July 13, 2022

Angel Investing in the Web3 Space

Shifa Maqba

A new set of angel investors has emerged since the advent of Web3. Web3 startup founders are increasingly seeking value addition, expertise and mentoring from investors, while offering them much-needed mentorship and community-building, perhaps even more than monetary aid. The fundraising landscape has also changed, as, for a considerable number of startups, token assets are gaining more prominence over equity stakes.

On a rudimentary, ‘tip of the ice-berg’ level, the pre-requisites of angel investing in the web3 space can be summed up in the following steps:

  1. Identify the Funding Stage: To even begin, a startup must identify what kind of funding it requires. Are we looking at pre-seed funding to help it cement the conceptual strength of prototype or product? Or are we heading into the Seed Plus stage to help it grow its team and address early user/community feedback? It is important to keep in mind that angels, being risk-takers, often invest in pre-seed/seed stages. Not that there's a hard and fast rule that deters them from investing in subsequent rounds, but here's where their contribution can be commonly found.

  2. Pre-Seed Funding: Gone are the days of staking equity! Well, not really. But the concept of purchasing equity for Web3 angels has become largely irrelevant. It's the era of digital assets and tokens now. Funding in this space usually entails non-repayable funds such as grants. A few avenues for startups to obtain funding for their Web3 projects may include: Blockchain or ecosystem grants; decentralized crowdfunding platforms; Web3 incubators, founder communities and accelerators, etc.

  3. Due Diligence: Brace yourselves because we are going to raise pertinent questions, A LOT OF THEM. And, to thoroughly assess the viability of a potential investment, you should too. In no particular order of importance, here's what you should ask as an investor:
  • What is the track record and how sound is the technical expertise of the founding team? What do the financials, fundamentals and business plan look like?
  • How big is the market opportunity and the ROI potential?
  • How urgent is the problem the startup has set out to solve and how much value will the solution add?
  • Is the business model, product and technology viable?
  • Is the product or network supported strong community (can look into GitHub, notion, or other in-built forums).
  • How high is the switching cost?
  • What is the competitive landscape? How quickly does the market need to be scaled up before it becomes saturated?
  • Is this the right time to launch the said product? More importantly, is it the right time to invest?
  • Lastly, what is the expected deal structure?

4.  Identify the Founder's Expectations: Modern entrepreneurs aren't just looking for monetary aid in the form of massive capital injections. Operating in a decentralized world, they expect guidance on equity allocation and building an open-source community. Much like founders of traditional startups, they might also expect you to hook them up with a sound network of fellow investors and like-minded founders. Last but not least, they might expect access to adequate commercial and operational expertise.

Source: Chainlink

Defensibility in Web3

In Web3, the defensibility comes down to switching costs and prior networks built. In this decentralized space, projects are open-source and maintained by a distributed network of contributors. This means that any project can be adapted, and a personal copy of the said project can be produced (forked) by contributories in the network. For example, the Uniswap DEX retains the top spot in terms of Total Value Locked (TVL) despite numerous competing DEXs on the Ethereum blockchain (such as SushiSwap). This example illustrates that in Web3, defensibility is more about timing and community.

Dilution Concerns in Web3

Unlike Web2 startups where founders and early investors find their ownership diluted over the course of funding stages, private funding rounds for Web3 startups don’t usually go beyond Series A. Once they reach a certain level of traction in their target markets, they resort to decentralized fundraising (crowdfunding), thereby eradicating the need for private funding rounds. Even if Web3 deal structures have different dilution concerns, it still is a matter of one. However, due to the absence of multiple private funding rounds, many Web3 startups primarily deal with this issue at the beginning of their fundraising journey.

The Mirrortable

To streamline the logistical mess of angel investing in this globalized era, the concept of 'Mirrortable' has found prominence in the Web3 angel investing space. Consider mirrortables as capitalization tables for stable coins and digital tokens. Since a particular company usually stores all its fundraising processes within a single platform like Carta, a mirror image of a company’s main capital composition table can easily be written to the Ethereum blockchain, and maintained during the company’s life cycle. Then, the shareholders will receive the mirrored shares to their ENS address.

From an investor’s perspective, the relevance of mirrortables can be noted as follows:

  1. To invest, a Web3 angel only requires the founder's Ethereum Name Service (ENS) address, using which the required amount can be sent to the founder (company.eth or possibly companyseedround.eth). The recipient's address can easily be confirmed, reducing the possibility of errors in routing numbers, wire transfer numbers, or encrypted currency addresses.
  2. When sending the money from your ENS, the signature and wire transfer become the same thing, and can be accessed using the private key. Both the angel and the founder can confirm the receipt of money by viewing the on-chain transaction on a block explorer (such as Etherscan), without sending a wire transfer confirmation letter to the bank. Block explorers are also instrumental in checking deadlines for funding rounds, viewing the exact number of shares you get in a certain round as well as the shares issued in the new round, analyzing the contract history, etc.
  3. If only accredited investors are permitted to invest, the platform can also handle this issue in the mirror. They can allow each investor to pass a KYC product (e.g. Jumio). The point is that each investor only needs to pass KYC once, as long as the mirrorable format of a specific platform works with the KYC provider.
  4. Upon clearing the KYC check, investments can be made in any Web3 startup in any country, using the mirror image of that specific KYC supplier. The founders can then convert the received cryptocurrency into their local fiat currency, subject to legal formalities.
  5. Social proof: This is perhaps the USP of mirrortables. Other ENS addresses can tell you whether other people have actually invested in the startup or not. This is useful to founders as well, since they can also prove the existence of other investors, thus increasing the credibility of their startup/product.

Mirrorable smart contracts can be configured through the platform’s interface to allow or disallow asset transfers between entity names or allow conditional transfers. Other than these examples, various complex clauses, such as lock-in clauses, liquidation, priority superposition, etc., can be encoded in the mirror. Contracts can also be updated as and when new terms emerge. For example, if they new shares are issued or if the share price changes, the relevant information can be fed into the interface of the platform, to be reflected by the mirrortable on the chain. Then, all digital wallets held by investors will be made aware of the revised ownership structure or asset valuation, whatever the case maybe.

Since mirrortables operate on a blockchain (primarily Ethereum), record-keeping is an inherent feature. From the date of your investment to the stablecoin or asset sent, one can dig any precise piece of information. However, an equally important financial function is the ability to carry out instant valuations. As an angel, you can calculate the valuation of your investment portfolio instantly by looping through your digital wallet without email confirmation. Lastly, there's no significant application of special rules and regulation as mirrortables are built on the existing compliant web2 capital table platform.

Web3 is still an evolving concept, angel investing in Web3 even more so. Nevertheless, it is interesting how capital markets have drastically changed over the years. From the domineering presence of a select few elite investors in the past to virtually no barriers of entry, we're witnessing insane levels of competition, particularly in innovative, community-owned projects and products. Although highly risky, this fusion of an age-old concept with a super-modern one, accompanied by previously untapped technologies, may just open the doors to a plethora of investment opportunities for seasoned investors and commonfolk alike.

Credits: Tarun Singh for illustrations.