Fintech startups democratizing venture capital

Fintech startups democratizing venture capital

Fintech startups are democratizing venture capital.

Value creation has shifted from the public to the private market. Of the $11 trillion created by companies founded in the last 10 years, almost 70% ($7.5 trillion value), are still private. The number of public companies is declining.

Most of value from tech startups is being created in the private market

Yet, the average investors (retail investors) used to not be able to access investment opportunities in private markets. This is changing due to a confluence of factors including regulatory changes, technological innovation, and macroeconomic trends. The private markets are becoming accessible to the masses as entrepreneurs build tools and platforms that expand private market participation, which have shaped culture and economic opportunities. Many fintech experts believe the opening and democratization of private markets is an inevitable trend

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Why the democratization of venture capital is inevitable

The traditional 60/40 portfolio is dead. For decades a mix of 60% stocks and 40% bonds have been expected to provide enough stable growth and steady income to meet retirement goals. This doesn’t hold true anymore due to inflated stock prices, near-zero interest rates and increasing inflation.

These factors have fueled the need for diversification and the rise of alternative investments in institutional portfolios. Alternative investments startups are already banking on the opportunity with more than $2B funding raised last year.

For decades, alternative investments were hard to access for the average investor, but this is changing. The most accessible alternative asset is real estate. But many other markets are opening up to retail investors, such as blue-chip art with Masterwork, luxury assets and venture capital markets. An unstoppable trend towards the democratization of these assets class is present.

Value creation has shifted massively from public to private markets and venture capital has massively outperformed public equity in the last two decades. Additionally, investing is now officially a part of culture. Investing is becoming more a community, social activity and consumers are coming together to invest in opportunities that align with their beliefs and passions.

Fintech startups democratizing venture capital

The most common way for retail investors to access private markets has historically been crowdfunding. Crowdfunding allows companies to raise from a mass of unaccredited retail investors and is mediated by platforms like Seedrs, Republic, Fundable, Wefunder and many others. Despite a few big successes over the past decade, equity crowdfunding has underperformed. This is mainly due to issues with adverse selection and lack of disclosure.

Adverse selection refers to the fact that startups recur to equity crowdfunding when they have exhausted all other sources. This is not always true, in several cases crowdfunding is used to close an already partially filled funding round quickly and efficiently. Although, Crowdfunding campaigns have been criticised for their lack of financial disclosures, leaving crowdfunding investors in the dark.

Another way for retail investors to access private companies’ shares is through secondaries. Secondaries bring liquidity to existing VC investors and even more importantly the company employees, allowing them to sell shares of the company before an exit occur. Several crowdfunding platforms are naturally expanding to these offerings. For instance, Crowdcube launched Cubex, a European marketplace for secondaries in May last year.

A key moment for secondary purchase is IPOs. UK based PrimaryBid raised $190M in January to bring the “public” back into IPOs, giving ordinary people a chance to invest directly alongside banks and other large, professional investors with the same conditions. Other neobrokers like Robinhood and Upstox have also expanded to similar offerings.

Startups like Forge Global, Funderbeam and EquityZen are building leading private marketplaces for secondaries. Forge Global has just gone public at a $2B valuation after merging with the SPAC Motive Capital. On the platform, private shares have traded in more than 400 companies since inception, representing over $10B in volume across 19,000 transactions with buyers and sellers in 70 countries.

Secondaries have historically had a bad reputation in the venture capital world. VCs prefer to hold on and get the full amount in an exit if they are confident in the company’s growth. Therefore secondaries have been often seen as a warning sign of issues in the company, but with startups staying private longer and longer, the need for liquidity has increased and this is slowly changing.

Blockchain is also opening a new range of opportunities through blockchain-based digital securities. The use of blockchain for smart contracts and digital securities makes the issuance process more effective and less costly, opening the possibility to expand the reach to more investors. Examples of startups working in the field include ADDX in Singapore, tZero in the US, and Cashlink in Germany.

Other interesting applications of blockchain include prePO, a decentralized trading platform allowing anyone, anywhere to gain exposure to any pre-public asset and Aktionariat which provide Swiss Companies with a toolset to create a market for their digital shares on their own website.

Angel investing has also become more accessible with companies such as AngelList, Syndicate Room and Leapfunder making it easier than ever to create syndicates, SPVs and pool funding across a huge number of angels.

All the ways described above relies on still cherry-picking single investments by retail or qualified investors. But there are also several ways to obtain indirect exposition to the asset class.

A good number of VC funds are completely or partially publicly listed and can be traded by retail investors as normal stocks, especially in the UK. Examples include Molten Ventures, Seraphim Capital, Augmentum Fintech, Forward Partners, Kinnevik, KKR, Beringea and Octopus Ventures.

Alternatively more and more startups are offering indirect investment VC funds selections, almost with a fund of fund approach. Examples include inVenture, Welt Ventures, Allocate, Reach Investments and Sprout.

Lastly, retail investors are already receiving indirect exposition to private equity and venture capital through their pension funds. Especially US pension and retirements funds are increasing their private market allocation, which reached 8.9% in 2021. Europe funds have a lower exposition to the private markets but are moving to increase it.

Fintech startups democraziting venture capital

Balancing consumer protection and access

Laws vary around the world, but in general the old mantra “it takes money to make money” still holds. Laws restrict the offering of some types of financial offerings only to “certified investors”, referred to as “accredited investors” in the US and “experienced investors” in the EU.

Basically, the prevailing narrative is that of “paternalism.” Retail investors have to be restricted in their freedom and choices in their supposed interest, to protect them. This position is anachronistic and we are fortunately seeing a few steps in the right direction. For instance, the SEC, the main regulator in this area in the US, is loosening the definition of “accredited investor”. As Bessemer Venture Partners’ Talia Goldberg and Katherine Walker argue in their Consumerizing the private markets, “This archaic concept should be abolished altogether and replaced with a short set of mandatory disclosures for private offerings.”

Despite all the technological advancements, the private market is highly illiquid and characterized by long cycles. Retail investors should invest only what they can lose and diversify their bets across at least 15-20 direct investments or across vehicles like funds.
Overall, 5-10% of the portfolio should be allocated to startups/private equity.

As Elik Aktug of the FT puts it, “My biggest concern with startups is that they are often most attractive to those who have fallen behind in saving for goals”. While it should be the opposite, overall, investing in this asset class is ill-advised for those with few savings and a need for liquidity.

The other big question that remains is the concept of adverse selection we introduced before. Will the best opportunity be made available to retail investors, when they have been historically reserved for insiders?

That is probably still hard to imagine unless regulation steps in to require transparency on the quality of opportunities allocated to the public relative to the overall mix.

Private markets are going mainstream and we are excited to see a wave of fintech startups democratizing venture capital.

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Additional resources:

Consumerizing the private markets – Bessemer Venture Partners by Talia Goldberg and Katherine Walker

The perils of democratising private markets – Financial Times

Carsten Huth

Raffaele Lucantonio – Allianz X