The Liquidity Problem

Carta Tried, And Is Exiting

Full disclosure, I am a Carta equity holder. I received my equity when one of our portfolio companies, Vauban, was purchased by Carta. For the record, I was a huge fan of Carta before the acquisition. That is a seed check I definitely would have written but I didn’t see the deal. If you are an individual investor, an angel group, a law or accounting firm, a PE/VC firm, or a startup, Carta makes your life so much easier. Everything at the click of a button. Our firm used Carta for everything and we encouraged every startup to get on it. The CEOs that were overly cheap didn’t get on it and those were the CEOs that generally didn’t do as good of a job. That deal never made it to Chicago when I was investing there.

By the way, if a deal makes it to Chicago from New York or Silicon Valley, check around and see why they couldn’t raise money in those two places. Maybe it’s a bad deal. That doesn’t work the other way around. Plenty of Chicago companies cannot raise money in Chicago and it has nothing to do with the value proposition of their deal but is more about the lack of risk appetite and expertise in Chicago.

Carta started as a capitalization table company. It was called “eShares”. If you have ever invested in a private company, you know the pain of capitalization table management. That pain gets even stronger when it comes to converting and accounting for things like notes, debt, and SAFEs. It magnifies when accounting for liquidation preferences and other terms like participating preferred along with dividends.

Employees of startups also have a lot more transparency into their equity when a firm is on Carta. It makes those discussions and allocations easier to track and takes away any distrust on the part of employees.

Carta automates and fixes all that.

Vauban was a good match because it solved all the problems in the syndication of the deal at the beginning. If you invest in private companies using syndicates and you aren’t using Vauban you are shooting yourself in the foot. It’s hard enough, why make it harder?

When we first invested in Vauban, the one worry I had was that Carta would enter the business. Instead, Carta decided to try and tackle another problem, the liquidity problem of holding shares in private companies.

Another pain point that any investor in a startup or private company feels is the valuation of the shares. The valuation process is not precise, and an arms-length negotiation. It happens infrequently. Additionally, often it has nothing to do with the actual marketable valuation of the equity, but has everything to do with the negotiation skill of the two parties, the market demand and competition to get into the deal, along with the math equation of how much dilution is the founder willing to accept to get money in the door.

In practice, you might see a company valued at “$500MM” in enterprise value, but their top-line revenue would never support that valuation. Forget about bottom-line profits.

There are generally accepted accounting principles (GAAP) ways to value a startup company. There are also 409.A valuations. Neither warms your soul. They leave a lot to be desired since they do not take into account the “market” at all.

Hence, it is a true problem.

Carta had an issue with one company. Somehow, employees of Carta reached out to investors on the cap table to see if they wanted to sell. Supposedly, they had a buyer for the shares. The CEO of the company found out and was livid. Yesterday, Carta’s CEO Henry Ward said they were exiting the business. He put it in what famous investor Charlie Munger (RIP) called his “too hard” pile.

Carta is not the first company to try and take this problem on. Why are they all falling short?

As a person who launched illiquid marketplaces and tried to get them to become liquid and succeed, I have the scars and experience to give you some insight that maybe the traditional big-name VCs don’t have.

I also used to make markets in the pit. “What’s here?” elicited a two-sided market. I didn’t care if I bought or sold as long as I was getting the edge. I think most venture capitalists don’t understand that they are market makers. If they did, they might be better at it.

Understand that as an investor in a startup, you assume the outcome is binary. I make a return, hopefully, a huge one like 30x or better. Or, I lose it all. Investors aren’t in the game to make 2x. Why take the risk?

The first problem in creating a liquid market is the buyers and the sellers. For a market to work efficiently, it has to have eager buyers and sellers who are willing to transact. If we look at a futures market like wheat, there are farmers, grain elevators, producers, and distributors all willing to transact. In a publicly listed company, there are institutional funds, hedge funds, employees, and private investors, all willing to transact every single day.

In both of the above cases, there are also speculators. If you read Scott Irwin’s book, Back to the Futures, you will understand the critical role speculators play in driving liquidity and efficiency into marketplaces. Without them, it’s a lot harder.

First question: Who are the natural buyers and sellers in the equity market Carta is trying to start?

• One side is the employees of the company and the investors in the company.

• On the other side are potential investors in the company.

Second question: What are their incentives to transact, and how often do they want to transact?

For the employees, they might want to offload the risk of working at a startup and convert it to cash. They are taking personal risks with their job working there. If the company folds, they need to find a new job. Selling equity might be a good idea for them since they will continue to be employed.

How often will they do it? Not that often. Maybe once or twice depending on the valuation they receive and how much equity they hold. For example, they can’t sell unvested options. Typically, it’s longer-term employees, not short-term employees selling.

How often does an investor want to purchase equity in a startup company? It depends on their view of that company, the market, and how much capital they are willing to risk. We get pinged by bottom-feeding investors all the time to buy shares in different portfolio companies we invested in. They are more than happy to buy your shares at a 70% to 90% discount to the last valuation.

