This post was last updated on July 11th, 2019 at 08:10 pm
My guest today is Stephen McKeon. Stephen is a visiting fellow at the Cambridge Centre for Alternative Finance, a finance professor at the University of Oregon, and most relevant to this podcast, a partner at Collaborative Fund where he’s leading a dedicated effort called Collab Crypto.
This is Stephen’s 3rd appearance on the podcast, making him our most frequent guest. His other two appearances were on episode 19, “The Economics of Cryptoasset Markets” and our very popular security token audio documentary entitled, “Tokenize The World.”
This episode is broken up into 3 chapters:
- Chapter 1: The state of crypto-focused venture capital
- Chapter 2: Collab Crypto’s approach to structuring investments
- Chapter 3: Collab Crypto’s thesis and what Stephen believes to be the biggest investment opportunities
Topics Discussed In This Episode
- How Stephen got involved with Collaborative Fund
- The current state of crypto VC
- Whether investors in the crypto space are getting more sophisticated
- How the crypto space is maturing
- Which funds provided inspiration for Collab Crypto
- Location patterns in crypto investments
- Governance and allocation
- Investment protection and how it is being standardized
- How Collab Crypto is positioned to provide value
- Equity vs. tokens
- Institutional Shareholder Services
- Protections against excessive dilution
- Opportunities beyond crypto assets and exchanges
- What’s happening in the security tokenization space
- Stephen’s thoughts about debt markets
- Value-added custody
- Where the scarcities are located in the crypto investment space
- Types of teams that are most successful in the crypto space
Links Relevant To This Episode
- Cryptoinvestor Weekly Newsletter
- Clay Collins
- Collaborative Fund
- Stephen McKeon
- Collaborative Fund on LinkedIn
- Stephen McKeon on Twitter
- Collaborative Fund on Twitter
- Union Square Venture
- Lowercase Capital
- Protocol Labs
- Radar Relay
“There are so many different industries that crypto potentially touches. You could see from the standpoint of a capital allocator that if they felt like there was potential disruption to other parts of their portfolio, they would want some exposure to this new asset class that is on the ascendancy.”
“And so, it’s interesting because the ethos of blockchain is kind of the idea that we don’t want to have to trust third parties whenever possible, and so you want to try to control for those things up front when you’re making the investment, but it’s very difficult to control for every possible scenario.”
“I think insurance is an area that we’ve seen some activity, but we’ll probably see a lot more activity over time.”
Clay: Welcome to Flippening, the first and original podcast for full time, professional, and institutional crypto investors. I’m your host, Clay Collins. Each week we discuss the cryptocurrency economy, new investment strategies for maximizing returns, and stories from the frontlines of financial disruptions. Go to flippening.com to join our newsletter for cryptocurrency investors and find out just why this podcast is called Flippening.
Clay Collins is the CEO of Nomics. All opinions expressed by Clay and podcast guests are solely their own opinion and [00:00:30] do not reflect the opinion of Nomics or any other company. This podcast is for informational and entertainment purposes only and should not be relied upon as the basis for investment decisions.
My guest today is Stephen McKeon. Stephen is a visiting fellow at the Cambridge Center for Alternative Finance, a finance professor at the University of Oregon, and most relevant to this podcast, a partner at Collaborative Fund where he’s leading a dedicated effort called Collab Crypto. This is Stephen’s third appearance [00:01:00] on the podcast, making him the most frequent guest. His other two appearances where on episode 19, The Economics of Crypto Asset Markets, and our very popular security token audio documentary entitled Tokenize the World. Professor McKeon is back on the show to discuss his recently launched dedicated effort called Collab Crypto which we alluded to earlier. This exploration is broken up into three chapters. In chapter one, we discuss the state of [00:01:30] crypto-focused venture capital. In chapter two, we discuss Collab Crypto’s approach to structuring investments. Finally, in chapter three, we explore Collab Crypto’s thesis and what Stephen believes to be the biggest investment opportunities available right now.
We’ll get to the episode in just a second, but before we get started, I’d like to pause for a moment to tell you that this episode is brought to you by the privacy coin Veil which funded this episode and made it possible. Veil defines itself as ‘privacy without compromise’, providing anonymity through a combination of [00:02:00] technologies like Ring CT. Having launched this year with over $1 million in seed funding, Veil boasts an experienced team, including members working on Ravencoin, PIVX, and more. Before its launch, the Veil team released the X16RT mining algorithm, which has been adopted by projects seeking resistance to ASICs and FPGAs. Veil’s hybrid Proof-of-Work & Proof-of-Stake consensus lets users mine the coin, stake or both. Veil states that staking allows Veil users to earn rewards anonymously [00:02:30] by holding coins in their wallets. Find Veil on leading data feeds like Nomics, CoinMarketCap, Blockfolio, and CoinGecko. To learn more about Veil check out their website at veil-project.com, join their discord and telegram chats, or follow them on social media @ProjectVeil. Thanks again to Veil for making this episode possible. Again, to learn more about them you can go to veil-project.com.
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Okay, back to our regularly scheduled program. Here’s my conversation with Stephen McKeon from Collaborative Fund. Enjoy.
Let’s start with a [00:04:00] bit of your background and how you got involved with Collaborative Fund.
Stephen: I’m a finance professor at University of Oregon, co-founded a software company called Skyward back in 2012, and it was in the context of that project that I came across Bitcoin and blockchains and immediately piqued my interest because it really felt like the intersection of finance and emerging technologies—both topics that I’m very passionate about. A good friend of mine named Craig Shapiro founded [00:04:30] Collaborative Fund. It was founded about a decade ago. Collaborative Fund has been deploying capital into early-stage ventures, things like Lyft and AngelList, Kickstarter and many, many others that are represented on the website for listeners that are interested in seeing more about the portfolio. But the theme throughout the last decade has been disintermediation and the sharing economy and the collaborative economy.
