Onchain Capital Structure

The finance industry is always undergoing transformations to its incumbent business models. For many decades, we’ve seen the increasing popularity of alternative investments, such as private equity, venture and especially private credit. Private credit has been one of the fastest-growing segments in finance.

M&A superstar Ken Moelis has recently lamented the demise of the M&A banker. These days, there is more lucrative business to be done in alternative, hybrid financing structures than buying and selling companies.

For curious crypto investors like us, there’s no reason why alternative financing couldn’t entail onchain structured products and tokenized elements of the capital structure. But it would be a real shame if this opportunity was first exploited by the unemployed M&A bankers instead of profitable crypto founders.

Thus far, the only products that have been produced by crypto, and accepted by the rest of the financial system, are stablecoins and Bitcoin. DeFi is yet to take off meaningfully outside of crypto and decouple from trading volumes.

One of the ways forward is to go bottom-up and build a business with a fully onchain capital structure (debt, equity, and everything in between tokenized). Tradfi loves yield and structured products. While the past has rewarded many of us with 1000x returns on vaporware, the future of institutionalized chains will ask us to rise to a different occasion.

We’ve been here before

For a long time, we have shown little interest in RWAs (real-world assets). We saw it as a skeuomorphic interpretation of the past—crypto is simply a digital wrapper for an asset that exists off-chain, in a different legal system than code is law. Today, we are rethinking this intellectually dull yet practical opportunity.

Tokenizing private credit and putting it onchain is simply a way for borrowers to access more capital. It has been facilitated by companies like Maple Finance and others. But in the event of capital impairment or default, the lenders are entirely at the mercy of an existing legal system (and the platform’s team, like Maple) to pursue recovery of capital. In many cases, the debt is issued in emerging or frontier markets where the rule of law might not be upheld. So it’s not a magical solution that its proponents would want you to believe (read our earlier
article for more context).

Then there’s the problem of adverse selection. The private credit that is offered onchain to crypto retail is likely to be of inferior quality. The best risk-adjusted opportunities would be always captured by mega funds like Apollo, Blackstone, and others, and never reach the blockchain.

The good thing is that there are profitable onchain businesses that are not available to Apollo and Blackstone (yet). Now, they need to get creative about raising capital given their unique nature of earning revenue onchain.

Tokenized US treasuries doesn’t achieve much either; it’s simply a yield sweetener for onchain DeFi strategies and a convenient way for crypto-natives to diversify by circumventing fiat offramps.

In the past, there have been some attempts to issue native onchain debt (e.g. Bond Protocol and Debt DAO), and guarantee it with project’s token or future cashflows. However, this didn’t work, for reasons that are not entirely clear to us. There are several hypotheses as to why:

• Absence of capital and users in the bear market. Very few projects were earning meaningful revenue;
• DeFi is a capital-light business. You can run a billion-dollar protocol with a small team and scale it with nearly 0 cost. That has always been one of the appeals of DeFi;
• As an alternative to debt, selling tokens in OTC to the right investors provides social credibility and status. This is then used to attract TVL and pump the token;
• Bonds are hardly competitive with other onchain opportunities that are incentivized (liquidity mining, points, and other flavors of incentives);
• Absence of regulatory clarity around debt instruments;

Because of the reasons above, DeFi founders had little reason to explore alternative sources of financing.

Programmable Revenue & Embedded Financing

We believe that, onchain businesses should have a lower cost of capital than their off-chain counterparts. When we say businesses, we mean anything that is related to DeFi, for it’s the only part of crypto that earns revenue. The cost of capital advantage should exist because all of the revenue is earned onchain, and is programmable. These businesses can directly tie their future revenue to credit obligations.

In traditional finance, debt instruments typically have covenants that measure specific leverage levels of the company. If they’re breached, then debt holders have the right to initiate the process and take over the company’s assets. The issue is that debt holders do not only need to expect the company’s revenue to do well but also costs to be kept under control. Revenue and costs are the two components that impact metrics measured by covenants.

Onchain, programmable revenue would allow credit investors to bypass the company’s cost structure and lend directly on revenue. This means the business should be able to borrow at much lower rates than if they did it at the company equity level, against their PNL.

Projects like Phantom, Jito or Jupiter should be able to borrow hundreds of millions of dollars from big institutional investors against their onchain revenue. The smart contract could be set up in a way that if the project’s revenue is drying up, the portion going to credit investors could increase (to minimize the risk of default), and decrease if the revenue is rapidly growing (to maintain the agreed credit tenor).

