Funding startups can be a tricky business. Uncertainty abounds at every turn – one moment, a startup promises a wealth of bountiful returns, and the next, it can be the perpetrator of startup fraud.
We saw this playing out through the infamous case of Elizabeth Holmes and Theranos, whose revolutionary blood-testing invention turned out to be a US$600 million wire fraud. The investments that Theranos received were mismanaged and used to fund a product that did not exist.
The genuine possibility of abuse and mismanagement in the startup world compels the VC community to implement a solution to nip this problem in the bud to mitigate such risks.
At Seedefy, we have found the key to solving these issues: blockchain. Specifically, we are looking at blockchain-based, milestone-driven smart contracts, which can safeguard VC funding from abuse and mitigate these risks.
The remainder of the article will systematically cover the following:
Before we dive into the mechanics of smart funding, we should first understand its roots: smart contracts.
In essence, smart contracts are self-executing programmes that run when predetermined conditions or milestones are met. Using blockchain technology, smart contracts are typically deployed to verify and execute transactions. Once the buyer and seller verify the terms of their agreement, smart contracts automatically execute the transaction.
With the entire transaction indelibly recorded on blockchain, smart contracts effectively render transactions traceable, transparent, and irreversible.
The decentralised nature of blockchain also means that smart contracts can be set up between disparate, anonymous parties. This allows parties to transact safely with each other, even without a track record of trust. No central authority or legal system is required to establish and verify the transactions that smart contracts serve.
The conditional aspect of smart contracts is key to revolutionising the existing funding process. Specifically designed to combat startup abuse and mismanagement, smart contracts are codified to only unlock access to investment funds once the startup in question meets preset milestones.
With no central authority in the picture, the smart funding process utilises a self-governing system. Under this system, the community of investors and startups determine the milestones, or key performance indicators (KPIs), that startups are required to achieve to gain access to funds.
These milestones may encompass the following KPIs:
Milestones are not set in stone. They are subject to change, determined by a democratic voting processinvolving the shareholders and investors. Once they pass a simple majority vote, the determinant KPIs are adjusted accordingly.
By enforcing these milestones, smart contracts will effectively reduce startup risk and fraud for investors.
At Seedefy, we use a seven-step process to guide investors and startups through the smart funding journey.
We begin the process by drafting a smart contract using Seedefy’s proprietary funding template. The community of investors, partners, and founders customise the terms of this smart contract.
Once the community has reached a consensus on the terms, Seedefy proceeds to generate a unique instance of the smart contract (eg: #XYZ) on a public blockchain. The custom attributes of each smart contract include the following:
The attributes in the above list serve as the conditions that the startup needs to meet. It is only by meeting all these conditions that the smart contract is activated. When the smart contract is active, the revocation of endorsements or the entire contract is temporarily disabled.
With the unique smart contract drafted for the startup, Seedefy permanently revokes its access to the process. At this point, we pass the reins over to the community of investors, partners, and founders.
Legal, financial, and technical partners perform endorsements. Two key scenarios could play out for this step as outlined below:
(a) Partners endorse the deal
This scenario occurs once all partners approve of the documents the founder(s) provided. These approvals are codified via an endorsement process that indelibly records a hash of the documents and the details of the approvers using blockchain.
Should the documents be later altered, the endorsement is automatically invalidated, as they will fail to pass the integrity checks done by cryptographic hashes. This mechanism ensures that valid endorsements are recorded for every legal, financial, and technical partner before fundraising can commence.
(b) Partners revoke the deal
This scenario only happens when partners decide to withdraw their endorsement. Deal revocations are by no means an indication of continuous monitoring of the overall smart contracting process.
Instead, this mechanism is a failsafe when the startup undergoes significant developments. For example, a revocation should the startup’s financial auditor be suspended for malpractice.
The smart contract automatically disables all fundraising activities when an endorsement is revoked. Fundraising can only resume when the endorsement is restored. Alternatively, the investors can vote to revoke the entire fundraising campaign to reclaim any remaining funds in the pool.
Investors use a Simple Agreement for Future Equity (SAFE) to invest funds into the smart contract. Fund transfers can be made via the following three ways:
Startups may choose to receive funding via a mix of any of these three methods. All fund transfers are made to the smart contract address, which serves as an escrow, or a temporary fund holding, for the process. For crypto transfers, founders will have to collect and exchange them outside the Seedefy ecosystem.
Each time an investor successfully transfers funds, the smart contract responds by issuing governance tokens representing their investment.
Governance tokens confer benefits such as voting rights to investors. To illustrate, an investment of USD 200,000 could translate into 200 governance tokens, or 200 votes. These tokens are non-transferable, do not hold any value, and do not represent startup shares and securities.
These tokens can only be used within the smart contract ecosystem set up by Seedefy.
With all the building blocks in place, it is time to kick-start the funding process. This can only take place when, and only when, all milestones laid out in the smart contract are fulfilled. Should any of these conditions be unmet, the funding process will be paused until the issue is resolved.
When the startup is ready, it will start by initiating a milestone vote. This will trigger a voting period of up to seven days for investors. Once the majority of the investors have voted in favour, the smart contract will be activated to disburse a portion of the invested funds to the startup.
If not enough investors cast their votes, the vote collapses and no funds are transferred. The startup will be able to initiate another milestone vote subsequently.
This step only comes into play when a startup or its founders are deemed delinquent or negligent. At this point, investors are permitted to call for a vote to revoke the entire smart contract.
When a supermajority vote (67%) is passed, the contract is revoked, and investors will be able to reclaim their remaining funds proportionately.
This mechanism only works for funds still held within the smart contract. All funds disbursed to the startup are outside the purview of the smart contract, subject to external legal proceedings and court orders.
At Seedefy, we believe that blockchain can drive positive change in the world of venture capital while mitigating risks. With the combined powers of blockchain and automation on our side, we will be able to propel the venture capital world into one that is fair and democratic for everyone.