Unicorn Slayer

What’s So Great About Equity Anyway?

What’s the best way for the average person to get equity in an early stage startup? The answer is not as clear as it used to be.

Curated prediction markets like Veil and Flux, and synthetic derivative creators like UMA and Market Protocol, now let you profit from the success or failures of startups without actually having to invest in them. Until recently, Regulation Crowdfunding was the primary avenue for retail investors to get equity in private companies.

When people talk about equity though, what they really care about is upside. Shareholder calls and board meetings may sound exciting, but most people invest to make a profit. Prediction markets and synthetic derivatives now offer alternative paths for retail investors to capture this upside.

Investing Beyond the Feeling

Owning a tokenized long/short position or an “event bet” certainly doesn’t feel as good as being an “investor”. It lacks all the social cache and swag of VC life, and makes for poor cocktail party banter. But the timing of these synthetic markets is fortuitous.

While crowdfunding proceeds grew 1.5x in 2018, most startups continue to raise capital privately. Private stock markets have become an accepted reality. Companies go public less often and much later in their life cycles than they used to, and when they do, retail is often on the losing end of the bell ring. As long as private capital remains efficient and going public onerous and expensive, there’s no reason to believe this trend will change. Retail investors will continue to miss out on some of the greatest wealth generation of our time. Decentralized tools in the crypto economy now make it possible to gain exposure to these markets, albeit in an imperfect way.

Below, I outline a few ways that retail investors can capture upside from startups, and evaluate the pros and cons of each approach. Then, I describe a marketplace ominously called Unicorn Slayer that could offer retail investors a new avenue for capturing upside from companies that do not crowdfund some or all of their capital.

Of course, none of this is financial or legal advice. Slay at your own risk.

Available Markets

There are three types of markets currently available. Generic forms include:

1. Crowdco — Crowdco is a fundraising platform that hosts Regulation Crowdfunding campaigns. These campaigns allow everyday people to invest in a range of startups. Issuers on Crowdco use a Crowd SAFE. Much like the Y-Combinator SAFE, the Crowd SAFE converts into equity if the issuing company is acquired or goes public. Unlike a SAFE though, the CrowdSAFE (i) does not automatically convert at a subsequent round of financing (the issuer must elect to do so) and (ii) when it converts into equity, it does so into non-voting shadow shares. While Crowdco is growing and capturing increasingly interesting and promising issuers, the vast majority of companies do not crowdfund for various reasons, including cost, regulatory disclosure, or unwarranted industry stigma.

2. Augurco — Augurco is a private company that’s built an interface on top of Augur, a decentralized prediction market. It has an extremely clean UX/UI and abstracts away the complexity of the underlying system. The available markets are curated by Augurco. They allow you to bet on discrete outcomes that are presented as yes or no questions.

3. Synthco — Synthco is a decentralized protocol that allows you to create a short/long tokenized position on any asset that has a publicly verifiable price. For now, the existing oracle solutions can only verify/retrieve prices. A more robust trusted oracle could theoretically retrieve any kind of information.

Note — For purposes of this discussion, I do not address the legality of whether any of these synthetic products may be considered security-based swaps. This is simply a review of the new markets made available to anyone with an internet connection by recently created crypto products.

The Bet

If you were to invest in a company like Uber on Crowdco, you could get upside when Uber:

1. gets acquired;

2. goes public; or

3. converts your investment into equity (likely at a subsequent round of financing) and distributes dividends to shareholders.

But let’s imagine that Uber does not want to distribute equity through a crowdfunding campaign. Uber’s CEO bought Bitconnect ATH and decides high-risk ventures are not suitable for the average person. So, what if we tried to synthetically capture the upside of investing in an Uber Crowd SAFE? Most investors profit from events 1 and 2 above, so a corresponding outcome could be listed on Augurco as:

“Uber will IPO or get acquired for $XX by XXXX date.”

Of course, it’s nearly impossible to predict an exact exit price. It would be easier to set a floor. Choosing too high a price limits your chances of success even if the company succeeds. An extremely low price will lower the overall risk of the bet, and therefore the potential upside for you as an investor. We could set a more modest floor of valuation:

“Uber will IPO or get acquired for *at least* $XX by XXXX date.”

You could further limit the scope by just focusing on the valuation of the company and untangle it from an event (acquisition or IPO) that confirms that valuation.

“Uber will be valued at *at least $1,000,000,000* by XXXX date.”

Relying on publicly available valuation data is difficult. Companies often wait years in between raising capital, making huge leaps from round to round, leaving large chunks of time where the last publicly available price does not reflect the real time price of the company. Many companies also do not publicize their exit price, let alone the valuations they raise at. The Augurco market would have to rely on valuations publicly available on sites like Crunchbase, Pitchbook, etc. To find a valuation not tied to the latest round, Mattermark and Datafox may provide some estimates, though that would likely provide undesirable risk.