What happened is that because that thesis [00:05:00] extends so naturally into crypto, Collaborative started seeing a lot of deal flow around blockchain, starting several years ago. What became obvious as time went on and as the deal flow increased, and Craig and I were talking more and more frequently about deal flow that they were seeing, is that it really needed its own effort, right? So, even though it is a natural extension of Collab’s thesis, it needed a dedicated team that was thinking about crypto every day, [00:05:30] that was really pounding the pavement for deal flow. We felt like it would be better for Collaborative. It would be better for the teams we work with. In fact, many of the teams often have mentioned a preference for working with investors that are entirely focused on crypto. That’s what we did. We put together a team that’s dedicated to this effort. You’ve got myself. You’ve got Brian Chang in San Francisco. Matt Lucas in New York, and of course Craig and Taylor who are also partners at Collaborative Fund [00:06:00] are involved as well, and so I think that’s really the gist of it is that it’s a subgroup within Collaborative Fund that’s going to focus entirely on the space.
Clay: Okay. Let’s kick off chapter one: which is about the state of crypto-focused venture capital. It’s been a while since this podcast has done a general interview with a crypto VC or someone involved in a crypto hedge fund. With that in mind, I’d love to hear your [00:06:30] thoughts on the current state of crypto investing. A lot of things have happened recently. We’ve had this long-running bear market. I’ve seen this emphasis on acquiring equity instead of tokens. I think the LPs have gotten a bit more sophisticated. They’ve maybe done a few investments like this that have gotten them crypto exposure, and so it’s not just about getting exposure to the crypto asset class anymore. [00:07:00] There’s a lot of things that have happened. How would you describe the current state of crypto VC?
Stephen: You touched on a lot of different topics there. I think maybe starting with the idea of fundraising under these conditions where we’ve been in a bear market, where we’ve seen large declines in the asset prices of the public assets like Bitcoin and Ether and, obviously, many, many others, and I think you can tackle that from two directions. One is that it’s harder for the funds to raise capital from LPs. [00:07:30] On the flip side, you could imagine that the teams that are raising capital particularly, many groups raised capital through ICOs in 2017, those have largely gone away, particularly the unregulated ones, and so the fundraising environment is probably more challenging at the team level, as well.
But one thing we can look at from history is that VC funds that deploy capital [00:08:00] following declines in asset prices in the public markets have often been the best performing funds when it’s all said and done a decade later. For example, if you were to look back at the data on VC vintage funds from 2010, 2011, 2013, I believe those three vintages outperformed any vintage for the decade prior to that, and so it is actually an ideal time to be deploying capital into early-stage ventures [00:08:30] because as the asset prices for the public assets come down, the valuations in the private markets come down as well. You can be a little more selective and you can really drive returns if you can find the right projects to invest in.
Clay: I think about some of the more famous VC funds like Union Square Venture’s first fund or Lowercase Capital’s first fund, and it seems like what you’re saying about timing [00:09:00] aligns with the success of those funds, so that makes a lot of sense. I’m definitely seeing here at Nomics a resurgence of capital deployment around the time that it feels like the bottom has locked in or at least investors think it’s locked in. When you think about what investors are thinking about in this space, do you think the questions are getting more sophisticated when folks go to make an investment in this space or to make [00:09:30] an investment in a fund in this space?
Stephen: Yeah, absolutely, the LPs are becoming more and more sophisticated about this asset class, and, you know, we’ve spoken with lots of LPs. I’m, of course, not going to comment on any LP conversations directly, but maybe I could shed some light on the way LPs are thinking about the space and the questions they have. I think you’ve got two main drivers for LPs that are allocating [00:10:00] capital to crypto vc funds or crypto hedge funds or direct. Actually, there’s nuances within each of those three allocations. But if you think about allocations to crypto VC funds, the two main drivers I would say, one is effectively a diversification idea where they look at their portfolio, right? So, if you’re managing a substantial amount of capital, hundreds of millions or billions of dollars, [00:10:30] you’ve got that allocated all over the place. You’ve got public equities. You’ve got bonds. You’ve probably got a bunch of private securities. You’ve got real estate. You’ve got all these different sorts of assets in your portfolio. You look at the things that are kind of coming up through the crypto ecosystem, and frankly, they look potentially threatening to a lot of the other things that are in your portfolio, right? And so, the question you’re asking yourself is, “What if what these VCs are telling us is right?” [00:11:00] We can see disruption to the banking sector. We can see disruption to the insurance sector. There are so many different industries that crypto potentially touches. You could see from the standpoint of a capital allocator that if they felt like there was potential disruption to other parts of their portfolio, they would want some exposure to this new asset class that is on the ascendancy, and so that, I would say, is one category of the thought process between making an allocation.
[00:11:30] The second is a thesis specific to crypto, and so maybe they have a thesis around tokenized securities. Maybe they have a thesis around the currencies. At this point, you’ve got a lot of different funds with different focuses. You can really tailor your exposure in almost any way you want. If you primarily want exposure to the currencies, there’s funds for that. If you primarily want exposure to financial infrastructure, you’ve maybe talked to a fund like ours, [00:12:00] and so, some of the LPs we came across had a belief about how they envisioned the ecosystem developing, and we’re making allocations based on that belief or outlook or thesis.
Clay: When I first started doing this podcast and speaking to investors, the main pitch that I heard for investing in the space was really around general exposure. [00:12:30] There really wasn’t much differentiation past that. It was about, “Hey, if you had invested in Bitcoin back in the day, you would have had this, or if you would invested in Coinbase.” The pitch was around not missing out on exposure to this exciting new potential asset class, but now I’m hearing more folks say things like you just said which is that there’s a little bit more differentiation and nuance to the perspectives of the funds. [00:13:00] You mentioned that Collab Crypto was focused at the infrastructure level. I don’t know that many people maybe 18 months ago were getting that specific. It was a lot more opportunistic and less focused and less differentiated. Have you found that to also be true?
Stephen: I think that’s right. I think the space is maturing in 2016-2017, there was sort of like this explosion of so many different directions that [00:13:30] we were expanding and so many different models that were being tried and so many different issuances, frankly. Now, what you’re seeing is, as we just discussed, more tailored exposure. I’ve seen a blockchain credit fund for people talking about a blockchain-focused growth fund as some of these things start to mature into later-stage races. I believe Invesco launched a fund dedicated to public companies [00:14:30] that have some exposure to blockchain. I do think we’re seeing more nuances and more targeted exposure to different elements of that ecosystem.
