There was a PE firm that came around about 4-5 years ago trying to raise money on this very premise.
Their thesis was that
- startups would remain private longer.
- employee's lost their options when they leave
- longer periods to go public means more employees return options to the pool which means employee option pools can be smaller
- longer private periods leads to more rounds raised which benefits investors over employees as the former can participate on each round to keep from being diluted
- exits would come eventually and the investors would always have superior terms, I believe that they were working under the assumption that investors would never have mandatory black out periods after IPO so they could essentially participate in the opening day IPO pop.
This is one of the coolest and most maddening things about finance. Every time you think you've come to a big realization, usually you find out that someone else came to the same conclusion many years ago and has been making money "arbing" it out ever since.
Where are all these secondary market companies "arbing" it out on employee stock option liquidity? The market should be HUGE, both for locked-in employees, and for buyers who want a small discount on hot startups.
This would totally solve the 90-day exercise period problem for the employees, without requiring company goodwill.
Some companies like ESOFund, 137 Ventures, EquityZen can do deals without company involvement, with a non-recourse loan with limited upside/downside, or a forward contract with cash delivered today, and the certificate held as collateral until IPO, when it is transferred.
There are increasingly share restrictions (which some consider unenforceable) on sales/transfers, loans, etc. First-hand knowledge online is scarce and lawyers give unclear answers due to the novelty of these deals. Can the company find out? Intervene? Sue? Are they likely to? Do we need a public case and TechCrunch headline in order to find out what the outcome is? How different is self-financing vs. a rich relative vs. angel vs. a marketplace investor?
Edit: It seems like I misunderstood, and the investors are investing in the company itself, not buying employee shares on the secondary market. The major point still stands though.
Usually the major problem with buying employee shares on the secondary market is information asymmetry - the company is not going to provide the buyer with any information, therefore unless the buyer is intimately familiar with the inner workings of the company (I.e. An investor, or incredibly well plugged in) they really have no idea how the company is doing (despite being a "hot" company) which in turn makes it incredibly difficult to come up with market clearing prices
That's definitely true - so basically, the buyer is more averse to buying especially considering they are essentially investing in the dark, going off of public news or hearsay? For some of the most-fundraised private companies e.g. Uber, Airbnb, Stripe etc. I figure many would be satisfied with the last private round valuation or a small discount, and the loss/market inefficiency here (5-10%) would still allow most deals to work. However, as a seller, your pitch, especially for less-well-known companies, would be much more difficult.
Basically your thesis is that as an asset class, late stage private technology companies are underpriced, since the presumed employee option pool will be smaller than previously assumed, and thus dilution will be smaller than previously assumed. Thus you can bid a higher price than your competitors and still come out ahead in your investment in this asset class.
What I don't understand is how you get around the fact that you would still have to "pick winners".
> What I don't understand is how you get around the fact that you would still have to "pick winners".
If you didn't lead investments and instead diversified substantially amongst late-stage companies, you could probably get sufficient overall exposure to the class so as to not be driven by the performance of individual companies.
In reply to your other comment, VC investors tend to have a "thesis" about a particular market but PE firms can and do have a much broader thesis. "Changing conditions have led to late-stage equity being undervalued as an asset class" would definitely qualify.
>If you didn't lead investments and instead diversified substantially amongst late-stage companies, you could probably get sufficient overall exposure to the class so as to not be driven by the performance of individual companies.
Oh that was the missing link. I forgot that you can "not lead" a round, allowing you to avoid committing too much of the fund in a given company. Thanks for pointing this out.
My impressions is that late stage investors generally have lots of protection here, so that the company is forced to IPO by certain dates to avoid penalties, and if the IPO isn't at an agreed upon number, the company gives more shares to the investor to make up for it. IIRC square had such a clause, although I don't know how that turned out.
Picking the winners isn't so hard if you can protect your investment like this. The lower bounds on their expected returns isn't $0.
To make it a classic arbitrage you would hedge by shorting an "equivalent" asset. For example, if 1/1000th of JP Morgan Chase's assets are those also in your portfolio, then for every 1000 long shares you would short 1 share of JPM.
Since JPM is far from equivalent and most VC capital you don't have access to short, in practice I assume that a) you would assume that any startup receiving financing / investments at unicorn valuations is already a winner, and b) go long a sufficiently large and diverse basket to try to eliminate risk.
Unfortunately (a) is so far from true I'm not sure this would be an effective investment thesis.
Seems like a pretty good investment thesis (especially if they were truly ahead of the curve here).
Except I doubt the last bullet is accurate. I'd be very surprised to find that even 10% of tech IPOs have significant preferred investors not subject to a lock-up. Underwriters really, really don't like holders (even small ones, but especially big ones) being able to sell right off the bat. And if the market is flooded with VC investors dumping shares just after the offering, then there may well be no "pop" to participate in.
Maybe I'm missing something, but that doesn't really sound like a "thesis" but rather just an identifying mispriced securities ("arb opportunity" also works).
I agree with the latter that the late stage market for startup growth capital likely did not price this advantage in, and that the PE fund had an edge. But even at that stage there are winners and losers, and I would think that a thesis would still need to resemble the kind that Series B investors must concoct, and be able to sift out the winners from the losers.
In any case I appreciate you sharing this info. It's enlightening.
Well ESO fund has been around for 3 years-ish. VCs also do this ad-hoc sometimes too with employees. I think other older engineers have known this to be a 'problem' too for many years.
Their thesis was that
- startups would remain private longer.
- employee's lost their options when they leave
- longer periods to go public means more employees return options to the pool which means employee option pools can be smaller
- longer private periods leads to more rounds raised which benefits investors over employees as the former can participate on each round to keep from being diluted
- exits would come eventually and the investors would always have superior terms, I believe that they were working under the assumption that investors would never have mandatory black out periods after IPO so they could essentially participate in the opening day IPO pop.
This is one of the coolest and most maddening things about finance. Every time you think you've come to a big realization, usually you find out that someone else came to the same conclusion many years ago and has been making money "arbing" it out ever since.