Explaining How DeFi Startups Raise Money to a 5-Year-Old

DeFi, tokens, protocols, smart contracts, staking, governance, and liquidity pools… are all distant words that would never become reality to everyone till a layman or a 5-year-old can understand.

A quote by Albert Einstein says :

If you can't explain it simply, you don't understand it well enough.

This piece will help you understand how DeFi startups get money. This tale is for laymen that wish to understand how DeFi companies raise money at the initial stage. I won't keep you waiting, let's get started!

Let's start from level 1- the basics

The term DeFi, short for Decentralized Finance, emerged as a response to specific issues within the traditional banking system. DeFi aims to address the lack of accessibility to finance that many individuals face by constantly exploring and innovating new ways to provide financial services.

There is a popular assumption that the activity officially began in 2009 when people started peer-to-peer transactions with Bitcoin - transacting without any financial middleman like the bank.

However, there is an argument that the word DeFi was coined in a Telegram group, nine years after Bitcoin transactions began during a conversation with Ethereum developers and some entrepreneurs some of which are now CEOs of Web3 companies.

Have a look at a screenshot of the conversation 👇

Understanding DeFi

All Web3 thought leaders have different definitions of what Decentralized Finance -DeFi means and that's very much welcome because we all approach issues differently.

However, a few things are repeated in the multiple definitions of DeFi that are worthy of mention to help you understand what it entails:

• Decentralized

Let's start with understanding one of the words that make up the acronym DeFi - decentralized.

This means no central authority is controlling financial activities. It is controlled by a network of computers used to verify transactions.

• Public blockchain

A decentralized finance protocol is argued to operate only on a public blockchain that is open to everyone rather than a private blockchain which is limited by control and privacy.

• Non-custodial

DeFi protocols are non-custodial which means you are the only one who has access to your funds. Not even the platform should have the right to freeze your funds.

• Open source

The codebase of the protocol is open to everyone.

DeFi: the way out of banking problems

Now that you know what DeFi is in the abstract, here's how it plays out to combat the problems faced when transacting with banks.

For the sake of analogy, we will use this image.

Peter wants to send money to Sara through his bank account. You would expect that this is easy since Sara has a bank account as well. Well, that isn't how it works especially if Peter's bank doesn't have a relationship with Sara's.

So Peter's bank will have to look for at least one more bank that has a relationship with Sara's bank to facilitate transactions.

All the banks interacting with each other have to maintain different ledgers. Bank 1 has Peter debited in its ledger and the intermediary banks 3 and 4 have separate ledgers. It will look like this 👇

Since each bank keeps separate ledgers, that means any one of the ledgers can be altered.

Let's have a look at how that plays out👇

Bank 4 altered its ledger and states it received $90 from Bank 3 and goes ahead to send $80 to Sara.

Sara will receive $80, unaware of when and how the funds were split, but knowing full well that Peter sent $100.

What if Bank 3,4 or even Peter's bank is experiencing a service downtime? That means Sara will be stranded and have to wait for the issue to be sorted out before she will receive the money.

What if Peter gets debited twice in a bid to send the money to Sara and this happens on a public holiday? That means he will have to wait for the holiday to end before he can visit the bank on a weekday.

Having a central authority control your finances, renders you no other option than to trust them and you can see one consequence of doing so.

It's just way too many issues 😕.

Imagine that after going through this experience countless times, a group of people- let's call them XYZ, decide to boycott the bank and start their own business that allows people to send money at any time without hassle.

With this, Peter can send money to Sara without trusting a third party. The transactions are registered in distributed ledgers - no single entity can decide to change the records because it would be easily traceable and the different ledger will be discarded.

In the ordinary world, we all know that you need capital to start a business, you even need more money in circulation when it's a financial business.

How will XYZ get money circulating into their business to attract users to their platform so they can offer exchange, lending, and borrowing services knowing that they are new and many still trust banks despite the challenges?

