the best way to achieve product market fit without mandating that they necessarily produce a token to do it and a keystone of this structure is that token rights give founders and investors alignment on some dilution plan for the community but by giving community members that stake in the network early founders and investors are leveraging this new tool for community growth and network effects that traditional syrups haven't really played with to date and so that's a really exciting new tool but it's important to plan what that token distribution looks like in advance so that both founders and investors know what their respective ownership stakes and the networks are going to be in the long run and finally the last takeaway well it's it's sorry it's it's what I just said it's is that token distribution should be considered upfront in order to reason about the team and investors long-term ownership stake and I guess it's good that I'm reiterating that a second time because it's that's a that's a crucial point when it comes to fundraising so let's let's dig in on that a little bit more and and this brings up the topic of network monetary policy so there's no one-size-fits-all monetary policy in crypto networks that dictates what the supply of tokens or ownership stakes will be this is all very dependent on the type of network that you're launching the various stakeholders involve and how you incentivize them to contribute but we can run we could talk about a few examples so of course most famous is Bitcoin where the code specifies that there will only be over 21 million tokens in circulation and those tokens are distributed each block to miners on a predefined schedule as a reward for contributing work to the network so that's a very simple monetary policy and it's easy to reason about ones ownership stake in the network because there's a predefined number of tokens but other networks such as the theorem they don't have a thick supply and instead have a perpetually inflating monetary support oaken supply so tokens and a theorem are continually minted to reward ongoing active participation of the miners in the network and so in the case of a network like aetherium if token supply is always growing then it seems as though founders and investors would be perpetually diluted losing ownership over time now in the case of aetherium that that that is actually true but in other networks it's not always the case so some networks have perpetual inflation that can actually be productive in the sense that capital assets in the network or tokens in that network can be put to productive use by by staking so let's look at that so in proof of stake networks like solo or Forte token owners can actually stake their bond their assets as a bond that secures they work the work that they do to can to keep the network operational if they do a bad job those tokens can get programmatically taken away that's that's proof of stake and this means that an investor or token owner can stake their tokens in the network in order to make them productive and when multiple investors and token owners do this the result is a live functioning decentralized network so token owners become the network operators and in exchange for their work the network mints new tokens and rewards them so here is inflation and it may be perpetual but it's non diluted since the that are making their tokens productive in the network are able to earn those inflationary rewards increasing their the number of tokens that they own while the supply of tokens continues to inflate so so here their ownership stays the same so long as they participate and and this is why raising capital from those native to the crypto ecosystem can be really advantageous to founders because number one they understand that community ownership in operation is critical to the success of these networks and with an effective network monetary policy these investors are highly incentivized to become active community members in order to maintain their ownership stake in the network and increase their returns as the service grows so with that kind of specialization in mind I think want to wrap up with a look at the different sources for capital in the ecosystem and and how they compare so yeah there's there's been a bit of an evolution of financial capital available to crypto startups crowdfunding was the most popular way for crypto stirrups to raise funding from 2014 to 2017 18 or so and during that period we saw many of the top 10 crowdfunding events in history play out as icos and that's that's probably because the ability to distribute packets of value in the form of tokens made investing in new startups as fast and as easy as sending an email and that's just never been the case before and and while crowdfunding can be a great way to build a community we know from Brian's talk that it comes with a host of regulatory considerations and dealing with those issues and the complexity of managing a large liquid token distribution can be a distraction from managing product development and achieving product market fit so super important to weigh the trade-offs of raising money from the crowd verse focusing on building a product but the the crowdfunding model is still one that is exciting and and the membership model that Brian Brooks talked about is a possible path forward for that that that we look forward to seeing more information on seeing around the same time that the ico boom hit its peak we started to see the emergence of another form of capital available to crypto startups and that that was coming from crypto hedge funds so a number of hedge funds got raised and typically hedge funds focus on training liquid assets and that's because their investors that investors in hedge funds typically are focused on short-term returns that you get from trading and and that's manifest in the lock-up period for capital invested in hedge funds which