Digital Connect: DeFi and the Digital Impact Investment

Jo Ruitenberg, Michael Jefferies, Isabel Roach

Digital Connect is a collaboration between Hamilton Locke and The Fold where we dissect the challenges and issues facing the digital assets ecosystem.

We recently caught up with Kat Dunn, Founder & CEO of strategic advisory firm Aviatrix, TEDx presenter and Australian DeFi Association contributor, to talk about the increasing prominence of ESG and impact in DeFi and associated investment opportunities and challenges in this space.

The Revolutions of DeFi

We are seeing a new digital revolution unfold, which has transformative implications for the way we think about organising people and entities. This is driven by the uptake in Decentralised Finance (DeFi) and tokenomics in recent years within the technological and social phenomenon of Web3 (blockchain enabled internet), where Kat describes there being three thematic revolutions at play:

1. the Peer-to-Peer Revolution, allowing people to work, borrow from and invest directly with each other without having to go through traditional intermediaries;
2. the Incentive Revolution, shifting from the people being incentivised by traditional profit and income generating structures to being rewarded for contributory or collaborative behaviours; and
3. the Purpose Revolution, changing how people approach their work and lives with a movement towards a shared purpose rather than only individual gain.

DeFi communities are self-organised around a shared collective purpose, using structures which abandon conventional hierarchies to embrace self-responsibility and peer-to-peer relationships in a vastly different way. This is where Kat’s Aviatrix comes in, by providing strategic advice on how inherently (or seeking to be) purpose-driven ventures can embed and benchmark measured impact. This includes considering whether a DAO is an appropriate vehicle to govern a project, and how its governance can be structured to best achieve its objects.

“The world is rapidly changing. Traditional operating models have led to inequality and planetary damage. Decentralised projects increasingly prioritise people and planet as much as profit. The movement values openness, active participation and collaboration.” (https://www.aviatrix.world/)

Opportunities with Web3 enterprises

This creates a treasure trove of investment opportunities at a time when we are also seeing ESG play an increasingly-prominent role in investment decisions. Whilst we have seen major market corrections in recent times – for example with the collapse of Luna and depegging of UST – there are many Web3-native businesses that are quietly working toward authentically solving social and planetary problems, whilst making a financial return. One example is Angel Alliance DAO. This UK founded, global project invests in female founded startups and scale ups that are building Web3 infrastructure. Angel Alliance is building capacity in Web3, and the venture capital ecosystem more broadly, by developing an investment analyst program to grow the pipeline of Web3 literate analysts. Aligned with Transforming our world: The 2030 Agenda for Sustainable Development (Goal 5), Angel Alliance is on a mission to become a sustainable and important contributor of the new economy by generating opportunities and developing talent. This in turn is intended to create long-term value for investors and society.

Digital assets are increasingly regarded as a distinct asset class, which also presents big opportunities to investors looking for novel and effective ways to leverage their economic or impact capital.

In the case of impact capital, this is driven by these assets shifting mindsets from a risk/reward decision to one which generates rewards through impact, returning value to consumers and the market by solving problems that face billions of people such as climate, housing, and employment. Some recent examples of this include Empowa, an affordable housing project in Mozambique that securitises the rent from a “rent-to-own” model to provide an attractive fixed income yield to investors – who are NFT holders (non-fungible tokens which is a certificate of ownership). Unlike the traditional charity or aid model, Empowa does not rely on a Central Bank to release overseas aid money to fund community projects – rather they are funded peer-to-peer by individuals who are passionate about deploying their capital to create real-world change. Another example of community driven climate action is Katalyst.Earth, a Sydney-based initiative that is funding regenerative projects including carbon removal and biodiversity conservation through NFTs. 

There are also options to design and create tokens that will align a favourable community behaviour with certain ESG aspects. This gives people and entities the ability to create their own transparent model that rewards behaviour that benefits ESG goals. Angel Alliance is an example of this. Angel Alliance helps to empower women with the skills and funding they need to grow their businesses, and become investment analysts. It is a community driven project which involves a self-governing DAO. The DAO functions as an investment committee which votes on businesses presented by the community, that they as a community, will provide funding and support to. Initial investment was made by buying NFTs using ETH which in turn gave community members voting rights. The project is now raising a larger round by issuing Angel Alliance tokens. These tokens can be used within the ecosystem to incentivise contributory behaviour, such as sourcing deals led by female founders, which entitles the contributor to rewards.

Surging investor interest

The resulting convergence of investor and donor mindsets in the international development space is leading savvy investors to look at impact as a way of analysing the viability of an investment over the long term that makes business sense. Meanwhile from an organisational perspective, Web3 is a big opportunity for enterprises to communicate their social impact returns and have its authenticity easily assessed.

More broadly, the growing acceptance and transition into “real world” adoption of Web3 projects together with the above developments has the sector now also receiving serious institutional investment attention. For example, earlier this year the A$50 million ‘AirTree Web3’ fund was launched, the first of its kind in Australia to focus on start-ups building tech using crypto and blockchain technology. Looking overseas, Andreessen Horowitz’s crypto unit a16z has just raised US$4.5 billion in its fourth fund, and Galaxy Digital Research has found that venture capitalists have invested more than US$10 billion in crypto start-ups during the first quarter of 2022 alone. These funds are gaining traction as a mainstream way for sophisticated investors to gain Web3 exposure in their portfolios, adding further dry powder to a booming sector.

Legal considerations for Web3 investments

The changing venture investment landscape presents new challenges and considerations for Web3 transactions.  The nature and substance of traditional due diligence will need to be reassessed given that “old-world” concepts may not necessarily apply to Web3 businesses. For example:

• How is ownership evidenced? What is the relationship between operational smart contracts and the “real world” legal mechanisms of ownership, rights and obligations between parties?
• What form of ownership is being sought? “Traditional” VC ownership levels of 10-20% stake may not align with the ethos of decentralisation. 
• Who has custody of the assets and what are the terms of that relationship?
• Who actually owns the intellectual property?
• If there is no incorporated entity, whose approval needs to be sought to the proposed transaction and how will that approval be obtained? 
• What regulatory licences are required? If there are no current licensing obligations, what is the regulatory landscape going to look like in the next 2 years and will that pose a threat to the business model?
• What form of investment should be pursued? 

These questions and more are being tackled in various Commonwealth Treasury consultation processes, for example as the Crypto Asset Secondary Service Providers (Licencing and Regulatory requirements) paper, however the scope of the regulatory perimeter surrounding crypto and Web3 is still wide open.

In conclusion, it’s clear that DeFi and Web3 presents many exciting opportunities with potential to reshape the world as we know it. At the same time, investments in this space often need to be approached differently to conventional VC strategies and structures. This gives rise to both new risks and opportunities that have hitherto been unexplored and curious investors may find this fertile ground for pioneering and innovation.