As an example, if pump.fun borrowed a billion dollars from a pension fund, and the bonding rate of new coins went down (like it did recently), the pension fund could take over the smart contract until its credit claim was satisfied. The desirability of such drastic measure would be debatable, but the direction should be explored.

Onchain revenue can go beyond a simple fulfillment of credit obligation. It could also be used to easily satisfy claims of different seniority in the capital structure (junior debt vs senior), make repayments conditional, auction and refinance the debt obligation, tranche and securitize the revenue by type of activity, etc.

Ultimately, securitizing the revenue as shown above should be a cheaper financing solution than selling the project’s tokens in a discounted OTC deal to liquid funds that will hedge or dump at the first opportunity. The revenue is infinite, whereas the token supply is finite. Selling tokens is easy, but it’s not a sustainable solution for projects that want to be around in the long run. We’d encourage the daring teams to set a new financing meta rather than walk the established path.

What’s described above is called merchant cash advances or factor-rate loans in traditional e-commerce. Payment processors like Stripe or Shopify have their own investment vehicles that provide working capital financing for the merchants whose revenue they process. The implied cost of debt on these loans is very high, often in the range of 50-100% or higher. There’s no price discovery; merchants (borrowers) are price-takers because they’re captives of their payment providers.

This model of embedded (in-app) financing could benefit from being onchain. Programmatic payments would enable conditional payments, real-time streaming of money, and more sophisticated payment strategies (e.g. which customers get a discount). Perhaps Stripe, with its merchant capture and Bridge acquisition, is closest to implementing this algo-first business model and pushing stablecoins to both merchants and consumers. The concept of embedded i.e. captive finance will prove to be immensely important for adoption.

Whether it will allow permissionless capital to participate and enable competition is entirely another question. It is highly unlikely that payment companies would give up their moat and let anyone provide loans to their merchants. Perhaps it’s a startup idea for onchain native crypto commerce and permissionless capital solutions.

Same Equity But Different

If the company’s equity value is entirely derived from the onchain revenue (i.e. there are no other sources of revenue), then it only makes sense for equity to be tokenized too. It doesn’t have to be straight equity at first, but could be something in between debt and equity.

There was recent news of Backed.fi offering tokenized Coinbase stock. It has Swiss custodians that hold the underlying stock and can provide cash redemption to KYC-ed individuals. The token itself is an ERC-20 so it brings all the benefits of DeFi composability. That being said, it’s only useful for the secondary market participants. Coinbase itself derives no benefit from such an instrument as it doesn’t allow it to raise new capital onchain nor do anything novel with the equity instrument.

So while tokenized equity (and other assets) has been a trendy idea lately, we are yet to see really exciting examples of it. We expect it will be executed by someone who has really wide access to distribution and can benefit from blockchain settlement, for example, Robinhood.

Perhaps another direction for tokenization of equity is building an onchain powerhouse that can raise nearly infinite amounts of capital against its revenue at cheap rates, and prove a point to the incumbents that halfway measures won’t work. You either start earning all of your revenue onchain and become a fully onchain organization, or you stay on Nasdaq.

Either way, tokenized equity has to enable new functionality or alter the risk profile of equity. Could a fully tokenized company have a lower cost of capital because its entire P&L is onchain in real-time? Or, could you change the way ATM (at-the-market) equity issuance works by making equity issuance conditional upon events that are validated by the onchain oracle? Could the employee stock packages vest upon certain onchain milestones rather than time? Can the company claim all the fees generated from trading its stock rather than giving it up to the brokerages?

Conclusions

As always, we have two ways forward: top-down and bottom-up. We, as investors, always search for the latter, yet most things in crypto increasingly have been delivered by the former.

Whether it’s tokenized equity, or credit, or structured products around revenue, the same questions remain: does it enable new forms of capital formation? Does it create incremental functionality around financial instruments? Do these things lower the cost of capital for the business?

The same way private vs public market was arbitraged in traditional venture (the trend is to stay private and not go public), we suspect the dichotomy between onchain and offchain capital will cease to exist in the future—there will be only a better or worse way to do finance. It very well might be that we’re wrong and onchain credit tied to revenue won’t result in lower cost of capital (in fact, it might be higher), but in any case, there hasn’t been price discovery yet. To get there, we will need to go through maturation of onchain capital markets and capital raising at a large scale, with new market participants.

If you’re a founder and want to explore how these ideas could help your project, reach out to us on X.