Clay: I think what also is a little bit different about starting a dedicated effort around this time is that we do have a little bit of history to look back on. I think Polychain Capital was one of the first large funds to really put themselves out there, get some publicity, but there have been a lot of other funds that were started during the bull market of 2017, and we do have some returns to look back on, and we’ve also seen a number of funds close as well. Let’s kick off chapter two, which is about Collab Crypto’s approach to structuring investments. Stephen, when you starting Collab Crypto, what were the funds you looked at for inspiration?
Stephen: I think the inspirations were largely around this idea [00:15:00] of long-term capital because Collaborative has this rich history of deploying capital over the last decade, these have always been structured as VC funds with the idea that you’re investing for the long-term, right. You’re going to really become active. You’re going to help the company grow. You’re going to try and create your own success. I guess one fund that was inspirational along those lines is Placeholder. Chris Burniske has been a good friend for a long time, and we really liked this [00:15:30] idea that it wasn’t going to be a hedge fund, kind of moving in and out of positions but kind of taking more concentrated bets and really getting involved with the teams and really trying to create value. I would say that’s a similar model to the way Collaborative Fund, not just in this crypto effort, but just broadly, Collaborative Fund is thought about engaging with any number of different industries.
Clay: That makes sense. It does seem like short time horizons [00:16:00] combined with the volatility of the space don’t make for a great combination. The last thing you want to do is spend a whole bunch of time managing tentative or scared investors that aren’t in it for the long haul when really what you need to be doing is investing against longtime horizons and, thinking in that way. Having raised $41 million in venture capital, I’ve spent some time talking to VCs historically, and I do know that there is this lore, [00:16:30] at least among Silicon Valley VCs around, “You should be located in one space or in one place. That place should be Silicon Valley for biz dev and a whole bunch of other reasons: raising capital, capitalizing the business, etc.,” and people wanted that. There were these ways that things were done. You raised a seed fund maybe through a safe until you got to a certain level of revenue, [00:17:00] and then you did a series A and a series A is between $8 million and $12 million or whatever it is during the given year. But there are these patterns that have emerged. Are there similar patterns when it comes to crypto investments? Are people looking for companies in the Bay Area? Is it important that there’s an equity component versus simply investing in tokens anymore? Has a consensus emerged about the [00:17:30] configurations for these projects or teams that are most likely to lend themselves to success?
Stephen: I’ll tackle the token versus equity question in a minute because I think that’s a bigger a question, but maybe first just touching on location. One thing that makes crypto a lot different, I think, than other segments of VC is that we see a lot more distribution in terms of location, both kind of within team and across teams. [00:18:00] Certainly, there’s a lot of activity in x the Bay Area, but you’re also seeing activity in LA. You’re seeing it in New York and not to be US-centric, you’ve seen a lot of activity elsewhere. You’re seeing activity in Europe. I’m currently living in Cambridge for a few months kind of building out a […] pipeline around London and around Europe more broadly. We’ve got great connections with Bitstamp, who we’ve been working with very closely.
Hey, this is Clay [00:18:30] cutting in to give you a bit of context about Bitstamp. Founded in 2011, Bitstamp is, as far as I know, the oldest Bitcoin exchange. The Nomics data transparency index gives Bitstamp an “A” rating. In other words, they provide some of the highest fidelity exchange data relative to their peers. To learn more about our exchange transparency ratings, and BitStamp, you can go to nomics.com/exchanges. Alright, back to Stephen.
Stephen: They help us vet deals and look for deals as well, [00:19:00] so they’ve been a great partner. We’ve got a lot of relationships through our LPs into Asia. We’re actively kind of looking at a bunch of dealflow coming out of Asia as well, and so, I think one thing that’s a little bit different in crypto is that the funds are a lot more open to looking globally. Even if you just look at the positions we’ve established so far, several of them are outside the US, and so I think you’ve got to be open to that in this ecosystem.
Clay: [00:19:30] There is not a location preference necessarily. Would you say that’s true? You’re open to fly to board meetings wherever, Singapore, Hong Kong?
Stephen: Yeah, it’s interesting because some of these don’t have board meetings in the traditional sense. We definitely can dive into the governance question, but the Maker DAO call is a call, right, and you can dial into it. It doesn’t matter where you’re located, and you can weigh in. Now, if there is a physical board to attend, of course, that’s going to be a little easier [00:20:00] when we have offices. We have offices in New York and San Francisco. Certainly, a bit of a preference there but as I said, more and more the governance piece is being executed remotely because there are investors from all over the world. The team is sometimes located in more than one place, and so it’s really just the ethos of the space is a more distributed environment.
Clay: I would love to hear how you think about governance. Do you look to get a board seat? [00:20:30] Some funds are structured to provide follow-on investments when there is a lead investor; other funds, they want to be the lead and they’re looking to own anywhere between 15% and 25% of the company with a first-round investment. How do you think about governance and also allocation?
Stephen: I think we can touch on this token versus equity idea, and that really leads into the concept of governance. We’ve certainly seen a lot more equity deals than we saw, say, two years ago. [00:21:00] We’re also seeing some sort of hybrid deals, so the kind of dual models where there’s a token that’s issued from a decentralized network with some particular goal and purpose. You could potentially invest directly in those tokens, but then there’s also going to be a company with equity that is launched to build something on top of that network. The network is facilitating something that this company is then going to pursue. You’ve got models [00:21:30] where you could invest in token or you could invest in the equity or you could invest in both, and there’s often some sort of discount for investing in both or there’s some relationship between the two but they are, in fact, separate assets in a sense. You’ve also got scenarios where you invest in equity, and they’re going to build a network and issue tokens, and then the equity holders have some right on the tokens or some right to a certain allocation of tokens in the future.