tends to range from monthly to quarterly or sometimes yearly redemptions so this shorter time horizon can lead to some sort of unstable alignment between core teams and in bet and hedge funds in that it takes time to build a product and the community and ultimately to exit to that community and investors who are focused on short term returns short term trading may not be able to or willing to stick around through volatile markets and and all the time that it takes to bring the product to fruition and so finally that that gave rise to another form of capital for for crypto networks and that is crypto focused VC and like traditional VC crypto theses tend to have committed capital which means their investors are locked up for ten years or thereabout so with that capital committed over the long term crypto VCS are much more capable of being aligned with founders for however long it takes to build and launch a network and and ultimately turn it over to the community to own and further you know specialization goes a long way to figuring out you know the appropriate valuation methodology the appropriate deal structure to structure the the unique sort of equity deal with token rights and furthermore you know crypto dedicated VCS have capabilities to participate in networks custody tokens do this sort of more technical that that crypto networks require because as community owned and operated networks they depend on on their their early investors and community members to bootstrap the network so specialization goes a long way and that's something to optimize for so with that a few quick takeaways number one it's important to understand how crypto fundraising is different from traditional start start up fundraising northstar is to exit to the community by giving the community ownership and inviting their active participation in operating and growing the network and so it's important to have a really clear plan for transitioning the community to that ownership and participation model and you know we think that raising equity with an option for tokens is the best structure for aligning founders and investors early on through this journey of progressively centralizing the product or service to a community on network and finally your your early community including investors play a crucial role in achieving this and so you need to make sure as you're going and thinking about fundraising how do you optimize your fund rates for a community that is long-term aligned and and so with that I'm gonna open it up to Q&A and Allie I think is graciously gonna help me moderate the question so I can focus on answering them so only if you're out there shoot those questions over awesome Thank You Jessie cool well the first question here is from James and it reads as follows so let's say that a company builds a great product and a strong community and then successfully launches a decentralized network powered by a token can you talk about what things look like for that original company afterwards who should be responsible for the mobile app that was the original product the mobile apps cannot be maintained in a decentralized way should this be operated by a new company and if so what should the funding and business model look like for that company yeah that's a that's a really good set of questions so so yeah there's the way that I think about it is you know the company that launches the network has you know maybe let's say they built full-stack as in James example and and I think compound is a really good example of this where they both built a smart contract and they built the first user interface which could be the mobile app and James example they once the network is live and running hopefully it becomes decentralized through multiple community members contributing to it and building on top of it and in that scenario the mobile app that they've built is just one of n or one of many mobile apps sitting on top of this this network or smart contract and so the business model for the company and the business model for the network start to diverge here right there's there's hopefully a business model at the network level which could be maybe a fee taken in a marketplace and then there's also a business model at the application layer and that could be different that could be an additional fee on top of that charge by this more contract it could be advertising it could be anything and so there that divergence in monetization is a big deal and it's something that founders of the company need to consider which one that they want to prioritize it may be the case that just by virtue of owning some some tokens in the network that company is sustainable as it sees fees coming out of the network and and hopefully growth in those fees as more community members contribute to it so that could be one viable model for the company and its investors is to just focus on making the tokens more valuable by say empowering third-party developers and and and then that once that's the case they could also build out a product team on top that that implements this other business model at the client level fantastic so the next question here is from Paul what is your best guess for how soon you'll have a norm for the right community ownership fraction do you imagine that once that stabilizes then that normal persists just like how that 4-year vesting schedule became so standardized in traditional startups yeah it's a great question you know I think it's gonna be highly dependent on the network and and it's application so for something like Bitcoin which aims to be a non-sovereign store value I think it's really important that it's it's extremely community owned right meaning it's the most decentralized ownership you you can imagine because that gives it it's it the trust guarantees that for for an application like non-sovereign store value that that make it valuable in the first place so so but but other