This piece is about one thing: what is the initial distribution of the capital that underpins a cryptonetwork? In a recent conversation between the Placeholder and USV teams, Fred Wilson commented that with organizations he’s experienced going south over time it can often be traced back to an original sin at inception (team, approach, economics or any other pivotal decision). For crypto, an original sin we regularly observe is insiders owning too much of systems that are marketed as public, egalitarian networks.
While “fair distribution” is a normative judgment, it flows from what we see as a consensus belief within crypto: creating level playing-fields where everyone has a chance at financial sovereignty. If a small group of insiders regularly take ~half of the fully-diluted upside (which is common), we’re seriously kneecapping the redistributive effects of this technology in order to make a handful of people obscenely rich. Truth is, those people are going to do phenomenally well even if they took less, they are just autopilot taking as much as they can, justifying it with “this is how things have always been done” or false claims of “muh fiduciary duty.”
We are working to build permissionless, open tech. Most of the process is open, but the part that remains the most closed and shrouded in secrecy is the early-stage financing. While this is in-part regulatorily and social norms driven, the more sinister component is insiders can disproportionately tilt the scales in their favor while keeping the details hidden from public view. The more early-stage investors get away with edgy behavior, the more emboldened and empowered they become, to the point where this power becomes detrimental to the health of the space as a whole.
Under the veil of this opacity the same norms and structures that have imbalanced past wealth and power distributions are at play. If we don’t openly address what’s going on at the inception of cryptonetworks, then we are bound to repeat the same past societal mistakes.
Where the capital accrues, so too will the power.
The two groups of individuals most intimately involved in the initial creation and distribution of capital are entrepreneurs and early-stage investors (either in VC, HF, or hybrid structures in crypto). Entrepreneurs want to build something, and unless they have the money to support themselves and their team independently, they turn to early-stage investors that fork over risk capital to fund the journey. While crypto has often demonized this process, it can be a healthy and helpful one that allows an entrepreneur with zero wealth to take risk on an idea and if it succeeds, get significant upside, and if it fails, walk off into the sunset without indentured servitude.
There is another world though where the relationship becomes unhealthy, especially in situations where there’s an opportunistic investor that is aware of the asymmetric distribution of information between the investor and entrepreneur, combined with an inexperienced entrepreneur. First-time entrepreneurs, beware. We have seen it frequently enough, in enough deals, to know that predatory behavior at the early-stage is more common than it should be in crypto.
This asymmetric upper hand gives the investor home-field advantage, and so long as they are able to get the entrepreneur to agree to legal agreements before any other investor says those agreements are unreasonable, then an entrepreneur can agree and the network runs the risk of being forever imbalanced from this original sin.
As an entrepreneur, a great resource to protect oneself is other entrepreneurs who have already gone through fundraises. Ask them about the reputations of different investors, things they regret, what they deem as fair, etc. If you’re considering a lead investor, you should be able to talk with any network(s) from that investor’s portfolio to get references on the investor -- references need not be one-sided. Furthermore, try to get more than one term sheet, if you can. These are a couple of simple steps to protect yourself as an entrepreneur.
If we want structural social change, then entrepreneurs and investors need to work together on what we want that change to be. If we don’t, the default is the way things have always been done. While crypto is a massively deflationary and leveling technology that directionally opens up access to capital, there’s a wide range of how (re)distributive crypto will be depending on the social norms we tolerate and endorse.
At Placeholder we have targeted 1-5% network ownership on a fully-diluted basis, with Placeholder’s most concentrated position coming in at 7% ownership fully-diluted. Some may argue this is still too high, but it’s a far cry from the 10-20% ownership of companies that private equity investors target. And that is fitting; cryptonetworks are emerging economies that use a protocol in place of a corporation or the government, specialize in a limited set of services, and are capable of global scale from inception. We hypothesize their scale, promise, and diverse set of stakeholders require more evenly distributed ownership than a company, to be maximally effective (companies don’t use equity to supercharge supply-side and demand-side growth, the way cryptonetworks regularly use their cryptoassets).
Zooming out beyond ourselves, when capital is first distributed, Placeholder advocates for “25% insider, 75% outsider splits (outsiders get 3x what insiders do).” By insiders, we refer to the core team, pre-launch investors, and close advisors -- everyone who takes a risk that the venture may go to zero and that their labor and capital is lost. 25% might sound like too much for insiders to some -- for example, Bitcoiners have long bemoaned Zcash’s 20% block reward allocation to non-mining network contributions -- but 25% is on the light side of what is a more common 40-50% distribution to insiders.
But Placeholder isn’t perfect. We don’t always get to this goal, and when we don’t (ie, more than 25% allocated to insiders) it’s often on the basis of anticipating long-tail inflation as a re-distributive and growth tactic over time. Additionally, when governance is handed over to tokenholders, planned supply distribution can be changed (ironically, when outsiders get their hands on a token, they can quickly exhibit insider behavior).
Another way of looking at the relative distribution is analyzing the multiples that outsiders get relative to insiders. For us, the range of what we see as viable today and that would help society move forward into more equitable lands, is outsiders getting 2-4x of insiders. Insiders represent a much smaller group by number, and so it follows that multiples of the network need to be saved for the permissionless public.
To hit this goal, insiders are allocated 20-33% of a network fully-diluted to get it off the ground. Within this insider allocation, we aim for entrepreneurs to get ~2x what investors get; the team is more important than the investors, and should be valued as such. The permissionless public then receives 67-80% of the initially distributed supply (2x insiders at low end, 4x insiders at high end).
There are some that would say that there should be no private funding rounds at all, just like Bitcoin. Depending on the objectives of the project, this may indeed be a viable alternative for some networks and entrepreneurs (see how Decred funded itself). We look forward to seeing more experiments along these lines, and potentially supporting them in the public markets.
As an entrepreneur, the important thing to remember is that you get to decide what you think is the fairest distribution of the network you're creating, and then find investors who match those values. If you prefer more concentrated ownership, seek out investors who have similar preferences. If you want to tilt the world towards a more even distribution of capital, don't be afraid to make that clear to potential investors, and we at Placeholder would enjoy speaking with you. Once you've moved past inception and initial distribution, the mechanism design of your network will then give you a second shot at sculpting where the power and resources accrue.
If there’s one thing we all can do, it’s to ask each network, “What is the initial distribution of the capital here, and the reasoning behind that distribution?”