[00:22:00] Again, these things could be structured any way you want. I think what the investors want to avoid is that they invest in something that then generates some sort of derivative asset that they don’t have exposure to and then more value accrues to that derivative asset, and so that would be the case if you invested in equity; they launched a network, but somehow you didn’t have any access to the tokens and the tokens ended up accruing a lot of value. Those things often get written into the investment documents. But [00:22:30] it does really touch on this idea of governance because with tokens, you don’t really have protective provisions like you do with preferred stock, right? With preferred stock, you have some control over corporate actions so, “Can they issue more stock? Can they take on debt? Can they sell assets? Can they do X, Y, Z?” They’ll usually have a longer list of things that require the approval of the series A or the series B shareholders. You don’t really have [00:23:00] those in tokens, right? We’re not seeing a lot of dual-class tokens where you’ve got different tokens with different rights.
Certainly, there are some of those models, but not really quite in the same way as preferred stock. The governance model is different because if you think about this question, “What is governance?” A big part of that is dispute resolution or resolution when there’s differences of opinions. In economics, we think about concepts [00:23:30] like complete contracts or incomplete contracts, and it’s challenging to write complete contracts, which means there are states of the world where some of the events where unanticipated, and there needs to be some sort of mechanism to resolve those situations. Governance is essentially how we handle and resolve those situations. This is where concepts like agency theory and moral hazard and holdup problems all come into play because we want to achieve optimal outcomes, [00:24:00] but different parties may have different amounts of information. They may have different incentives, and so, the mechanisms to resolve these things are kind of what we call corporate governance for corporations, anyway. There’s a huge literature on corporate governance. Now, some of these ideas will map over to tokens, but not all of them because decentralized governance has some of its own advantages and its own challenges. We can dive into that a little bit but that’s, I guess, broadly, [00:24:30] how I think about governance.
Clay: I often think about the early investors in Binance and, “What if they had not been able to get a cut of issuance of the BNB token?” They’d really be missing out on a whole lot of value accrual and, “What if they did have some right to BNB?” But then Binance launched some other thing that was like a work token in the future. Perhaps they won’t. I don’t know. But it seems problematic, or at least that it requires, [00:25:00] potentially, a lot of trust. There’s just so much that’s been standardized around venture capital. There’s the safe documents. There’s the National Venture Capital Association, model legal documents that are used for doing a series A round, for example. And a lot of this has been standardized, and it feels like we’re a bit in the Wild, wild West again here. You know, if you invest in equity, ‘How much of a right do you have to the tokens? Is it as a discount or is it pro rata to what you invested? [00:25:30] What’s the lockup on those tokens? What if another token is issued? What if a nonprofit is created that’s associated with the…” There’s just so many directions that things can go in now and there’s so many more legal jurisdictions. How do you think about protecting your investment and/or are there precedents that have started to arise that people are standardizing around?
Stephen: You brought up Binance. You’ve got a bunch of examples [00:26:00] in that same vein where there was a C-corp or a corporation of some type in advance of the network being launched. You know, Civic, I believe, had a corporation before the Civic Token was launched. Protocol Labs existed before Filecoin was launched, Binance and so on. Ultimately, it depends on what the token represents, and I guess your question is to how you handle it. You try to handle it in the documents. You try to make the contracts as complete as possible. [00:26:30] “If X occurs, then this is how we’re going to handle it.” The problem is you just can’t cover every state of the world, as I mentioned previously. It’s interesting because the ethos of blockchain is kind of the idea that we don’t want to have to trust third parties whenever possible, and so you want to try to control for those things upfront when you’re making the investment, but it’s very difficult to control for every possible scenario. [00:27:00] Ultimately, there is some trust, or there’s at least trust in the process by which those would be resolved.
Clay: It seems like perhaps there’s so many different things that can come up that you kind of just need to take each potential investment on its own merits and figure it out. Maybe something to talk about here is how investors provide value in this new world. I think in the old world, for me, at least, [00:27:30] I feel like the greatest value that an investor can provide is around governance. I think when there’s alignment at the board level, everything else just kind of falls into place and I think when there isn’t, the entire company feels it and it can create a lot of problems. I remember there was this Jason Calacanis interview, this Israeli investor, who was asked about governance, and he said that he’s found over time [00:28:00] that a lot of things that he thought he was going to do to provide value to a company, it just didn’t end up providing value. The companies that were going to succeed were going to be successful anyway, and the companies that most needed his help ended up being the investments that returned the least. Now, he just says, “Here’s a check. I’m not going to hassle you. Here’s a phone number. You can call it. I probably won’t answer,” and it really is about the capital. When I think about the categories of [00:28:30] value that a VC can provide, there is this governance issue, I think good governance and advice at the board level is incredibly valuable. But it seems like in the crypto asset space, there’s a lot of other potential areas of value, things like generalized mining or help with token economics. How do you think about the kinds of value that you provide and that Collab Crypto is sort of [00:29:00] best positioned to provide value around?
Stephen: I think there’s a lot of different categories of potential value creation. I’ve certainly heard lots of VCs articulate the idea that you mentioned earlier that, in fact, it’s quite difficult to provide value. I think in crypto, there’s so much that is yet to be understood; that there’s a little bit more opportunity to provide value at certain skill sets. [00:29:30] I guess you could think of one place to provide value is externally, right. Really just connecting the team to groups that may be helpful, connecting them particular experts, connecting them to exchanges to connecting them to professional services like certain attorneys that have certain expertise. That’s, I guess, one sort of value creation, or even really just connecting them to investors for subsequent rounds. [00:30:00] the VC fund potential is more connected in the ecosystem to a lot of external partners that might be valuable to the project acting as a conduit for those relationships is one place where you can add value.
The second one would be, I guess, more internal items. That’s where you maybe get involved in the governance like with a board seat if it’s the type of company that’s going to have a board. It’s where you might help the CEO [00:30:30] think through a really big decision where you just really need a sounding board. Again, these things are all different depending on the project because if it’s a decentralized network, it doesn’t necessarily have a CEO. It doesn’t necessarily have a board. I think it’s very project specific. I know for me, I think because I have a background in economics, sometimes the type of advice that they’re looking for is really just around the economic model. [00:31:00] Again, this is particularly if you engage with them early, before the network’s been launched. And, I think different investors have different technical expertise or economic expertise or legal expertise, and the projects can lean on those investors to provide some advice around those specific areas.