networks that are sort of you know maybe less paranoid about decentralization and just want to meritocratic aliy reward folks for contribution you can imagine a very different distribution maybe one that more fairly reflects the the degree to which you know community members are contributing over time versus the the value that the core team has created at the outset so I don't think to answer the question directly I don't think there is yet a precedent set for this but but certainly you know I think it will emerge over time and it will likely be standardized relative to the type of application or networking question yeah and his leg leads was to depend on the specific like monetary policy that the network has with the amount of inflation that it has over time Bret Hart is sort of have like a single kind of one-size-fits-all solution upfront yeah yeah exactly you need to really need to consider who are all the stakeholders what is the value of their contribution and how does it play out over time and design the network's monetary policy to to best reward those efforts the next question is from both Stefan and Paul how should founders think about networks a networks concentration and how it impacts decentralization versus ability to fundraise and how can founders protect themselves and the retail community against aggressive token sales from investors that could hurt the credibility of this base in the long term hmm well I think you know well Bryan Brooks model that he proposed earlier I think is a really interesting thing to bring up again here I think it it points to a way to conduct a crowd sale that that really like aligns all the participants in this network or in a network I should say in a in a really useful way so you know you do benefit from you know speculation is a powerful tool people wanting to profit is a powerful incentive to get a network going and so but you want to do it in a sort of responsible way and I think you know limiting membership to those folks that are you know defined in a useful way people who can actually participate or contribute that's one way to mitigate some of the risks that we saw in in sort of the Wild West of ICO crowdfunding so I'm excited about about that I think that answers the second part of the question the first part remind me again it's a it's about the the problem that concentration and the network poses the question of decentralization is very centralized is that was that / - credibility of the space does that also impact the ability to fundraise that there's a trade-off between yeah so so yeah I think I think there there is a trade-off whether it hurts the project or not I think again depends on the application in question so it may not be the case that all projects need to be extremely decentralized it could be that some startups in the space tend to have you know stronger leadership and maybe you're sort of more product focused and leave those products as such but then have a vibrant community of contributors that that gets some ownership but not all right and that could be an acceptable way to operate one of these networks so long as you're very transparent about that but then others that require high degrees of trust they will require much more decentralization in order for all the participants to feel as if you know they have control they have a say and there not some overarching you know oligopoly that that will topple their interest so again I think it really depends on the application but decentralization maximalism I think is useful for a certain class of applications but maybe not for all allowing these in lines what what are your thoughts on like things like lock ups and air drops as a way of managing a community and ensuring that they stay aligned over the long term yeah so I think I think lock ups are a great tool very common in start-up equity you Wester tokens over time often it's the case that when a company goes public and equity get gets liquid employees are locked up and investors are locked up and and and that's useful because it means those with with insider information and so into how the product or service works aren't you know able to dump those equities or tokens in the case of crypto networks on unknowing investors who are just sort of finding out information from from the company day one so yeah I think I think lock ups can be a very powerful tool investing and can be about a powerful tool that we take from the equity world into the token world and you know it there's new ways to do it which are which are interesting like the perpetual inflation is a great way to keep contributors active over time right so if you don't participate in a network and you just let your tokens sit there and the network is perpetually inflating you get diluted so that's that's sort of a similar way of you know achieving the same ends of keeping people committed to the network and so there's some new new ways to explore this concept of lock ups that have a similar effect what about what about air drops yeah air drops well I think air drops are an effective way to to make the transition from you know traditional product team and start up to community ownership and especially so once you have users actually using the product or service because at the point that you know you have usage and to analyze you can really start to think about who's contributing value and then reward them through an airdrop so that's that's a pretty powerful tool and in my talk on on progressive decentralization I sort of you know discuss the idea that you could do some sort of a promissory way so for example running a test net program where you tell folks hey if you you know participate in the network early and run this test net when the main network goes live you'll receive some some tokens in the Genesis block which is similar to to an airdrop so I think that can be a really effective way to sort of make the transition to