Why P2P share transfer is good news for founders, employees and investors alike
This weekend we were struck by an article on the front page of the Financial Times’ Asia print edition reporting that Silicon Valley start-ups shun IPOs:
A chasm has opened between the private and public financing of fast-growing tech groups as more Silicon Valley…on.ft.com
The FT continues that this has “provoked consternation among venture capital investors in Silicon Valley, who have seen a hoped-for payday repeatedly deferred in recent years as companies such as Uber, Airbnb and Palantir have opted to stay private rather than follow earlier generations of successful start-ups to Wall Street.”
The FT continues that this is not only bad news for investors, as the lack of liquidity “reduces the opportunity for employees, many of whom hold stock, to cash in.”
Regulatory Berlin Wall
At the core of the issue is the artificial separation, largely as a result of legacy regulations, between what is a private and what is a listed company.
A private company is essentially a bundle of private contracts between consenting adults, with little in the way of consumer protection. Once listed however, a whole different set of regulations kick in, from financial disclosure to governance prescriptions.
This regulatory Berlin Wall between a private vs. a listed company has resulted in a materially different treatment of how their respective stock can be transferred.
In a private company, transferring stock is a largely analogue affair, plagued by archaic protocols such as physical stock transfer forms endorsed by wet signatures. Who owns what at what time is reflected in a manually updated glorified spreadsheet by way of captable.
Listed stock, by contrast, can be traded by opening a brokerage account. Shares certificates have been dematerialised for decades and are held in central depositories such as the Depository Trust Company in the U.S. or Europe’s Euroclear.
Wall Street’s Dark Arts
These segregated “rails” have an obvious impact on a company stock’s liquidity.
In the case of private companies, there is virtually no market for its stock. The few trades that happen are when VCs invest in successive funding rounds, or when they sell to each other or to a CVC (Corporate VC).
Founders are usually subject to key man/women provisions, and employee options typically won’t have fully vested yet. Even if founders and employees would be allowed to sell, there is no real price discovery.
Things change once VCs push towards an initial public offering for their portfolio companies. Bankers get appointed to build a book of cornerstone investors and set the price at which the shares in “free float” will commence trading. Once listed, stockbrokers can start applying their dark art.
Technology to the Rescue
Perhaps part of the tech group’s recent reluctance to list may be their suspicion of Wall Street and its machinations.
This distrust predates the 2008 crisis: Back in 2004, Google was ahead of its time by trying to go public using a novel auction system, but met strong resistance and eventually gave up on its plans. However, at the time of the Google listing, the technology was not there yet to put a whole new set of rails underneath the IPO process.
This may be about to change. Various startups (full disclosure: Otonomos is one of them) are working on “asset tokenisation”: in simple terms, pegging stocks to coins to let them transfer with the same ease as sending bitcoin.
The initiative in this space that perhaps received most media attention was Overstock’s Patrick Byrne, who as part of his veritable crusade against the intermediary role of bankers in the IPO process received SEC approval to represent private company shares as digital tokens and use blockchain as the rails for their peer to peer transfer.
Towards Continuum Funding
The SEC’s cautious approval is encouraging. Combined with its recent JOBS Act implementation, it chips away at the regulatory Berlin Wall that separates private and listed companies and opens the way for “continuum funding”: a gradual, quantitative increase in a company’s liquidity in which angel and seed funding is eventually complemented by a crowd-funding type share distribution to wider group of accredited investors and eventually the retail public at large.
In this light, NASDAQ’s pilot to help private companies in the US with captable management by way of a blockchain-powered pre-IPO liquidity platform, is indicative that exchanges are keen to capture high-growth companies before they list on the main board.
V 2.0 of the Limited Company
At Otonomos, we go a step beyond the mere peer to peer transfer on the distributed ledger and make the shares themselves programmable by using Ethereum’s “blockchain 2.0”. Instead of tokens, we code “contracts” for each shareholder, watermarking the shares with their identity to make everyting Know-Your-Customer (KYC) compliant, and adding features such as the type of share class (e.g. voting/non-voting).
These “smart shares” also allow us to e.g. put a lock on shares to make Key Man provisions work automatically. Further down the line, once the private company has hundreds of shareholders, dividend payments can be automated by crediting the payouts straight to stockholders’ wallets.
The end result is a private company that forms itself by opening a KYC-compliant share wallet for each successive shareholder and keeps a continually updated register of who holds shares where and at what time. By virtue of this blockchain-powered captable, funding rounds can be continuous in a decentralised marketplace.
Such company is good news for founders, employees and investors alike. It opens the way to V2.0 of the limited company as a distributed project around which globally dispersed actors can independently contribute, be it with money or sweat, and get paid in shares which they can freely trade in a decentralised marketplace. That should alleviate anxiety of all involved.