A Synthco bet would need to be tied to a price (either an event-based price or last available price). The framing would be slightly different as participants would go short/long on a floor price, with long positions offering an effective “yes” bet and short positions a “no” bet on the price.

“Uber will be valued at at least $1,000,000,000 by XXXX date.”

Scalar Market

You could also create a scalar market that would allow you to wager on a range of outcomes. A scalar market would avoid a winner-take-all scenario. You could create a scalar market for both the time horizon and the exit amount.

“Uber/USD $1,000,000,000.”

The closer the exit price is to the billion mark, the more the “long” position token holder would make. However, scalar markets present an interesting problem for startup valuation forecasting. Should the bet reward, or punish, companies for having an earlier exit?

If a company gets acquired after only a few years, the cost of capital for the investor is less (shorter lock-up). The company has “succeeded” in a shorter time period, but presumably, the company may have built less and will be acquired for less. The median exit timeline for venture backed deals is approximately 8.2 years.

Milestone/Benchmark Approach

Another approach is to bet on a benchmark or milestone tied to key metrics of a company’s success. There are two broad categories of instructive milestones: (i) securities/capital markets events and (ii) general business milestones.

For example, Flux currently has a market tied to securities/capital markets benchmarks of success (companies like Crowdsmart claim to be able to accurately predict the likelihood that a startup will raise subsequent rounds). The market on Flux says:

“Will Flux Raise a Seed Round by July 1, 2019?”

The second type of event based bet could look to whether a product is launched, a strategic partnership is signed, a company opens up a new branch, etc.

“Will SpaceX launch a manned rocket mission by the end of 2019?”

“Will Wendys open 100 new branches in 2019?”

“Will Wendys offer a vanilla softee that doesn’t charge for a cookie dough add-in by December 31, 2019?”

“Will Republic launch 100 crowdfunding campaigns by December 31, 2019?”

You could also just bet on the chances of an exit, regardless of the price of that exit.

“Uber will IPO or get acquired by 20XX”.

Here, the odds of the event occurring are less uncertain and therefore less risky. Acquisitions can be cheap, and it can be difficult to define an acquisition in a meaningful way without providing a floor price, i.e., I can sell my company to you for next to nothing and trigger the event at little to no legal/business cost. Therefore, the upside for predicting such an event correctly will be significantly less.

Each of these options above present their own challenges. One of the greatest shortcomings in all of these markets is that they preclude the discovery of the outliers, the bets that make or break a venture capitalist’s portfolio and produce returns beyond their wildest dreams (Uber, Facebook, etc.). With synthetics, the imagination is limited by sheer numbers and the calculated risk of the spread.

Problems with Synthetics

1. Liquidity — Tokenized synthetic markets are generally illiquid. For prediction markets to do what they are supposed to do–use incentives to accurately forecast the likelihood of future events–markets need to be efficient and liquid. There is not enough interest in existing tokenized synthetic markets, let alone those focused on startups. It’s difficult to envision enough liquidity given how obscure and difficult to price most startups are. Flux, a prediction market focused on startups that’s currently in its private alpha, currently has ~150 ETH in open positions.

2. Augurco Framing — Synthetics don’t capture many of the ways an investor can get returns. Acquisition prices may not be disclosed, and shareholder payouts, stock buybacks, etc., are all eventualities that can’t efficiently be accounted for in the derivatives discussed above.

3. Moral Hazard — Startups are contentious workplaces. Founder and employee disputes are commonplace even when your startup is decentralized. Allowing employees an avenue to hedge against their sweat equity limits the appeal and potential impact of early employees. Worse, it allows those who don’t believe in the company to bet against its success. This risk is compounded if the markets are thinly traded. For disgruntled employees or those who believe they are on a sinking ship, the markets offer a way to cash out on insider knowledge.

4. Inefficient Lock up of Capital — The time horizon for a startup bet is extremely long. Keeping that capital locked in an Augurco or Synthco contract is highly inefficient. It’s possible (and likely) that Augur may allow markets with longer time horizons to automatically lend the positions (through protocols like Dharma) or even trade out the positions to fund managers disclosed at the time the market is created. Private forks (like Augurlite) could also easily add this feature in.

5. Complexity — complex financial instruments favor sophisticated investors. There’s a reason the financial requirements for being an Eligible Contract Participant are so high.

6. Lack of Value Creation — Arguably there is no value being created when placing a synthetic bet. Derivatives are useful tools for hedging against risk in more robust markets, but here, retail investors are just hedging against lack of exposure to one class of assets. Part of the promise of opening up capital markets to retail investors is that it expands access to issuers and creators who otherwise don’t have funding from traditional venture capital. Synthetics do not solve this problem.