community ownership the next question is from Stefan how important is for protection or defense ability to fundraising yeah that's a good question well so this this goes back to the talk that you gave on business models and also the one that I gave on progressive decentralization in and and I think it would what defense ability comes down to in crypto is network effects and switching costs and so where there are strong Network effects whether you know around liquidity for example or security there are there are switching costs and those switching costs allow for networks to extract some margin of defense ability now maybe less than the margin that traditional startups are able to take because their code is proprietary and crypto code is open source but it's nonzero now so that's to say that defense ability is important when considering fundraising and it'll be important to investors to assess the project on the merits of how defensible it is but defensibility does exist and crypto networks and so to the extent that you've thought about it and designed for it you know it should be possible to communicate that to investors and raise funding accordingly yeah absolutely and I think it's important to know what exactly we mean here by for protection is you could interpret that in two ways you could you could imagine the potential protection means making your code base proprietary or something like that and then that would have that kind of be the negative result of that would be that you would have a smaller community because people are less likely to believe in a platform that's not really open it's not inclusive whereas what you're talking about now is for protection that comes from network effects and from the switching costs that emerge as a result that's kind of the kind of protection that you would want to go and I think that kind of the fundraising question hinges on on whether or network has a potential to be massive and to include a very large community so has to become a fundamental kind of primitive that people build on top of each other they agreed so the next questions from abhishek i'm hoping i pronouncing that correctly do you see room or have a structure for multiple classes of tokens for the investors founders and community that distinguish their role in keeping the community and network alive yeah it's a good question so they're in traditional startups there are different classes of equity there's common stock and there's preferred stock and they have different rights in crypto I don't think I've seen a network that has that distinction it's usually the case that most tokens are equal but that's not to say that that it's not possible to do otherwise right you could imagine assigning certain logic to certain subsets of tokens and like for example just sort of thinking out loud through a process of delegation you could imagine that you know community votes to to say hey this address and their tokens count for double in a voting scheme for example so I think you could you can program any kind of classifications that that you want and that's something interesting to experiment with but I haven't seen much of that most most tokens amount in the network's I've looked at or sort of you know the same or fungible and there's advantages to that of course there's non fungible tokens for unique you know digital items and that's a whole another thing but yeah I think I think it's a it's an interesting idea to explore networks with difference with hierarchy and structure that that you can get in equity but here in crypto you'd program it as code maybe a good example might be maybe compound where you have C tokens there's a specific C token for every trading pair for every every asset you might kind of lend out to the platform and then there's a separate governance token for the whole platform and so those two are kind of very different and that one is kind of global for the whole network and then the C tokens are specific to their liquidity providers for each of the specific assets yeah maybe that's an example but I think I think you're right that it's probably under explored and there's so lot that can be done and it's kind of the sky's the limit given that it's all fully programmable oh right yeah the compound example is a good one also maker has died and it has MKR so yeah these are not different classes of stock or tokens but they're two distinct tokens that sort of are the product of the same network right so there's one more question and this one is from Tina and it reads raising human capital versus raising monetary capital is it possible to design a continuous flash organization for quote unquote side gigs that first raises human capital via Mutual's model and only later raises monetary capital from funds to scale after providing after proving product market fit hmm okay so the way I'm interpreting this question is is like there's human capital which I which I would sort of classify as a subset of production capital and and and there's the financial capital which is just money that maybe buys that human capital I think I think this goes back to what I was saying earlier where encrypted networks part of the production capital of the network comes not now not just by hiring employees to a company but from the community actually contributing resources themselves so that could be that could be in the form of human capital could be for example you know community building or you know marketing or you know or code right that's all the product of human work and so that's that's part of the production capital that community members contribute to crypto networks and so so yeah I think I think it's very much the case that human capital has a role to play in in crypto networks and it's part of the production capital that they're comprised of yeah absolutely well that's one last question okay sweet all right what well thank you guys [Music] you [Music]