Decentralized Finance (DeFi) In Early-Stage Funding: Perks And Risks For Startups

Decentralized Finance (DeFi) in early-stage funding is a viable option entrepreneurs should consider when raising funding. This option is suitable for innovative and industry-disruptive projects and has revolutionized venture capital functioning in the startup ecosystem.

DeFi enables small investors to enter the finance market and transforms it into a more inclusive field by leveraging blockchain technology. Essentially, DeFi is about peer-to-peer lending and opens up opportunities for small business owners to access capital.

Decentralized finance eliminates banks, financial institutions, and other intermediaries with platforms that add transparency and streamline investment processes. The concept is quickly catching on, and more and more founders are using DeFi platforms to access the funding they need.

Read ahead for detailed information about the DeFi markets and how the lending procedure works. You’ll also understand the benefits and potential pitfalls you need to look out for. Let’s start you off with a few statistics.

The Decentralized Finance (DeFi) Market Has Attractive Prospects

Statistics indicate that the DeFi market worldwide will reach $46.61B in 2024. It will continue to achieve a CAGR of 10.98% between 2024 and 2029. The expected revenue the market will potentially generate is over $12.5B, with an average of $1,378 per capita.

Revenues will continue to rise quickly in the coming years, and the annual growth rate (CAGR) from 2024 to 2028 will be 9.07%. Translated into a dollar amount, that works out to $37B. By 2028, close to 22 million entrepreneurs will be using this funding source.

This strategy makes perfect sense since close to $52B worth of funding is available in the DeFi market. If you were to approach DeFi platforms, you could get access to assets worth $55.95B in value. These platforms demonstrate a 0.25% user penetration.

Understanding How Decentralized Finance (DeFi) Works

Decentralized Finance is a revolutionary system that aims to democratize the finance industry. It is essentially a digital ecosystem where applications are driven by blockchain technology.

These apps are open-source, enabling anyone to create them or participate using capital in small denominations.

By logging into the apps, users can borrow capital, lend, invest, and operate their accounts via smart contracts.

These digital agreements have the terms and conditions embedded inside the code and execute automatically under pre-determined situations. Blockchain and cryptography technology create digital contracts that don’t need intermediaries to execute, verify, or enforce.

The biggest advantage of DeFi is that it also overcomes geographical and financial barriers to investing and effectively achieves globalization. Participants on DeFi platforms can borrow or invest without going through banks and institutional investors, such as VCs or PEs.

As a result, investors and entrepreneurs can enter into transactions without incurring overhead costs. Users who have traditionally been unable to access capital or investment opportunities can now use applications to manage their finances.

DeFi platforms enable functions like:

• Yield farming, where investors can deposit tokens into a liquidity pool on the DeFi platform. They can earn rewards by way of a specific annual percentage yield (APY).
• Trading in crypto synthetic assets like cryptocurrencies, commodities, fiat currencies, and stock. People can speculate on these assets and earn profits without actually owning them.
• Cross-border payments
• Borrowing capital and investing money
• Decentralized Exchanges (DEX) or trading cryptocurrencies
• DeFi or blockchain insurance involves insurance products using smart contracts
• Asset tokenization is where real-world assets are converted to tokens using blockchain. Estimates suggest that assets worth around $16T will have been converted by 2030.
• Decentralized Autonomous Organizations (DAOs)

 

Decentralized Finance (DeFi) in Early-Stage Funding – Accessing Capital

Traditionally, startups have relied on investors like venture capitalists, private equity firms, and angel investors. However, decentralized finance has transformed the way investments are executed. For starters, DeFi has opened up a broad pool of investors that founders can approach.

They can leverage smart contracts to automate agreements while cutting back on legal costs. Entering into agreements and executing time has become automated, and founders can access capital beyond borders.

Options like Initial Coin Offerings (ICOs) or Security Token Offerings (STOs) are also available as capital. Companies operating in the tech sector can raise funding quickly from investors familiar with blockchain technology.

Tech startups developing digital assets can use them as collateral on DeFi platforms. That’s how they can access cost-effective and flexible funding options. Smart contracts allow them to customize terms and conditions that work well for both participants.

Startups can also provide liquidity to decentralized exchanges (DEXs) and get token rewards in exchange. Or they can release Initial Coin Offerings (ICO) and Initial DEX offerings (IDO) on the DeFi platforms. This strategy enables them to approach a global pool of investors.

Perks of Decentralized Finance for Early-Stage Startups

Decentralized finance (DeFi) in early-stage funding has several perks for entrepreneurs. Here’s what you need to know.

Overcoming Geo-Political and Other Barriers

Founders can sign up on DeFi platforms and access capital from worldwide sources without the need to comply with regulations. DeFi protocols enable a streamlined exchange of capital.

Further, since investments are executed over the platform, anyone can access capital regardless of the capital sizes they need. Underrepresented founders can also get backing without the biased screening they typically go through with traditional investors. DeFi investing eliminates barriers that founders from unconventional socio-economic classes may face.

DeFi platforms circumvent regulations and approvals from banks and financial institutions. Founders need not worry about stringent screening processes that make it harder to access capital.

Flexibility, Speed, and Efficiency

Each transaction is flexible and infuses customization per the entrepreneur’s needs. The DeFi platform enables participants to enter into smart contracts that don’t need monitoring or verification.

