5 Ways Venture Investing in Blockchain Differs from Investing in Traditional High-Growth Startups | Orrick – On the Chain

Venture investments in blockchain companies are often similar to investments in traditional high-growth technology startups. However, there are a few differences that any company or investor should know about:

• Board seats: Lead investors in venture-backed companies often claim the right to appoint a member of the company’s board. Having a seat on the board allows investors to exercise corporate governance oversight and influence the company’s overall strategic direction. However, given the complex and evolving regulatory and enforcement environment in blockchain, as well as the difficulty of blockchain companies in obtaining cost-effective insurance for directors and officers, investors often refuse to acquire or fill a seat on the board. Investors may prefer board observer rights or shareholder-level approval rights.
• Token Rights: Blockchain-based companies can provide returns to investors via capital growth of preferred stock investors’ purchases and/or via tokens or other digital assets linked to the target company’s products. As a result, investors often demand secure rights to tokens in the future via token warrants, token side letters or simple contractual terms. The features of token rights investors negotiate are often specific to a company’s business and stage of growth.
• Blockchain-specific diligence: Investors often conduct more thorough legal due diligence on blockchain companies than they would for traditional high-growth technology startups. For example, investors in blockchain companies typically ask detailed questions about the company’s regulatory compliance efforts and plans – including in the areas of securities regulation, anti-money laundering and money transfer 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 underlying the company’s products.
• Negative covenants: It is not unusual in traditional venture capital financing to have negative covenants that regulate conditions to which the investors’ consent is required. However, blockchain-based companies bring increased focus to these deals given the typical trajectory of many companies in the space. For example, there may be further agreements regarding how the company’s subsidiaries and associated entities are managed and what they are allowed to do. In addition, the licensing of intellectual property outside the ordinary course of business is likely to receive additional attention. Finally, despite the existence of fiduciary duties typically imposed by state law, it is not uncommon to see negative covenants associated with transactions between the corporation and its executive officers. Although none of these provisions are exclusively used in blockchain companies, due to the nature of these types of companies, investors will have an increased focus on these types of provisions.
• Transaction time and costs: Due in part to the increased due diligence and custom negotiations regarding governance rights, token rights and negative covenants, investments in blockchain companies often take longer and cost more than investments in traditional startups. Businesses should be prepared for the increase in time and cost as they venture into their fundraising cycles.