The law of unintended consequences is alive and well.
We all learned the dangers of having banks that are too big to fail. But now we have fewer banks than at any time since the great depression, in part because Dodd-Frank is more difficult for small banks to follow than the large banks.
http://www.wsj.com/articles/SB100014240527023045794045792323...
One of the "reforms" that was enacted in response to the 2008 crisis was to give the Federal Reserve regulatory powers. They now get to decide whether banks are "viable" or not and if they are not viable, can force them to merge with candidates of the federal reserves choosing.
This might sound reasonable to you, if you focus on the "Federal" part of the name and that makes you think of the Federal Reserve as an agency of the federal government (like the DEA or FCC)... but the reality is that the Federal Reserve is a commercial, for profit, bank owned by major banks. (The ownership is kept secret but the owners of the "too big to fail" banks are highly correlated with ownership in the fed.)
Thus you have a bank which has way too much power to begin with -- it literally profits by issuing US government debt-- able to force mergers of smaller, potentially competitive banks, with its owners.
This means that the owners of Morgan Stanley can force banks that might be competitive with Morgan Stanley into Morgan Stanley on terms that are good for Morgan Stanley, via the hand-wave of having the "Federal Reserve" decide that the target bank is "in danger".
I'm not giving you conspiracy theory, this is the literal facts of how the Federal Reserve was set up and is run. For an authoritative account of the history of the Federal Reserve read "The Creature from Jekyll Island".
Liberals are often very concerned about the corruption of government institutions or misuse of government power by corporations-- this is a far more relevant and dangerous example than most others of this action.
Conservatives are often very concerned about the undermining of the sovereignty of the country and the federal government, and here we have a major group that has massive control over the federal government (it is the Federal Reserve that enables deficit spending). Since conservatives oppose deficit spending, this institution is a key enabler of the massive government debt they are concerned about.
Everyone with a passing interest in finance and economics should really read this book. The Creature from Jekyll Island is wonderfully written and not too dry. (Lots of historical anecdotes and since they are from within the last 100 years they are pretty relatable.)
The fact that venture investors now need to wait many years for an exit (and the startups can really only access institutional capital during that time) helps keep things a lot more grounded in my opinion (though I'm sure many will disagree).
There are a lot of factors at work here, ranging from macroeconomic factors, to changing industry structures in both tech and finance. SoX is a factor to be sure, but it's not the only factor.
And besides... if SoX means I get liquidity on private company shares, then hooray for SoX.
The article raises excellent points on the pitfalls of trading pre-IPO stock on secondary markets. The opportunity is risky to be sure, only for educated investors as ready and able to lose money as to make money. Information is limited and protections are only as good as the integrity of the participants. That puts a premium on honestly, transparency, and strict adherence to securities regulations.
The American economy is built on liquidity and rapid turn-around of investments: new company founders, investors, even venture capitalists and private equity fund managers got where they are because an early exit allowed them to cash in early gains in order to re-invest in the market. This used to take a few years, but now, due to market changes, they will no longer see a penny until their company goes public after an average 7.5-year wait. More likely, their company will fail despite years of hard work and success, leaving them nothing. Secondary markets are a relief valve for these founders, early angel investors, and current and former employees.
When shares cannot be traded, even the most ambitious and brilliant entrepreneurs are locked in for the better part of a decade, waiting for something to happen. If they have liquidity they can start something new — perhaps a cure to disease, a new media company, or one that launches rocket ships. This liquidity is how many of today’s great companies got their start.
Collectively, we owe it to founders and investors, and the economy, to create reliable secondary markets. That’s why Equidate was founded.
That's bullshit. We let poor people gamble and they aren't "ready and able" to lose anything.
The laws around accredited investing are a disgusting example of how the 1% legally entitle themselves to opportunities while excluding the other 99%.
Also gambling odds are heavily controlled. Could you imagine a pit boss telling you "Table 5's die have an unfair advantage to land on 7"? Conversely, people raising money tell you exactly why they will succeed and why they are a better choice than some other company. These people can be very convincing as well.
When gambling, bets are easy to understand. You make a static bet before the wheel spins. When investing, size of the pot depends on how well the company was valued when you made that bet. The next players may decide that the company was only worth half what you paid. This isn't something uneducated investors expect.
No we don't! There are no reliable secondary markets and there is not going to be one simply because they are based on pure speculation. It exists for one reason only - shareholders of pre-IPO companies don't want to wait years and hence are willing to trade their shares for immediate cash.
Secondary markets are just another way to create derivates. And we all know how unregulated derivates turned out!
Your last paragraph doesn't make any sense to me. Mostly people sell equity shares on secondary markets. Equity shares are not derivatives. They can also sell stock options, which are derivatives, but are not created when they are sold on a secondary market. It sounds to me like all you know is that the word "derivatives" is scary, so things you don't like must be derivatives.
Yes, secondary markets are designed to provide liquidity to shareholders in pre-IPO companies. At the same time, most investors who want access to pre-IPO stocks have no ability to participate. Value creation has increasingly shifted from the public markets toward private markets. Consider eBay, which was valued at $32 million in 1996 and went public with a $1.9 billion valuation in 1998 (a 60x gain), compared to Twitter which went public in 2013 at a $24 billion valuation, a 657x gain from their $35 million valuation in 2007.
Why should those who are extremely wealthy and well connected be the only investors with access to such investments?
A secondary market is any market where securities are traded not with the company, but with a third party. The big stock exchanges (NYSE, Nasdaq) are primarily secondary markets (only IPOs are primary, and even then, the primary transaction is to underwriters who then resell the stock as a secondary to other investors in the IPO).
