a new economic environment
Why Smart Securities?
Capital Markets Are Evolving
Conventional finance has a broad spectrum of products and services that work well in many situations. But the challenge is that these categories are well defined both in convention and under law - there are tight limits around what they are (and aren’t). To illustrate this, there is broad international agreement about the nature of equities or debt instruments as used in corporate finance. Except in specialized instruments not typically associated with corporate finance (such as derivatives), the weight of market inertia has kept the rate of innovation low, meaning that at a public financial market level, the structural opportunities available to a company seeking to unlock new growth remain relatively static.
Megadeals and unicorn IPOs
But while the structural opportunities appear largely the same, the underlying dynamics of the global capital market are evolving. We see this manifested in the global decrease in mid to small cap securities offerings and the growth of the $1bill+ megadeals. From peak to trough, the current US market has seen a dramatic reduction (81%) in the number of IPO’s per year when compared to the mid 1990’s. Even when looking at broader time periods, IPO’s per year in this important global market have still reduced by approximately half in this decade when compared to the 90’s as a whole. However, as identified by public research from Vanguard, the headlines mask the important trend that the sharpest reductions have been in the small and micro-cap market space.
When speaking at the inaugural Security Token Summit in Sept. 2018, David Weild, a former vice chairman of the NASDAQ, confirmed this view when asserting that “…our (conventional) capital markets are not designed to support small issuances.”
EY, in their May 2017 analysis of US capital markets, makes the case that private capital has to a large extent filled the gap highlighted by Mr. Weild, but the question remains as to how efficiently it has done so - just as the public capital markets have a relatively fixed topology, the growing private capital market also has structural barriers that create alignment for certain opportunities but not for others.
Private Capital Silos
Generally looking for investment opportunities that fit a set of specific criteria involving industries, capital uses and scaling perimeters. The venture industry has grown significantly: in 2006, $31.2b of venture capital money funded 2,888 private US companies while in 2015, $77.3b went into 4,244. But, while venture funding enjoys high alignment with some types of companies and business models, it generally has low alignment across a broad cross-section of global companies seeking to unlock new growth.
Private equity / project finance
Generally focused on large scale opportunities - either companies that already turn over substantial revenues or which are represented within project finance categories dealing with broad, commoditized markets (such as alternative energy or logistics).
Private Capital raises
A massive capital market, but one that is hampered by opaque peer discovery and limitations to how investments can be marketed - inefficiencies make it hard to match the right funds with the right deals. McKinsey identified a global total of $740b in private capital raises in 2017 alone, continuing an 8 year growth trend (figure including funding of private equity and other entities deploying capital onward into the market).
A growing and exciting demonstration of the evolution in private capital markets. However, works best for companies developing retail-focused products or services and presents significant challenges for investor rights. Typical participants in equity crowd funding hold little share capital and have a very limited role in company governance. Even worse for investor rights, investments made in the form of pre-sales or products or services seldom provide anything beyond a discounted sales price.
Demonstrated that there is an unexpectedly large market appetite for novel investment types, but regulatory challenges and the poor performance of many of the ICO business models has essentially closed this sector to new entrants.
What if your business can create a compelling investor opportunity but doesn’t fit neatly into any of these categories?
Transactional friction / liquidity: Prof. Aswath Damodaran, widely cited valuation expert from NYU’s Stern School of Business, makes the assertion that regardless of business type, private companies suffer from a 20-30% valuation discount due to the illiquidity of the private equities market. While this discount level generally applies to formal valuations (such as those determined when raising capital), owners of illiquid private securities often pay a far larger sellers-penalty when trying to sell interests in all but the largest and most well know private organizations.
Investor rights enforcement: In Hunit’s view, investor rights enforcement is due for a big update - regardless of the investment instrument (private or public). Investor rights in even the highest quality securities, such as equities found on major global exchanges, are guaranteed by court-based enforcement processes. Calling upon one’s rights as an investor requires a proactive, costly process where legal representation is retained, a lawsuit pursued and a decision is adjudicated.
In the best cases, this process takes time, capital and resources for what can be an uncertain outcome. If the security itself or assets backing it have contact with poorly functioning judicial systems (such as those found in many countries in the developing world), the risk associated with poor investor rights enforcement is multiplied.
Smart securities (security token programs) have the additional challenge that global body of law has yet to establish a clear understanding of how token holder rights coexist within existing corporate governance. Currently, there are no known cases of a bankruptcy or serious malfeasance in a regulated smart security (security token) - how will the courts view commitments made to token holders? How will token holders call upon those commitments prior to or during a legal process? There have however been ample cases of unregulated ICO’s failing to comply with token holder promises - typically with disastrous effect on token holder values.