That brings us to the next subtopic and the main subject of this piece…

How DeFi startups get capital

There are many ways this can happen:

• Initial coin offerings (ICOs): XYZ can decide to sell its tokens to the public so it can raise funds.
• Initial DEX offerings (IDOs): Similar to ICOs explained above, the only difference is that XYZ decides to sell its tokens on a decentralized exchange platform.
• Venture capital funding: If XYZ is lucky, they can attract funding from Venture Capitalists.
• Community Contributions: XYZ can also decide to raise money through airdrops, bounty programs, and even staking rewards.

Let's face it, it's not easy for a startup nobody knows about to raise funds through venture capital. Selling your tokens to the public is also not an easy way for an early startup like XYZ to raise funds.

How can XYZ raise funds without external support? Through bootstrapping! Yes, that's what it's called in the ordinary world- raising funds for your company with resources from your pocket. This is a hectic process but let's see how it works in the DeFi world.

Bootstrapping in DeFi

For XYZ to raise funds and attract users to the platform, money has to be available. We already know that XYZ can't pull funds externally so the team has decided to raise funds internally. For this to be actualized, the following have to be in place:

• Smart contract

An automatic agreement that binds major activities in XYZ'S DeFi protocol like exchange, lending, borrowing, and even payments. It is usually written in code, so it could look like this:

In the "pay" function any amount can be inserted as an argument. If the sender has enough money in their wallet, then the transaction will be successful.

That's a glimpse of what XYZ'S smart contract looks like. XYZ uses its smart contract to automate decisions.

• Token pool

XYZ needs an asset that users can interact with that binds the users with XYZ- that's the XYZ token. (Picture it as a ticket to a cinema).

The XYZ token is stored in a token pool and the token pool is locked 🔒 by a smart contract.

At this point, the token pool is empty, and without it, XYZ can't provide services to users, without users they have no incoming fees to attract liquidity providers.

Now that XYZ has a smart contract and an empty token pool, what next?

They have an agreement with a group of people.

Now we will see how this plays out with 3 groups of people:

1. Liquidity providers

These are the people that provide tokens to XYZ'S token pool and they don't do this for free but on an agreement to make a profit and that's where users come in.

But before we talk about the users, let's also remember that XYZ is an early-stage startup so the fees gotten from no users, will not be adequate to incentivize liquidity providers.

So XYZ decides to issue a large number of their tokens to the liquidity providers with the intention that when many users start using the platform, the worth of the tokens will increase.

These tokens are called governance tokens - they give the holder the right to vote on certain decisions that affect the platform. The liquidity providers are incentivized with a portion of the fees paid by users and the ownership of XYZ governance tokens.

XYZ is careful not to give out so many governance tokens so it doesn't reduce its value.

This type of bootstrapping is called liquidity mining - providing governance tokens in exchange for liquidity.

Let's see how this affects XYZ

Thankfully, XYZ now has liquidity in its token pool.

The token is pegged at a price based on demand and is bought by users to enjoy services on the XYZ platform. Users will pay for the token because they want to enjoy better services like faster payment, swapping, and borrowing. They can also earn interest on their XYZ tokens lent to other users on the platform.

Remember the smart contract is an agreement, so certain conditions will have to be met for users to get the tokens, exchange it for other tokens in XYZ'S token pool and carry out other activities within the platform.

2. Users

For every activity carried out by users on the XYZ platform using the token, a fee must be made. A percentage of this fee is sent to the liquidity providers and also the governance token holders.

3. Governance token holders

Picture governance token holders as shareholders in the ordinary world - they own a stake in the business.

Governance token holders own a large number of tokens in XYZ'S token pool and because of that, are granted the right such as:

• Financial rights - more like dividends in the ordinary world. Governance token holders earn a portion of the fees paid by users.
• Voting rights- they are allowed to vote on XYZ's smart contract parameters.

Remember that the liquidity providers are also governance token holders because XYZ is bootstrapping. The only difference is that the governance token holders don't provide liquidity but they have governance rights as well as the liquidity providers.

I know it's quite a lot to take in but let me use this image to summarize.

I hope it helps😌