Clay: I definitely hear your point about the networks. They’re not firmly entrenched. It’s not clear who knows what, [00:31:30] and things like hiring a developer—that are still hard for a traditional startup—are sometimes so much more difficult in the crypto space because it’s just hard to find people and there’s often a big difference between who’s marketed to be good at things versus who actually is and what attorneys to go to, and there’s so much that’s still unknown. We’re just discovering things.
A good place to return to is this [00:32:00] equity discussion because it does seem like something that is a bit new. In the beginning, people were just making investments, at least, most of the investors I knew in the space were just investing in tokens, and they were highly liquid, and they could enter exit positions pretty quickly. Now, it does seem like equity’s back. Having experience as a founder is back. A lot of things that we always knew to be true but somehow [00:32:30] forgot about during the big bull market, we’re returning to. Do you have a preference for equity? How do you think about equity versus tokens? Do you even care about one versus the other or does it just depend on a particular investment?
Stephen: We’ve invested in both. I mean, Collaborative’s history is invested in equity, and so we obviously have no problem at all investing equity. We have a lot of experience in [00:33:00] structuring those deals, but we’ve also invested in several projects that are tokens only, and of course, the governance is a little different. The degree to which you’re going to be able to engage or the way you engage, it is a little bit different. The short answer is we will invest in either. I think that when it comes to tokens, you’ve really going to understand what they represent because ultimately, a token is just a wrapper, right? It’s just a digital wrapper. [00:33:30] In fact, you could make an equity investment in token form, as we’ve talked about at length on previous podcasts with tokenized securities.
The question really is not, “Are you investing in equity or tokens?” but, if you are investing in tokens, what do those tokens represent? It does come back to this idea of governance because with equity, you’ve kind of got representative governance. You’ve got the shareholders, and then the shareholders have elected a board, and then the board is going to become informed and it’s going to make certain decisions. [00:34:00] And with a lot of token projects, you don’t really have the same representative governance. Although, we are starting to see it emerge in a few projects that I’ve seen, but historically, the reason we used representative governance was one, there were sort of coordination problems. Think about trying to collect votes on every single item from a million shareholders. Obviously, that’s becoming easier and easier as [00:34:30] everything is becoming digitized to the extent we can observe the wallets were all the tokens are held. Potentially, the coordination problems are even reduced further. Maybe now, it really is feasible to collect votes from all the token holders in a relatively expedited in efficient manner. But the other issue we have is an incentive problem because most small shareholders or token holders don’t have the incentive to become informed and actually participate in the governance [00:35:00] participate in the votes. Think about it. It’s costly to become informed. To become informed means, you have to spend time reading. You have to spend time thinking about it. If this is just one of 100 positions you have, it’s not clear that an individual token holder has the incentive to dedicate the resources to become informed, to participate in the governance. That becomes a real issue when you’re talking about distributed governance versus representative governance. [00:35:30] We think there’s huge opportunities around disclosure. I think the idea of pushing disclosure directly to wallets is an interesting idea and a huge area of opportunity, but the shareholders still have to be willing to consume it, the token holder, I should say. And so, it’s interesting because within corporations, we have something called ISS. Are you familiar with ISS. Have you ever heard of this group before?
Clay: I have not, nope.
Stephen: ISS stands for Institutional Shareholder Services. [00:36:00] What ISS does is they will examine all of the items that are coming up for a vote for any particular corporation as you approach an annual meeting or a quarterly meeting where there’s going to be a vote. Because the institutions are looking for some advice or some analysis. I mean, even for institutions, it’s costly to become informed on every single position because they might have hundreds. [00:36:30] Think about an S&P 500 fund. They’ve got 500 different positions and they can subscribe to ISS, ISS will produce an analysis of the item that’s being voted on, and make a recommendation as to how the shareholders should vote. They have come to wield enormous power because so many institutions now rely on them for the analysis of the item that’s being voted upon. I wouldn’t be surprised to [00:37:00] see something similar start to emerge in crypto. Although, I hope it’s not a single organization. I hope it’s a variety of organizations where you can effectively assign your proxy to one of these organizations that is going to vote in a certain way, and then the idea is that you can always reassign that proxy at any time you want.
In a sense, it’s representative governance, but it gives you complete power to reassign it. [00:37:30] There’s not terms, necessarily. It’s not as if a board is being elected for a certain term. You can essentially change who’s representing your vote at any time. And so, that’s an idea that I’m excited about. We have seen a lot of that popping up yet that I think is as we get more and more decentralized governance out there, there’s going to need to be groups. I know Masari is certainly making efforts in this direction as well in terms of collecting information and disseminating it. [00:38:00] There’s going to need to be groups that help token holders become informed at a low cost so that they can make informed votes and really increase participation in these ecosystems. I’m looking forward to seeing that develop over the next few years.
Clay: I know in the traditional equity world, there’s a lot of thinking and protections against excessive dilution of investors. How do you think about dilution when it comes to token ownership, [00:38:30] or are investments made based on what the entire pool is capped at?
Stephen: Yeah, I mean, I think you’d think about dilution maybe the same way you would think about it in the context of equity which is, “What is the network getting in exchange for the dilution?” Dilution, again, let’s think about equity and then we’ll map it over to tokens. In an equity investment, you can kind of get dilution from two sources. One is, the company issues [00:39:00] new shares of stock and sells them to a new investor, right. The company is issuing more shares and so you’re getting diluted. Your percentage of ownership is going down, but the investor is providing resources to the company. In theory, what you now have is a smaller slice of a bigger pie. You don’t really care about dilution as long as the pie is getting bigger and bigger and bigger and the absolute value of your holdings is increasing.