A derivative is whether you're selling a real share, or something else based on that share. A derivative can be both primary or secondary. Employee stock options are derivatives, and what Equidate trades is also a derivative. If you sell your stock directly to a buyer in a secondary transaction, then it's not a derivative, and the company usually has the right to intercept the transaction (the right of first refusal).
I used to work at Palantir. If I want to know what my shares are worth, GSV (which is publicly traded) owns Palantir common and preferred shares (as well as shares in several other private companies) and reports a fair market value in their public 10-Q and 10-K filings. This is useful as a baseline sanity check. There are also enough interested buyers that it's feasible to get multiple price quotes.
Just out of interest: do anybody buy this bullshit today? Do you talk like this in public?
Honest question: What is wrong with above sentence?
it won't be long until this gets securitized so you can buy a basket of pre-ipo stocks that are at the mezzanine level of funding.
Employee's get to take a bit of risk off of the table, investors get to buy into pre-ipo stocks.
As long as we can create a suitable vehicle to get around the share holder limit, and I'm pretty sure this is a well researched area, I can't see how this doesn't become another securitized product.
If the alternatives are private secondary markets or employee's being locked up util the company chooses to go public then this seems like a clear win.
This fixes one of the biggest problem with valuing startups. Right now startup valuations are high because, just like free agent sports stars, you only need one person to cut you a check for the valuation you want. Meaning, even if everyone else thinks you are extremely over priced you still get the valuation/money due to the one rogue investor/owner. This has the effect of pushing valuation only upward.
Imagine an ETF that pools shares in pre ipo stocks. Now you can take the positions that the unicorns are over priced and short them. This should give us much better insight into what the entire market thinks these startups are worth.
EDIT as pointed out, companies may change their option plans to counter this, I disagree that this will happen in a meaningful way. I think the good companies to work for won't and the bad companies will be left with the choice of hiring only people who can't get better jobs or following along.
30 years ago stock options for everyone wasn't common. 10 years ago, perks like free food weren't that common. Eventually if people are hard to find, companies come around.
You could be right that this will never fly, but I'm betting on the good companies dragging the rest of them along.
One of the problems in this arrangement is that the companies themselves don't want to encourage it. Therefore there is always going to be a trust issue of, "How do I know that you really can deliver this stock?"
Securitization allows people to get comfort of, "There may be some bad actors, but this is diversified enough that I'm sure that this slice of pie is safe." The problem with that is that now the people originating deals have little incentive to be careful. The people buying deals have no insight. And the people reporting on deals have interests more strongly aligned with issuers than purchasers. This conflict of interest can result in demand being met through ever more shady stuff being in quickly put together deals.
When that blows up, the entire sector will blow up at once. Like subprimes did in 2008. Or like the S&L crisis in the 1980s.
The phenomena is called control fraud. And it is a cycle that repeats in different asset classes. No matter how many times it happens, it will happen again due to the combination of people not learning from history and people's willingness to believe that they've figured out how to get rich.
Actual price transparency (with low volume that will further distort the differences) for thumbsuck, pie-in-the-sky valuations in an overheated market has only a major downside for founders and investors.
Remember your incentive stock option plan can be changed on a whim by your "stock plan administrator" (e.g. the founders and investors).
That goes against the practice of "pump and dump". Investors who invest 50mil+ and raise valuation to billions and sell the company to Googles of the world not going to like your idea. They might do anything in their power to stop it.
"Terms of the deal call for Mr. Ballenegger to pay back the money if Chartboost goes public or is sold"
So if the company is acquired for less than the valuation made when he established the transaction with the derivative seller, he'd be up shit creek, no?
Derivatives like this are typically structured as a sale of the economic interest, not a loan. In this scenario, if the company sells or IPOs, the terms call for me to liquidate my position as soon as possible and transfer the proceeds to the buyer. If the sale is not a positive outcome for the investor, I have no liability.
I think this could probably have been worded much better in the article.
The idea behind a deal like this is you get money now based on the valuation, and then when you're in a position to sell, you pay back on the valuation then. Which money you presumably have because you sell the actual stock you receive.
However there are a lot of ways this can go south. For a realistic instance Chartboost goes public, he gets hit with AMT taxes, and then finds out that as an insider he's not allowed to actually sell the stock for 6 months. He now has to cover both the current valuation and a tax burden he never knew about, but has no actual money.
I could multiply scenarios here. But the lesson is don't do this unless you have good legal advice. And the Wall St guy just wants to do the deal, carefully protecting the person providing shares is not a priority.
But you're right, one potential large risk is a Chris Sacca -like situation, where one investor/investment group uses many anonymous buying agents to acquire a huge stake in a takeout/IPO candidate, via secondary liquidity. That can mess up a final outcome for whoever thought they had control over the cap table.
Things like lockout provisions are bullshit meant to provide a benefit for insiders. In addition, founders and early investors can often "cash out" some of their shares to another investor while the rank and file never get that chance.
Anything which provides added liquidity to the little guys is good.
1. for employees, startups are a lottery where an ipo is no longer a prerequisite for winning
2. for the rich and well connected, there exists an entirely separate and privileged market for startup equity.
3. the world isn't a fair place and complaining about it doesn't help. be luckier or do your own startup if you want more money.
So as of now, risk may be limited to investors in question only but if the scope and invested money increases, then it can create fresh financial crisis worldwide.
I'm also always happy to chat and answer any of your questions. Feel free to email me: sohail at equidateinc dot com
This model of paying employees in options, then having traders offer to liquidate those for cash, puts risk on the person who can least afford it out of the three parties involved - the employee.
