Venture investments in blockchain companies are often similar to investments in traditional, high-growth technology startups. However, there are a few differences any company or investor should know about:
- Board Seats: Lead investors in venture backed companies often require a right to designate a member of the company’s board of directors. Having a seat on the board lets investors exercise corporate governance oversight and influence the overall company’s strategic direction. However, given the complex and evolving regulatory and enforcement environment in blockchain, as well as difficulties of blockchain companies in obtaining cost-effective directors and officers liability insurance, investors often decline to obtain or fill a seat on the board. Investors may prefer board observer rights or stockholder-level approval rights.
- Token Rights: Blockchain-based companies can provide returns to investors via capital appreciation of the preferred stock investors purchase and/or via tokens or other digital assets tied to the target company’s products. As a result, investors often require secure rights to tokens in the future via token warrants, token side letters, or simple contractual covenants. The features of token rights investors negotiate for is often specific to a company’s business and stage of growth.
- Blockchain-Specific Diligence: Investors often conduct more thorough legal due diligence in blockchain companies than they would for traditional high-growth technology startups. For example, investors in blockchain companies usually ask detailed questions about the company’s efforts and plans for regulatory compliance – including in areas of securities regulation, anti-money laundering and money transmitter regulation, and tax. In addition, because many blockchain companies use open-source code, investors typically want comprehensive representations and diligence regarding the company’s compliance with the open-source licenses that underlie the company’s products.
- Negative Covenants: It is not uncommon in traditional venture capital financings to have negative covenants governing matters on which the investors’ consents are required. Blockchain-based companies, however, bring increased focus on these covenants given the typical trajectory of many companies in the space. For example, there may be additional covenants around how the company’s subsidiaries and affiliate entities are governed and what they are permitted to do. Additionally, licensing intellectual property outside the ordinary course of business will likely get additional attention. Lastly, notwithstanding the existence of fiduciary duties typically imposed by state law, it is not uncommon to see negative covenants relating to transactions between the company and its executive officers. While none of these provisions are used solely in blockchain companies, due to the nature of these kinds of companies, investors will have an increased focus on these kinds of provisions.
- Transaction Timing and Costs: In part because of the increased diligence and custom negotiation with respect to governance rights, token rights, and negative covenants, investments in blockchain companies often take longer and cost more than investments in traditional startups. Companies should be prepared for the increase in time and cost as they venture into their fundraising cycles.