If you are an investor who isn’t desperate for cash or one who isn’t winding down a fund, you aren’t interested in selling.

Here is another incentive to factor in. If you are a venture investor, there is a theory called the “power law of investing”. By the way, the power law is exactly how Berkshire Hathaway invests too.

The power law says that one investment will pay for the mistakes you made investing in several other companies. Hence, when you get a good one, you don’t sit on your hands. You keep investing as much as you can or what we floor traders call “pressing”. The other thing you do is let your winners ride unless someone is willing to pay what you think is a preposterous price to buy shares from you.

My incentive as an investor is not to sell winners.

Other broader market incentives that you might not consider are factoring in as well. If we look at big huge return on capital gains, the IPO market over the last twenty years since Sarbanes Oxley was passed, the big gains are in private markets. Microsoft went public at $300MM and today ChatGPT is still private at $100B.

Private markets have yielded better returns than the indexes in public markets. Chicago Booth Professor Steve Kaplan has done a lot of research proving that fact. Leveraged buyout funds (PE) and venture funds (VC) beat the market.

Of course, zero percent interest rates factored into the risk-reward views of investors and they were willing to invest in riskier assets when rates paid 0%. That’s not as true at 5% and we saw the startup market valuations drop because of it.

Illiquid markets are prone to manipulation. A big buyer or big seller can whip and drive a market to where they want it to go, not where it should necessarily go based on the underlying fundamentals of the market. Private startup company stock would be prone to that manipulation.

The incentives are very different for each natural buyer and seller of private stock.

Next question: What does transparency look like?

It’s very possible that employees of the firm and non-major investors don’t even know what the actual cap table or financial statements of the company look like. They just see a price, multiply it by the shares they have, and look at that number. If it fits them, they have a willingness to sell without knowing if there are liquidation preferences, debt, or anything like that on the cap table.

The buyer wants to know all that stuff. It is often impossible to get.

That all leads to a very wide bid/ask spread. Buyers want to buy stuff on the cheap and sellers value their holdings, maybe more than they should, and demand a higher price. Since the market is illiquid, sellers cannot sell and then turn around and re-enter the market.

Private markets are very difficult for most speculators as well. It is impossible to post a tight bid/ask spread and be able to buy and sell because there just isn’t enough stock being transacted. In listed stock markets they would call this “the float”. Risk gets magnified. That keeps speculators out, and bid/ask spreads wide.

Other legal issues complicate things. In most startup investments, one of the terms you will see is “right of first refusal”. ROFRs are there to protect the management team and the investors. There might be outside investors neither party, or one of the parties doesn’t want for competitive, strategic, or other reasons. An online market where anyone can accumulate shares isn’t comforting to them.

If I as an investor want to sell a chunk of shares to another entity, I have to run it past all the other investors and management first. They have to approve my sale to that particular investor.

That blows a big hole in the idea of a publicly listed market to transact in private shares. It turns the idea of a bid/ask liquid market into a point-to-point over-the-counter market. OTC markets are highly specialized, and that’s what the market for startup shares currently looks like.

Hence, it might be impossible to have an efficient, transparent, and liquid market in private startup securities.

This is one of those stupid ideas that would be really cool if it worked. But, it’s too hard to solve.

Where might this idea work? Digital, programmable securities otherwise known as security tokens. Why? They would have some of the same problems the other market does with incentives to buy and sell. However, they should be more transparent since all the “stuff” is programmed into the security. Because digital programmable securities are by definition decentralized and held on chain, the ROFR problem goes away.

However, the SEC has taken a very dim view of security tokens. I invested in OpenFinance and we got through the SEC process thanks to our lawyer. We were the only one at the time to do it. Once we got through, the SEC wouldn’t let us trade them. In addition, because we were using Ethereum, the price of “gas” to trade was prohibitively expensive. We were able to sell the investment to another firm because the license was valuable, and the “hope for the future” component was large.

Carta made the right decision to exit. It has some work to do to build trust back with its customers. But, I think it can do that.

SOLVING:

One solution for this is to end the huge spider web of regulations in existence for public companies that make them significantly more expensive to operate. Sarbanes-Oxley is one example but here is another.

I was at a University of Chicago conference. An alum who was CEO of a public company that had been taken private was on the panel. He said, “I will never be CEO of a public company again.” That CEO trends center left in is politics.

Why?

He said and I paraphrase, When I was CEO of a public company there were all kinds of wasteful things that I had to do which didn’t accrue to any return for shareholders. They were check box things the government regulators wanted but had no material effect on the operation of the business. In one board meeting, we spent hours and hours of company time getting ready for a two- to three-hour presentation on how the company was doing with diversity. This was to comply with a government mandate. It had no bearing on the success or failure of the company.

When we were private, all those hours wasted were put to use so employees could take care of customers better and return money to shareholders. Our board of directors didn’t care about the government regulation and never wanted to see a presentation on it again since it wasn’t necessary to understand the business.

Their thrust was:

1. Board meetings should tell the board how the company will make more money.

2. When in doubt about what to do at a board meeting, see rule number one.