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Stephen: The other source of dilution is when new shares are issued and provided to employees. It’s actually not that big a difference. The employee is providing a resource to the company. The investor provides cash. The employee provides [00:41:30] labor. The equity is being issued in exchange for labor. There’s a whole kind of literature and theory around why employee options are good and they can provide a sorting mechanism so you get the most enthusiastic employees and incentivizing them to work hard. We don’t need to necessarily go down that rabbit hole, but then if you think about tokens, it’s the same thing. [00:42:00] If you’re getting diluted because there’s increased issuance, what’s being provided in exchange for those tokens? It could be that they’re being allocated to individuals or computers or entities that are providing work to the network. Maybe that’s mining, like in the case of Bitcoin, there’s new Bitcoin mines every day, so you’re continually getting diluted in terms of the total number outstanding increasing, but they’re going to miners that are providing [00:42:30] work to the network, and there’s a bunch of different models of providing work to the network.
Staking is, of course, a different category. Or, to the extent that the project is going to issue new tokens to raise more funding, just like an equity investment, there might be good reasons to do so if they need more capital. That’s where I think it gets a little more complicated when it’s a decentralized network because at that point, it’s like, “Who is getting this capital? How is that capital going to be distributed? [00:43:00] Is it a foundation? What’s the governance of the foundation?” There’s all these questions that maybe you don’t have as much with a C-corp and a board in an equity issuance. It’s pretty clear where the capital’s going and what the decision process is going to be to distribute it. But I do think there’s a lot of aspects that map over.
Clay: One thing that might be a little bit different with decentralized networks and is actually a good thing is that, for the most part, [00:43:30] it’s rare to see the total supply that is possible. It’s rare to see that increase, or at least to see the economic policy change much. With Ethereum, we basically know how many new ether are being created and we can kind of model out what it’s going to look like over time, same with Monero. Bitcoin is capped at 21 million. It’s probably easier to estimate with tokens what’s going to happen with [00:44:00] regards to dilution just because these things are encoded in a way that’s much harder to change than equity.
Stephen: I agree. I agree. I think it’s a good thing and a challenging thing because it’s good for the reasons you mentioned. This idea of scarcity and knowing exactly what supply is going to be, knowing what the supply schedule is going to be is often something that people point to in terms of a source of value for Bitcoin or for Ether. The challenge is [00:44:30] that over time, as that declines, the model has to change a little bit, right? Either transaction fees need to increase or in some cases, you’ve got token issuances where maybe all the tokens are issued or created, I should say on day one, and then a foundation holds back a certain percentage of those to help fund development. And over time, the idea is that the network will become [00:45:00] self-sustaining, but it’s still a question. We haven’t seen a ton of examples of that yet.
I think it’s going to be interesting to watch this over the next, I’m not talking about the next year, I’m talking about the next 5, 10, 20 years.How are you going to incentivize the core development teams 20 years from now? Certainly, many of these protocols have ideas about how that’s going to work, but actually [00:45:30] watching it evolve over the next several decades is going to be fascinating because it is very different from equity in that way. It almost could be like for Uber at founding saying, “How many shares total are you ever going to issue?” And making them stick by that even if they needed more capital. Of course, that’s not how it works with equity. They issue a little bit of equity and then they set some milestones and then investors agree or not to provide some more [00:46:00] equity, and so effectively, the total shares outstanding can just increase perpetually as the company needs more and more capital while it does mean you’re going to suffer from more dilution over time. It does build in a certain amount of flexibility to provide more capital to those things that are working well when they need it. In that sense, fixed supply schedules do entail a certain degree of [00:46:30] rigidity which again, I think, is a good thing and a challenge depending on how you look at it.
Clay: It seems like probably a good thing for crypto assets like Bitcoin that need to be a store of value, and a bad thing or at least a source of inflexibility when maybe flexibility is needed for other kinds of projects. Let’s move along to chapter three and explore Collab Crypto’s thesis and your beliefs about the largest crypto-related investment opportunities. It strikes me that [00:47:00] traditionally or historically, the best performing investments in the space have been in crypto assets themselves and also in exchanges. I can’t think of a lot of other types of companies that have hit notable home runs. When you go to think about infrastructure, what are the categories of infrastructure that you think about, and what other opportunities do you see as maybe existing in the near future other than, I guess, [00:47:30] crypto assets and exchanges?
Stephen: When we say financial infrastructure, it’s a pretty broad basket of projects that can fall under that categorization. Some of the verticals we’ve talked about historically is certainly the items like exchanges. As I mentioned, we have a working relationship with Bitstamp. We’ve invested in Radar Relay, very interested in exchanges—potentially new exchanges—things that might be strategic to Bitstamp [00:48:00] over time or other partners. You’ve certainly got that category. I would classify payments as one vertical within the concept of financial infrastructure. Payments actually does encapsulate many of the currencies, right, and so we have investment in Coda, for example, which is currency. There’s going to be others in that category as well. Payments, again, it’s a big basket. We talked previously about product markets [00:48:30] versus capital markets. I don’t think we’ll be doing a ton of kind of utility token product market sorts of investments, but there might be a couple to the extent they have a very interesting or targeted use case around payments.
Stepping back a moment you could say, when we first started talking about this, we started thinking, “Well, blockchains are effectively protocols that are particularly useful for moving value,” and so, then you say to yourself, “Where does most value move?” [00:49:00] Certainly, quite a bit of value moves through retail, and those, I would say, are the ones that are categorized as utility token where there’s a particular good or service that’s being offered. The token represents participation in the network or provisioning of that particular bit of service. But much more value moves in asset markets. Things like ownership claims that represent equity, or debt, or real estate, or increasingly, perhaps, [00:49:30] ownership in a decentralized network of some type—that really has been our focus. I think insurance is an area that we’ve seen some activity, but we’ll probably see a lot more activity over time. Insurance is a huge categorization of financial infrastructure, and insurance is largely contracts. They’re contingent contracts for states of the world that may or may not occur in the future. They’re a very natural fit for smart [00:50:00] contracts, and so we’re really interested in insurance. Of course, tokenization of securities. We view that as one of the largest opportunities, and are actively pursuing investments in that space, as well.
