By Arnav Guleria, Arizona State University
A few weeks ago, SecondMarket released its January private company stock market figures to some of its investors – yours truly secured a copy from one of these investors. SecondMarket is a novel form of private OTC marketplace that specialises in illiquid, private assets including auction-rate securities, bankruptcy claims, limited partnership interests and restricted securities. Their private company stock platform allows for the trading of equity in private companies – current listings include Facebook, Tesla Motors and LinkedIn.
According to the January numbers, most of the shares traded were Series D and above, suggesting a pre-disposition towards more mature companies. Not surprisingly, Northern California and LA lead the pack in regards to headquarters of listed companies, followed by New York City. Buy-side demand, by number of transactions, is concentrated in consumer products and services, such as Facebook, while sell-side demand is fairly consistent across categories. A conversation with an MD at SecondMarket revealed that while individual investors make up the bulk of SecondMarket transactions by count, secondary firms command the majority by dollar volume. Seller composition has shown waxing institutional representation numbers over the past few months. It should be noted that SecondMarket just last week raised $15M in Series B financing from Temasek in the PRC, pushing forward plans to expand into Asia.
Though commonly portrayed as a low-cost alternative to the frozen IPO markets, SecondMarket’s compelling value rests in its ability to bridge seed-stage venture capital with the public markets. Let’s say a venture capital firm operating under the Silicon Valley model (see Silicon Valley’s High Octane Business Model) wishes to invest in a commercial space start-up whose profitability is predicated upon the attainment of three serial research milestones. Today, VC Firm A would inject the seed capital; if the start-up hit research milestone 1, it would raise a second round, bringing in VC Firm B and so on. The key observation is that each firm takes on cumulative risk. That is, VC Firm A takes on the entire risk VC Firm B did plus the risk between time zero and research milestone 1. For long, capital intensive projects, such as those found in the commercial space sector, this means that the cumulative risk of the whole project is often too much for a single VC firm – resultingly, many concepts with great benefit to humanity are unable to secure seed funding.
SecondMarket and similar private company stock markets offer the opportunity to synthetically slice long-duration ventures into smaller risk and time tranches. Let’s return to our commercial space start-up: once again, VC Firm A invests at time zero. When the venture achieves research milestone 1 it will still bring in VC Firm B, but VC Firm A will have the option to liquidate in whole or in part its position in the firm. This option means that VC Firm A has taken only the risk of the venture reaching research milestone 1. It follows that VC Firm B can now exit at research milestone 2, taking only the risk of the start-up reaching research milestone 2 contingent on its achievement of research milestone 1. Since the company appreciates in value after every research milestone - a space company with its rocket technology in hand is much more valuable than one with only a prototype - the midway exits will still produce an attractive un-levered, risk-adjusted return. Granted, VC firm A may stay on through research milestone 1, but the option to exit makes the initial cash injection far more palatable. By removing the compounding effect of risk over multiple iterations, the exit option significantly reduces funding costs for start-ups while increasing the diversity of investments VC (and for that matter, all PE) can target. Additionally, long-term ventures of 10 or maybe even 20 years become feasible – this will fundamentally re-form how we see start-ups.
The example above is a case of financial innovation that seldom sees the front page. The author acknowledges the risks inherent in systems that create financial assembly lines like the one proposed above, but believes that the benefits of this innovation outweigh the inevitable growth pains. And history is littered with similar examples – before 1957, with the founding of Fairfield Semiconductor, VC in its modern form didn’t exist. The venture model that we find so natural today has had less than half a century to catalyse humanity. And VC has evolved several times, turning only recently into the single-stop innovation shop, today epitomised by the Y Combinator, a seed fund that funds startups in batches, encouraging them to collaborate with each other through a variety of networking functions.
The financial innovation debate has a habit of drifting off into talk of esoteric derivatives and other matters which encompass a whole series of separate articles. Financial innovations are immensely powerful in that they re-tool the basic framework of how our society allocates resources – it will take time, trials and mistakes for our civilisation to learn how to wield these new tools. Before declaring the value an entire industry's creative spirit inferior to the ATM, it would be wise if critics broadened their definition of finance beyond a few, albeit journalistic-ally exciting, examples. Let’s not ban medical research because of drug abuse.