Further, funding processes are quick and efficient with access to a larger pool of available finance. Transactions are typically executed using smart contracts that automate and speed up the process with maximum efficiency and accuracy. Eliminating the human factor lowers the risk of costly errors.

Security Thanks to Blockchain Technology

Investment transactions are entirely transparent since they are recorded on the blockchain, ensuring security and accountability. The risk of fraud is minimized, which raises investor confidence. A ledger records the transactions for an added layer of security for users and borrowers.

Since the different DeFi protocols and blockchain networks are interactive, they allow for seamless, interconnected operations.

Additional Perks

DeFi platforms infuse liquidity into all assets, even those that have traditionally been illiquid. This factor brings higher amounts of capital into the market, making it available to founders. Then again, transactions are more cost-effective since they don’t involve transaction fees, service charges, legal costs, and other overheads.

Decentralized autonomous organizations (DAOs) involve the community of token holders in the decision-making and governance with voting rights.

Small Investors Can Pool Their Assets

Decentralized exchanges have liquidity pools where small investors and cryptocurrency owners can add their assets. These pools enable users to conduct quick transactions and enter into deals to take advantage of price fluctuations.

Investors providing liquidity earn profits according to the percentage of assets they’ve contributed to the pool.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor on Facebook, with a $500K check that turned into more than $1 billion in cash.

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Risks of DeFi Funding Options for Startups

Although decentralized financing options for startups are viable, you’ll want to approach them with caution. This industry is still in its nascent stages, and the full scope of risks is as yet unexplored. Here are some of the pitfalls to watch out for.

Lack of Regulatory Protection

Decentralized finance platforms operate outside conventional systems and without the restrictions of geo-political boundaries. While this factor is an advantage, it results in deals and transactions executed without regulations and monitoring.

Further, these platforms are not subject to existing regulatory compliance since they are innovative and the technology is emerging. Investors and deal participants could be at a higher risk because of the lack of federal protection.

The lack of regulations could also be a limitation since investors may be wary of entering an unregulated and unsecured market.

Need for Tech Skills to Navigate Investments

Token holders and small investors on DeFi platforms are not necessarily tech-savvy and knowledgeable about how cryptocurrency works. This factor can be a limitation since only a specific genre of investors can navigate the sector.

Further, non-technical users may find it challenging to understand or navigate the interface on DeFi platforms, which is usually complex.

Volatile Market Conditions

The assets and cryptocurrency traded on DeFi platforms are highly volatile in nature, and unexpected price fluctuations are a norm. Inexperienced investors and founders stand to incur heavy losses in case assets depreciate substantially.

Security Concerns

Security because of blockchain technology is considered to be one of the core defining features of decentralized finance (DeFi) in early-stage funding. However, users should be aware that this technology is evolving rapidly, and the possibility of hacking incidents is very real.

The entire market is tech-driven, complete with smart contracts to manage transactions and online applications that run investments. Considering that trillions of dollars worth of assets are traded on the exchanges, the risk of cybercrime cannot be ignored.

More so, since there are no strict federal regulations and monitoring to oversee transactions, the threat of crime is even higher. Security vulnerabilities could put both investors and founders at risk. Smaller investors with limited assets are also susceptible to fraudsters and phishing attacks.

Decentralized funding is only one of the fundraising options. If you need detailed information about how to raise startup capital, check out this video I have created.

Venture Capital or DeFi Investment – The Better Choice?

Traditionally, venture capitalists have been the go-to capital source for most sectors. While VCs do have their advantage, the money they offer comes with several strings that founders must accept. For starters, VCs expect voting rights in the decision-making with a board seat.

They also have conditions for offering funding, such as veto rights over future funding rounds and the right to preferred shares. VCs may also require pro-rata equity to minimize their risk of dilution. But also walk away with a higher percentage of stock during an exit.

Founders must also agree to offer a percentage of profits in exchange for funding. All of these issues are eliminated with DeFi funding. Token holders in DeFi platforms have voting rights but are rarely interested in the startup’s internal functioning.

Most importantly, unlike VCs, token holders and smart contracts are unconcerned by the founder’s location, gender, nationality, socio-economic background, or cultural ethnicity. These investments are driven by specific criteria, terms, and conditions.

In Conclusion

Decentralized finance (DeFi) in early-stage funding has effectively revolutionized the startup landscape by democratizing the investment system. Leveling the playing field has eliminated barriers that small investors and underrepresented founders face.

A larger pool of capital is now available from smaller investors for founders who might find it challenging to get funding from traditional sources. Innovative blockchain technology has enabled funding opportunities via decentralized platforms and applications.

Although the technology and investment protocols are nascent and steadily evolving, they have opened up funding opportunities. The objective is to ensure transparency and security. However, the full scope and the impact it can have is yet to be explored.

DeFi platforms are exploring the applications and connotations this industry can have as it extends to prediction markets and decentralized insurance. At the same time, the threats of cyberattacks, breaches, and hacking incidents are always present.

Federal agencies and regulatory bodies must enact the necessary laws to govern this sector to protect small investors. If you are considering using DeFi platforms to raise funding, approach this option with caution and do the necessary research before diving in.

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