Clay: Maybe that’s one place to focus on since we’ve talked about that in the past and a significant portion of our audience came to us because of the success of the security token documentary. Maybe let’s talk about how value might accrue around [00:50:30] investments in security tokenization. I’ve thought about this quite a bit, “Where would I place a bet in that space?” The conclusion that I came to is that security tokenization creates a lot of value that’s spread around. It creates a lot of liquidity and there’s a lot of efficiencies in the system that lift the entire system up in a pretty distributed way. But it was hard for me to [00:51:00] conceive of a specific company or technology were I thought a preponderance or at least a large amount of value would accrue to. It’s still very early for any of these exchanges. I don’t know that there’s really a highly active security token exchange, yet and the platforms themselves are a bit more like a utility token model. Where do you see the winds occurring in that space as an investor?
Stephen: [00:51:30] You could kind of think about all the different layers that might potentially accrue value. Let me just kind of work through it somewhat systematically in terms of the way we’ve thought about the different parts of the security token ecosystem you could invest in. You could start right at the bottom, “What base layer will security tokens be built on?” Of course, much of the activity has been Ethereum, to date. There’s [00:52:00] reasons to think that it might be something in addition to or instead of Ethereum down the road. Or, if your thesis was that, “No, Ethereum’s got this huge lead. It’s got the first mover and this is what everything’s going to get built on because some of the scalability and other issues are going to get sorted out,” then you might invest in Ether. I would say one category of investment around security tokens is just really thinking about the base layer. “What’s it going to get built on? To what degree is that base layer going to [00:52:39] accrue value as more and more things are built on top of it around security tokens specifically?”
There are certainly new projects that are coming to market that are focused on security tokens and have really, really strong technical teams, and so, I’m going to have to speak kind of in generalizations. I can’t really dive into details on any of the projects we’re talking to, but I guess, first category is base layer. Next category is the technology [00:53:00] around the tokenization itself. Even within that, I would say there’s a few different pieces of the stack. There’s the technology provider. There is potentially the group that is bringing issuers onto the platform. There’s money to be made, potentially, around the transaction of the actual issuance. There’s the technology provider, which might have an ongoing relationship with the token. There’s potentially value capture around bringing investors onto the [00:53:30] platform. You’ve kind of got three different little slices within that stack. And then, I guess, the far end of the stack, which is maybe related to that last piece is around secondary markets. These would be where the exchanges come into play. And then, I think you’ve just got a constellation of other plays around the stack. Maybe there’s a specialty provider just for disclosure [00:54:00] where the projects sign on with a particular disclosure provider which generates the rails that allows them to push notifications directly to the wallets of all the token holders. Maybe there are companies that generate analytical tools, so that you can do cap table scenario analysis. I’m just kind of throwing ideas out here, but the point is that once we’ve automated a lot of these ownership claims, it’s going to [00:54:30] create new opportunities for things that have been more difficult to do in the legacy systems. I think you can kind of invest directly in the stack that runs from base layer up through exchange, or you can invest in some of the service providers to that stack, and so that’s kind of the way we think about it.
Clay: Base layer would be like Ethereum or, I don’t know, even potentially if Binance turns into a platform for issuing these kinds of things, [00:55:00] potentially BNB Chain or whatever it’s going to be called, Binance Chain, and then there’s issuers like Securitize or Harbor or Polymath or what have you, and then there’s companies that facilitate exchange like maybe SharesPost or tZERO or I don’t know. It gets a little bit murky the further up you go, or OpenFinance, things like that. Yeah, that makes a lot of sense. I don’t have a strong conviction personally about where exactly the majority of the [00:55:30] value is going to accrue, but I don’t want to ask too deep questions here because it sounds like you are in some very specific talks around this stuff right now.
I’m trying to think about other big opportunities that exist; security tokenization, payments, infrastructure. How about debt? Something I’ve thought about quite a bit is that debt markets worldwide, bond markets are usually much larger than equity markets and also often [00:56:00] much larger than M2 money supply. Everyone borrows money. Rich people borrow money. Poor people borrow money. It seems like there’s just such a huge opportunity there, and that debt might be the killer app for blockchains. The average person right now that would engage with this technology. A lot of people don’t have spare money to invest in something like Bitcoin, but if there was an opportunity to [00:56:30] get a loan to start a small business, that’s something that would get them to figure a lot of these things out. How do you think about debt?
Stephen: I think it’s a huge opportunity, debt or a fixed income. As you mentioned, there’s huge markets. I think to the extent that these new models can reduce cost of capital or provide greater access to capital, as you mentioned like with the small business owner, that’s going to be a [00:57:00] huge driver of broad adoption. We think also that just like insurance, fixed income you can specify in a contract pretty clearly. The way that the feedback models work so, this is what makes it different from equity. Equity is residual claimant which means that there’s a lot more variation in potential payoffs and dividends, of course, are optional. You’ve got lots of [00:57:30] different degrees of freedom that you have to try and contract for which makes them much more difficult.
Fixed income is actually relatively simple. It’s saying, “I’m going to provide you a certain amount of capital today. This is like a plain vanilla offering and you’re going to pay it back according to this schedule.” Maybe those are interest payments. Maybe they’re principal and interest. Maybe it’s just a big balloon payment at the end. I mean, obviously, there’s lots of variation in the terms of the contract, but the payments are [00:58:00] basically contractually set from day one if there’s no convertible aspect or anything like that. It’s a little more straightforward to specify those things within smart contracts and have those distributions just get pushed directly to the wallets that have the ownership tokens.
We think it’s a place where there can be a lot of efficiency created. I think as you see more and more high-yield offerings, [00:58:30] the whole world is looking for yield. we’re very excited about those models coming to fruition. I would actually kind of categorize that within tokenized securities; just a different type of security. Fixed income securities, I think, are going to be a big thing. Some of these will be more through a decentralized model like; others, you’ll see more of a traditional lender tokenize the ownership claims on the pool of [00:59:00] assets and on the distributions simply because it’s a more efficient way to raise capital.
