Here's what you need to know about SAFTs -- the cryptocurrency fundraising craze that's shaking up venture capital

Ethereum creator Vitalik Buterin. Picture: Getty Images

Just as blockchain technology is shaking up the startup space, it’s also revamping the way venture capital firms invest in emerging companies.

Over the last year and a half, startups have raised nearly $US4 billion through initial coin offerings, or ICOs, which are a kind of unregulated fundraising technique involving the creation of new digtial tokens, or units of value.

Venture capitalists have been wanting a piece of the action. Enter the Simple Agreements for Future Tokens, otherwise known as a SAFT.

In a SAFT deal, VCs invest a certain amount of money in a startup in exchange for its promise to one day give them a set amount of the tokens it sells in an ICO. The agreements are premised on the notion that once the company’s service is up and running and consumers are using the tokens to pay for things on it, those tokens will become valuable.

A SAFT is like a mashup of buying a gift card for a store that hasn’t yet opened and purchasing shares in a private company.

As more and more blockchain startups look to raise funding, VCs are experimenting with SAFTs as a way to get involved early on. Among the pioneers is Matt Huang at Sequoia Capital.

Here’s what you need to know about this emerging funding technique:

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SAFTs are only possible because blockchain technology lets companies create their own cryptocurrencies and tokens.

Blockchains, which are widely distributed digital ledgers, are the technology behind bitcoin, ether, and other cryptocurrencies. The technology is really good for publicly documenting rules and changes, which is why some large enterprise technology companies including IBM and Oracle are designing blockchain products for shipping and contracts.

Blockchains also make it easy to create unique digital tokens, or units of value. Companies can sell those tokens to investors to raise money or allow customers to use them on their sites and services as a medium of exchange.

If Facebook had been built on top of a blockchain, for example, it could have issued tokens that could be exchanged for upgraded profile features or used to buy advertising.

In a SAFT, investors buy the rights to tokens that will be issued in the future, rather than equity in a company.

In traditional venture capital investing, investors give a startup money in exchange for an ownership stake in the company. But with SAFTs, venture capitalists receive the rights to future tokens instead.

Typically, in the agreement, the VCs get the rights to a certain portion of the tokens a company issues in an ICO.

SAFTs are related to ICOs, the superpopular new fundraising technique.

SAFTs are venture capital's way of adapting to the boom in ICOs.

ICOs are similar to initial public offerings, or IPOs, in that they are a way for companies to raise money from the public. In an IPO, a company sells stock, or ownership stakes, to the public; in an ICO, a company sells its tokens. After an ICO, the public can buy, sell, or hold the tokens in much the same way they can stock.

Ultimately, investors and VCs hope that the tokens gain enough value that they will be able to cash out their tokens for a profit.

The first ICO was held in 2013, but the technique has boomed in recent months. Startups have raised nearly $US4 billion since mid-2016, and most of that has been raised since May.

There's growing concern about how well companies that are choosing to use ICOs for fundraising are being vetted and how well the public is being informed about the process. Controversy has swirled recently around Centra and Tezos, both of which raised money through an ICO this year.

With SAFTs, venture capitalists are investing in a company's technology rather than in the company itself.

With traditional equity investments, VCs have a stake in the success of the startup they are investing in. But with SAFTs, the VCs are much more concerned about the success of the underlying technology.

It's a subtle distinction, but an important one. A SAFT pay off for an investor if a token becomes valuable -- even if the organisation that created the token is a non-profit, a loose affiliation of programmers, or even potentially a for-profit company that goes out of business.

Take bitcoin as an example. The protocol behind the popular cryptocurrency was created by an anonymous programmer or group of programmers under the moniker Satoshi Nakamoto. Bitcoin has become extremely valuable even though there's no single company behind it.

Most VC firms can't invest much in digital tokens because SAFTs are outside their mandate.

While SAFTs are a great solution for VCs looking to get involved in the burgeoning ICO movement, there are typically limits to how much firms can invest in blockchain startups. Firms' venture funds can usually use only a small portion of the total amount they have raised on investments other than traditional private equity ones.

That means venture capital funds generally can't put much money in public stocks, hedge funds -- or new digital tokens via SAFTs.

So while there is a lot of excitement in the space, many VC investors are stuck using designated 'experimental' funds on blockchain startups, rather than taking money from their larger, traditional venture funds.

And there are basically no regulations, so investors are making the rules up as they go.

SAFTs make lab rats out of us all.

Venture capital is guided by a set of best practices developed by people in the industry through five-or-six decades of trial and error. But SAFTs are so new -- the first formal white paper on them was released on October 2 -- that there aren't any rules about how they should go.

It's unclear, for example, if investors are protected when the startups they invest in don't succeed in building their promised platforms.

So for now, investors and founders alike are just playing things by ear.

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