From the beginning of our development, Hunit’s aim has been to provide the global financial industry with a phase change in how investor rights are committed, recorded and enforced. Our approach provides a meaningful answer to ‘why consider a smart security’ and, potentially, is ready to disrupt classical asset classes as well. Read more about our platform and technology.
The Global Opportunity of Decentralization
Simply put, we at Hunit believe that we’re on the cusp of a new environment for international finance and we’re committed to accelerating that evolution.
We’re increasingly living in a global age: flows of capital, personal and professional horizons, investment opportunities. Even the goods and services provided by startups today address massively international markets, often from the very start. This reality is at the core of Bitcoin - in a global environment, who does (or should have) centralized control? How does currency look when its unteathered from national externalities and belongs to everyone equally?
Regardless of its success as a currency, Bitcoin’s lasting revolution is likely found in the concept of a blockchain. Its a term that’s hard to avoid, and for good reason: it promises to disrupt some aspect of nearly every global economic sector. This is due to its core feature - it creates the opportunity for a large, diverse set of market participants to trust each other and trust the market, without the need for a centralized authority. This innovation has the ability to dramatically impact things as diverse as how stored value (money) is recorded and transferred, how international food supply chains are monitored, how carbon offsets are accounted for or how financial investment instruments are created, managed and traded.
But the future isn’t only sunny days - to reach critical mass, blockchain based financial instruments (smart securities) need a robust system for responding to bad weather. Smart contracts (as generally used in the space) provide key functionality, but we feel that Hunit’s patented approach is a key tool needed in opening a new environment in international finance.
Benefits of Smart Securities (Security Tokens)
So, if you’re not a unicorn getting ready to IPO and don’t fit (or don’t want to fit) in a traditional category of private capital financing, what opportunities do smart securities offer?
combine the right features to make the Right instrument
If a traditional debt or equity issue makes the most sense for your company, using a blockchain based platform creates a number of efficiencies and improvements in investor rights enforcement. However, you don’t need to be limited by the boundaries of traditional financial instruments. Create exactly the right financing instrument for your company’s needs. For example:
Debt features: Link (encumber) specific assets to smart securities programs
Royalty based financing features: Provide token holders with periodic payments based on revenues from a specific business activity or set of assets
Equity features: Provide token holders an upside participation if your company is sold or optional dividend payments based on the company’s or project’s bottom-line
Project finance features: Employ fixed coupons or lease-type arrangements to invest in depreciating assets that are critical to your company’s growth
Loyalty features: Token holders receive preferential status or discounts when using the assets or service financed via your smart security issue - tie your customers to your success by giving them a reason to invest
Governance levels: How much will your smart security holders participate in the decisions that shape your success?
Smart securities can be flexible and category cross-cutting - use them to create an instrument that presents a compelling opportunity for your target investor base.
determine what investor commitments fit your business and needs
Hunit’s patent-pending smart contract system allows companies to maintain high levels of investor confidence by determining the obligations to which their smart security will comply and by providing automated, decentralized enforcement of them.
In a decentralized economic environment, the issuer determines for itself what it will do, report on and respect(*) - and decides what happens if it doesn’t meet those obligations. (*depending on the nature of the smart securities issue, applicable regulations may impose certain minimum requirements that must be respected)
But while its tempting to define a set of light rules, the market will reward companies that provide stringent protection of investor interests - even if you’re negotiating with yourself, its best to prepare for a stringent set of commitments.
Manage compliance issues, automatically
Do you anticipate issuing your smart security using a registration exemption that carries with it certain limitations on who can own your token? If your smart security will be limited to certain classes of investors or have a limit on the total number of investors, our smart contract system will reflect those limits and, in combination with the Hunit Foundation’s investor onboarding and management platform, only allow transactions of your smart securities involving permitted investors.
Find peers on the blockchain
One of the reasons why Hunit decided to develop its platform and technology on the Stellar blockchain is that it has a native decentralized exchange built into its core protocol. This means that the blockchain itself provides one of the critical functions of external exchanges - finding peers for completing purchase or sale transactions. While smart security issuers still need to build awareness around its investment instruments (which may include listing them on external exchanges), finding peers directly on the blockchain means that smart securities have access to potential liquidity without having to dedicate the time and resources to gain acceptance to external exchanges.