Venture capital formation for software cooperatives

A guide for crypto entrepreneurs on how to balance for profit motives and long term stakeholder control in private financing rounds.

Crypto networks aren’t corporations. At maturity stage they rather resemble software cooperatives which are owned and governed by their stakeholders. Mostly, they are privately funded by venture capitalists with for profit motives which can result in conflicting interests between ecosystem participants and investors. This post aims to provide some guidance for entrepreneurs seeking to balance out such interests to optimize for long term stakeholder alignment and success. 

Source: https://unsplash.com/photos/U3cctUBucn0

Network-VC fit

The relevance of network-VC fit can hardly be overestimated. Early stage venture is a human centric business and the first group of investors joining a project should be perceived as the nucleus of the rising community around the project. 

Individuals over organizations.

Entrepreneurs and early backers should be explicitly vision aligned. Working on a shared vision statement and project values before investing is recommended.

Other criteria worth benchmarking are:

• Value add - skill sets, networks, references 

• fund lifecycle - what’s the investor’s time horizon to close the position?

• fund size - will the investor participate in future rounds?

• Fund structure - VC or liquid strategies?

• LP base - which synergetic institutions / individuals / companies are involved?

• Investment philosophy - firm’s DNA, investment style? 

• Syndication - is the project’s capital base sufficiently optimized for long term success?

Incentive alignment

While venture capitalists are optimising for value extraction per mandate, crypto cooperatives intend to create and distribute value as broadly as possible in order to stay minimally extractive long term. This is why decentralization matters.

In order to balance out for profit motives with long term neutrality the following factors can be taken into consideration: (1) Capital need and ownership of a project, (2) Syndication and relative allocations, (3) Governance rights. 

Capital need and ownership

Intuitively, founders tend to over-fund their projects whenever cheap capital is available. What looks like an attractive deal in the short term might fire back long term. Some high level points to take into account before structuring a round:

To figure out what would be a (1) sufficient capital base. A simple bottom up framework suffices, ideally including 2-3 scenarios for growth trajectories. From there an estimated capital need can be projected for at least the next 18-24 months.

With such an estimate in place we can think about (2) a reasonable dilution which is always a normative judgement rooting back to what we see as a shared belief among crypto innovators: democratising access, ownership and data sovereignty. Crypto networks are global, public infrastructures which primarily provide a trusted execution environment for collaboration. They aren’t supposed to benefit private insiders to the disadvantage of users and stakeholders.

Labor over capital.  

Benchmarking against legitimate and related projects is recommended. For DAOs an overall dilution throughout the private market phase (pre launch) of 15-30% (fully diluted network valuation) seems appropriate to balance the interests of all stakeholders and to avoid concentrated ownership and governance power. With continuous or dynamic supply schemes for long term stakeholder incentives these numbers might vary.

Based on capital needs, projected dilution, the overall stage and risk profile of a given project a (3) reasonable valuation can be estimated. In the best interests of entrepreneurs and stakeholders extreme scenarios in either direction should be avoided. If the valuation is too high and the project is forced to go through another round of private funding, a down round might occur which comes with a lot of friction and frustration among all early contributors (on paper value has been destroyed, not created). If the valuation is too low early investors benefit from drastic valuation uplifts but might demotivate follow-on investors and stakeholders to join. Contributions and risks in the past and future need to be reasonably balanced.  

Resilient Governance  

Concentrated ownership can lead to concentrated governance power. If venture capitalists control crypto networks they are likely to shift from minimal to maximal rent extraction over time, thereby undermining cooperative principles and ecosystem interests.

Broader ownership structures could be achieved through rather fragmented private syndicates (see below) or a continuous asset issuance scheme post launch (dilution). Besides governance minimization more progressive voting schemes could be explored (quadratic voting, decreasing voting power over time etc.) to mitigate concentration risks. Most of the emerging governance frameworks and tools are still in their infancy but will become crucial in this context - shout out to the folks at Colony, Orca, Daostack and Other Internet. 

Syndication and allocation sizing

Once the terms of the raise are set, founders need to decide on how allocations should be sized. While venture investors have to optimize for maximum ownership founders might want to optimise for: 

• value add profile: The project’s support areas over time should define the ideal investor base over time. E.g. positioning, product strategy, key hires or financing strategy are essential early on followed by venture building, business model and governance design. Post launch liquidity provision, market making or brand signalling might be highly relevant. Getting a concrete picture of the respective investor and defining areas of support with measurable or at least explicit expectations is recommended, e.g. time commitment per month, KPIs, OKRs.
  

• fund size / skin in the game: the size of a given investor’s fund should be taken into account to slice allocations. Larger funds will need larger allocations to justify their involvement. Taking in large investors too early bears the risk of not getting meaningful attention and increased signaling risk in case the investors refrains from leading any follow on rounds. Micro funds (sub $100M fund sizes) are overall better aligned with founders and early contributors in the very early days.
  

• diversity: sustainable crypto networks need to be robust - technically, economically and politically. Onboarding investors with diverse profiles and access to various hubs helps to maneuver regulatory risks and multiplies access to talent, customers and capital pools.

To avoid

There are various behaviors founders should watch out for to avoid frustration and misalignment. Most of them can occur in different variations, hence a case by case judgement is required. The list below is indicative and non comprehensive:

• aggressive super pro rata rights: might indicate a ‘foot in the door’ strategy for a large scale fund buying optionality while exposing founders to specific signaling risks (see above). ‘Aggressive’ is normative and contextual - a rule of thumb might be 1:2 and beyond ratio of initial vs. follow on capital.
  

• no / very short vesting: might indicate an interest in short term value creation vs. building a network of long term significance. The lines between investing and trading are blurry. In early stages a sub 3-4 year vesting clause increases the risk of early exits harming price discovery.
  

• forced token integration: business and governance models of crypto networks are still highly experimental. Pressuring a team to integrate a token (pre product, pre business model) should not be tolerated. Early stage projects need flexibility in a high paced innovation environment.
  

• deal sweeteners: Committing capital synchronously with other parties within a syndicate and asking founders for special treatment and discounts should be a mere exception. All investors should earn their allocations by bringing something to the table. Providing discounts to single parties can be justified as long as such contribution lies outside the scope of the usual involvement or cannot be accessed otherwise. In such cases explicitly defined milestones or KPIs can make sense to manage expectations.

Thanks for your inspiration, discussions and reviews of this piece Chris Burniske, Tony J., Zhanna Sharipova, Ash Egan, Jutta Steiner, Nathan Schneider.