Revenue Sharing Trusts — An Awesome Idea that’s Not Quite There
I’ve been fascinated by the blockchain and cryptocurrency over the last years, and recently came across a few readings sharing the theory behind continuous organizations that propose a new alternative for companies to raise funds and retail investors to participate in upside of companies. After digging in for a few days, I think that the rising world of crypto-economics will bring about an awesome and more inclusive world, but we’ve still a lot of work to do.
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Problems with our current fundraising status quo
There are several misaligned incentives for the parties involved in the fundraising and investment process. There is no efficient way to strongly align the interests of founders, investors, the workforce, and the community around a company.:
- Founders spend tons of hours raising money in rounds and balance the desires of all parties involved in running a company. Additionally, they give away large swaths of equity to attract investment.
- Investors experience massive illiquidity when investing in private companies. This largely drives their need to see crazy returns on crazy odds. Oftentimes, investors push companies to make decisions against their best interest in order for them to realize profits gain from early private investments.
- Retail investors cannot participate in any asset classes that are not on a public market. This locks up tons of dollars that otherwise would be invested. This problem is exacerbated by the huge decline in the number of public companies.
- Early employees also receive highly illiquid financial instruments and bear a ton of risk in taking early bets which more often impacts employees.
- Community participants (such as early users or gig economy participants) often see no upside in successful organizations and aren’t fully incentivized to participate. Companies have often explored incentivizing early users without much luck.
TEs and RSTs
A potential solution could be the creation of Trusted Entities (TEs), which are organizations that create Revenue Sharing Trusts (RSTs) to create a more fluid, inclusive, and incentivized experience for founders, investors, and all parties involved in the fundraising model.
In short, a Trusted Entity is an organization Revenue Sharing Trust where participants can buy digital tokens to gain rights to future cash flows of the RST. TEs funnel in cash flows into RSTs as a reward for token holders. These tokens allow TEs to raise funds from token contributions without giving away equity, without experiencing the volatility common in current crypto-economics, and provide a completely liquid venture investment that includes participation to a much larger population of investors as well.
The work and theory is built on the work of bonding curves and the theory behind continuous organizations. For more information, refer to these documents.
How do RSTs work?
A TE sets up a RST that implements Bonding Curves in a Smart Contract with distinct Buy (B) and Sell (S) curves. The Sell curve is always less than or equal to the Buy curve.
These curves imply that there is a limitless supply of tokens that can be purchased, and each token has a unique price depending on the current supply of tokens in the market. They also are immediately liquid.
As a TE harnesses interest and success, investors are more likely to want claims to future cash flows and purchase tokens from its RST. When an investor invests, say $10, a fraction of that investment will be held by the RST to mint new coins and serve as a reserve for people looking to buy back coins. The rest of that investment is funneled to the TE for its growth and scale.
The revenue generated by a TE is the sum of the difference in slopes between the buy and sell curves. This schematic incentivizes investors to make longer-term bets as the immediate price at which they can be sold after tokens are bought is lower than their buy price. This serves as an effective cliffing schedule without imposing restrictions.
An investor sees profit when a successful TEs harnesses interest for investors to purchase RST tokens that raise the sell price for that given quantity of tokens above their original purchase price. When an investor decides to sell his tokens back to the RST, the TE uses funds stored in the “buyback” reserve to pay the investor in exchange for their tokens, which are immediately burned, thus reducing the marginal price for the RST token. It is important to note here that the contributions to a TE are not used to buy back tokens from investors — that’s what the buyback reserve is for. Therefore, the RST model provides a resilient and effective method of raising money for organizations without the swings in the value raised that plague ICOs.
A TE has the option to have its revenue funneled into the RST, where a percentage of the revenues are used to additionally fund the “buyback reserve.” TE themselves can also contribute to the RST “buyback reserve” by sending money to it. When done so, 100% of funds are placed into the reserve. This last action increases the slope of the sell curve, making the RST token more attractive to investors as their sell price increases for every given quantity. RSTs can also choose to burn tokens, which also effectively increases the slope of the sell curve, providing upside to token holders.
A Large Secondary Market
RSTs lend themselves to a large secondary market. In actuality, the RST should be the last resort for participants to buy or sell their tokens to. There exists a range of prices for every given quantity in the spread between the buy and sell price where participants are incentivized to transact on a secondary market; buyers of a token can buy it below the buy curve while sellers can sell it above the sell curve. Of course, secondary market transactions do not affect the amount of money raised by a TE.
Incentives of an RST
RST present interesting new incentives for participants in the fundraising process.
First off, VC funding is highly illiquid. VCs have shown that they are willing to trade in liquidity for non-governance. Many have posited that VC investors would behave differently if investments were liquid.
Secondly, ICOs are susceptible to scams and are very volatile methods for teams to raise funds — a company’s revenue from an ICO is directly tied to the price of its coin and is exposed to pump-and-dump schemes. The RST mechanism incentivizes against pump-and-dump schemes, and also makes sure that revenue generated by TEs from RSTs are not affected by market volatility.
Thirdly, RSTs make it more likely that companies will provide upside to retail investors and early community members. Because no equity is exchanged in this mechanism (and thus no control or voting rights), there is much lower risk for young companies to invite such a large population of ‘investors’ to share in their upside.
What’s the Issue?
The biggest question about RSTs is who is which companies are the right ones to use them and benefit from them. At the moment, they are a solution and awesome mechanism in search of a problem.
First off, current VCs and sophisticated retail investors have had trouble putting support behind RSTs. A subtle point to unpack has to do with the expectation of revenue when investors put money into a venture. Oftentimes, there is not an expectation of revenue (what crazy times we live in!). Rather, investors are betting that the technology or solution at hand is interesting enough for an acquisition or another alternative exit. Without the expectation revenue, RSTs don’t hold weight.
Secondly, RSTs bring about a world of continuous funding, while our fundraising world today largely functions on a need for funds rather quickly. Startups often raise funds when they need an influx of cash rather quickly. There are frequent rounds where companies raise simply because they can at a relatively cheap price, but these companies often see no pain in raising money or giving away rather small amounts of equity in exchange for those funds.
Thirdly, to address the elephant in the room, there are a few regulatory road blocks to get by — I presume the largest market of companies that would want to use RSTs are located in the US, and current SEC regulations make it hard to implement them. RSTs are clearly securities. We find ourselves in a bit of a stand-still when it comes to SEC guidance and securities.
After tons of conversations and some basic modeling, I think RSTs could be useful for orgs with large community support behind them that would be able to generate revenues rather consistently, so that investors could be convinced that RSTs will be backed. But when phrased in this way, it feels that some sort of debt financing alternative with ties to revenue sharing would be preferred.