Clay: One thing that I’ve heard you in particular talk about a lot with a high degree of depth is wallets, what you think they’ll be able to do. You called it out specifically in the announcement for Collab Crypto. It seems like a lot of things that we maybe look to exchanges to do, or wallets to do, [00:59:30] or custodians to do, kind of fall into this category of a value-added custody whether it’s voting, some kind of distributed governance mechanism where you can vote on different proposals. There’s voting, there’s staking, here’s communication channel around disclosures. It seems like so much can be done around this concept of value-added custody. What else are you thinking about around this idea of value-added custody?
Stephen: [01:00:00] I think wallets are interesting because they’ve got the users which can be hugely valuable but simply operating a wallet in and of itself is not necessarily a way to generate a lot of value, or a way to provide a lot of funding for growth, or anything like that. What we’re seeing with many of the wallet providers is they’re looking for some service. You just mentioned a bunch of that them. Can they align with an exchange? Can they open an exchange so that their [01:00:30] users can exchange more easily directly from their wallet—more access, more markets, perhaps—directly from their wallet? Can they make it very easy for their customers to stake tokens where then they can do some sort of revenue-sharing agreement for the staking revenue and kind of generate some income in that way? I think no matter what it is, that the wallet providers will have to find some other service. It’s kind of like, [01:01:00] ask yourself, “Why do banks give away free checking accounts?” There are really two reasons. One is, because they want the deposit assets so that they can then lend them back out for a higher rate and make the spread, but the other one is a conduit for other services within the financial institution. Lending out the assets, we could see some of that among wallets. I mean, certainly, we’ve heard of a bunch of different groups that are kind of looking at opportunities to lend assets, [01:01:30] but I think you’re going to see more activity around this conduit for other services. “Can they provide easier access to exchanges? Can they provide easier access to staking? Can they provide easier access to someplace where value is moving?” I think is probably the models that you’re going to see a lot of wallets pursue.
Clay: A big one that you mentioned is in being able to earn interest on the capital that you’re holding in that wallet, and also to be able to get fiat loans against your [01:02:00] crypto assets, and things like that. There’s just so much room for value. The space is so new. Maybe the next area for exploration is, I’d love your perspective on what you see is most scarce when it comes to finding opportunities in the space? Often, there’s these different kinds of categories of scarcity. Are you finding that the biggest source of scarcity is experience teams that you feel like you can make a bet on? Is it large markets? Is it defensible moats? [01:02:30] When you look out there and consider your deal flow, what do you think is most lacking that you wish weren’t?
Stephen: Defensibility is an interesting concept in crypto because there’s so much open source. One of the things I think we’ve learned through a lot of these forks is that the value isn’t necessarily in code; it’s in the community and it’s in the distribution. To be defensible is to have sticky users, and this is going to get more and more challenging as everything becomes more interoperable, [01:03:00] as switching costs are reduced. The real scarcity is the combination of all of those things you just mentioned where you’ve got a very capable team, potentially with a lot of different areas of expertise because so much of this touches on multiple dimensions of law, and of finance, and of tech. Pursuing a large market with some sort of strategy for [01:03:30] community building or distribution or something that’s going to be defensible.
For most early-stage investors, if you pushed them to choose one, it’s usually going to be team because some of those other things can evolve as the project evolves. You can expand the market by kind of expanding scope, like you get a beachhead in one particular area, and then you’d use that to expand scope and expand market. You can [01:04:00] figure out where you can develop defensible moats as the project evolves, and how to build your community, and how to make a lot of the things that create moats more robust, but major changes to the team are harder to pull off successfully. As we’ve discussed on this podcast, we have areas that we’re kind of focusing on. We know we’d like some exposure here. We know we’d like some exposure there. I think finding the right team that’s got the right combination of [01:04:30] experience, and skills, and tenacity—whatever you might look for in a particular team—that’s the challenge because some of those other things can evolve but of course, you’d like to have a three: a path towards defensibility, a highly capable team, pursuing an opportunity in a very large market.
Clay: It seems like because the space is disrupting, there’s so many incumbents that are up for grabs, [01:05:00] it does seem like there’s a lot of large markets. Finding a gajillion-dollar financial industry that’s a dinosaur and ripe for disruption is probably not the hardest thing to do, but is there a team that can actually pull off that huge of a disruption, and can they do this with open source software that can’t just be immediately forked? That seems like it can be a high bar. When you think about teams, do you think it’s a different kind of team that is successful in this space [01:05:30] versus traditional teams or they’re about the same? The reason why I ask this is because I’ve been looking recently at some of the teams that have been funded in this space, and it does seem like, at least in 2017 and 2018, they were a bit less experienced. There were lots of examples of someone who had been an intern at Coinbase for nine months and now they’re the CEO of a company, and there’s someone that’s ex Airbnb, but they were [01:06:00] on the marketing team for five months before they dropped out and joined this startup. A lot of people that maybe had interesting pedigrees, educationally or in terms of companies that they’ve worked at but were very fresh in the space and were getting funded at high dollar amounts, that doesn’t seem to be happening anymore. Do you think there’s a different DNA for founding teams in this space, or is it roughly the same as in the traditional startup space?
Stephen: I think how you even [01:06:30] define team can be very different in this space relative to the traditional space. You’ve got some companies in crypto that are pursuing a particular model that is not a decentralized network, but they’re providing some type of service to the ecosystem. It’s more like a traditional company; it’s more like a SaaS play. Those are, I guess, easier to analyze from a team standpoint in the sense that [01:07:00] Collaborative has been deploying capital of the early-stage companies for a long time where you have a situation where the team’s job is really to deploy a decentralized network, and then really hand over the reins to some sort of decentralized model of governance. Those are a lot more challenging and not necessarily the same skill set that’s required to run the more centralized company for years and years. I do think the way you [01:07:30] analyze teams and their skill sets is a little different depending on the project and depending on what they’re trying to achieve.
Well, that wraps up this conversation with Stephen McKeon from Collaborative Fund. I hope you enjoyed it. See you next week. Take care.