7. Brand Ambassador — Founders looking for early capital often look for “strategics”. The promise is that industry insiders and experts in the field can unlock access to important partnerships and provide key insights and advice. When crowdfunding, founders often look for brand ambassadors who can evangelize the company and test a product early on and grow its network. It’s unlikely (though not impossible) that holders of synthetic positions will be willing to go to bat for a company in the same way.

8. Social Capital — People like investing not just because it makes them money, but because it brings them social status and prestige. In many ways, investors are just gamblers. That reality becomes much more apparent when the bet is placed synthetically. Unlike gamblers, investors are given much more glamorous titles like Angels, Venture Capitalists, Strategics, etc. Predictive bets may be a good talking point at The Battery, but they are mostly uninteresting in the rest of the country.

9. Pricing — oracles are extremely complex, and existing solutions each have their own problems even with highly liquid public markets. Retrieving accurate and instructive pricing is even more difficult with startups, especially where the price is not always the best indicator of value.

Enter, the Unicorn Slayer

One solution is a marketplace I’ll call the Unicorn Slayer. This marketplace could solve some of the main issues above, including (i) liquidity, (ii) counterparty interest, and (iii) inefficient lock up of assets.

Let’s imagine that a hedge fund called Munger, Diamond, and Rubini Partners (“MDRP”) decides it wants to short every crypto startup. MDRP is confident that the crypto industry is all vaporware. Bitcoins are space bucks sold by thieves, used by criminals, and ultimately dumped onto patsies. Fugezee fugazee. MDRP is willing to bet against any crypto startup with 98/2 odds that the company becomes a unicorn within 8.2 years.

That would give investors a 50x return if their prediction is accurate. In 2018, the median for post-money seed valuations was $10mm (!), so the upside of predicting a unicorn is not quite the 100x return you might expect as a traditional Angel investing in a unicorn, but given the parameters, it’s not terrible.

MDRP thinks the whole industry is toxic, so they don’t want to rely on valuations alone. They want at least two parties to put their money where their mouth is, so they will tie the trigger to a valuation and an event. MDRP will of course not sit on those assets; those will serve as the AUM for the fund. They will go ahead and trade it out and maintain what they are confident is a guaranteed 2 points of alpha.

“Will XX startup get acquired or go public at a valuation of $1b or more before XXXX?”

If you are thinking this sounds familiar, well that’s because it is. A similar type of market called Sand Hill Exchange opened and closed up shop quickly in 2015. They promised “Startup Investing, Democratized” by offering a similar p2p version of MDRP. The SEC closed them down for a host of reasons, but primarily because they failed to comply with the legally onerous requirements for selling derivatives to retail investors. One of the only ways MDRP could compliantly host these offerings would be for them to file an S-1 for each derivative and have those listed on a national exchange. Registering a security and listing on a national exchange can be very expensive, and given the lack of interest in such complicated products until now, it’s unsurprising that no one has offered them. However, there’s no reason to think that in the current climate, if more popular options were offered (e.g. Coinbase, Ripple, Kraken, Blockchain etc.), the process couldn’t be standardized so that the overhead of creating such a market was cost effective. Once a single market is approved, the process could be easily replicated. The only variable would be a change in the name of the underlying company the bet is placed on.

Another approach would be to ask for injunctive relief for either security based markets or event based markets. No such injunctive relief has been provided for security based markets, but an event based startup prediction market is not out of the question. To date, two markets–Predictit and Iowa Electronic Markets–have succeeded in receiving No-Action Letters that allow them to operate reasonably open political prediction markets. These letters placed serious restrictions on the market, mandating that these marketplaces (i) operate as nonprofits and are used for educational purposes, (ii) limit investor participation to $500, and (iii) limit the number of participants per market.

The arguments in favor of injunctive relief here would be similar to the arguments used by Predictit and Iowa Electronic. They created the markets “[T]o determine whether markets can aggregate information and predict election outcomes more accurately than the alternative technology of public opinion polling.” Here, an applicant would seek to determine whether “markets can aggregate information and predict the success of companies or their products more accurately than traditional accredited Angel and VC investors.”

The need for this kind of data has never been more germane. The ICO mania, with all its bumps and warts, has cast doubt over the contained wisdom of Silicon Valley elites. The 2017 ICO rush gave retail investors venture scale returns in time cycles of days or weeks, instead of years. This has done more than wet the appetite of retail investors. Innovations like the Silicon Valley LTSE exchange, which encourages startups to go public earlier by decreasing regulatory and governance burdens, might be too little too late. Investor protection is always at the center of the debate about retail access to venture investing.

However, one of the legitimate gripes retail investors have always had about venture is that the elite get access to the best deals. Synthetics offer one path towards solving the access obstacle by allowing predictions on any underlying company. I would bet that the wisdom of the crowds on most early stage startups would be just as instructive as most VCs in the valley. If only there was a place I could make that bet…

A special thanks to Paul Fletcher-Hill, Jasper de Gooijer, and Seth Rubin for your feedback and input in writing this article.