February 25, 2022

The Future of Markets for Startup Equity

The theme of this episode is MORE. More funding, more startups, more investors, more everything. Funding for startups has grown 10x in 10 years, an astonishing 26% annual growth rate. We analyze the three big trends - more VC money, more new types of investors, and more investor-friendly regulations - before we predict the startups that will emerge to serve this market in the years and decades to come.

Hey friends -

We're wrapping up our dive into startup equity with a look to the future. The theme is more - more funding, more startups, more investors, more everything.

It builds on the current state of the world we explored in the most recent letters:

We discussed all three on the Fat Tailed Thoughts podcast. We'll explore this week's topic in the next episode on March 1.

In this week's letter:

  • The future of startup equity liquidity: three trends and three predictions
  • Regulators impoverishing rural America, a scientist busts popular beliefs by actually measuring calories burned, and more cocktail talk
  • A drink to cure whatever ails you, the Penicillin

Total read time: 12 minutes, 17 seconds.

Three Trends for Startup Equity Liquidity

The train's already left the station. There are more startups, more multi-billion dollar startups, more startup investors, and more startup employees than ever before. We're not going back.

All of this means more startup equity. The market for turning it into cash is going to get bigger. Fast.

Three key multi-decade trends underpin the growth:

  1. More venture capital money
  2. More new "not venture capital" investors with different investment philosophies
  3. More investor-friendly regulations

We'll tackle each in turn.

More venture capital money

Venture capital is in a new stratosphere.

Venture capital invested over $600 billion into startups in 2021, 92% growth over the year prior. That was spread across over 12,000 deals, also a record. The industry also raised over $600 billion - another record - half of it outside the US. 2021 was record-breaking across the board.

This isn't isolated. 2020 broke most records. Same with 2018 and 2017. Almost every year for a decade has smashed the records set the year prior. The industry is 10x bigger by most measures, an astonishing 26% annual growth rate.

The dramatic growth in size hasn't led to lower turn returns, as was expected by previous dogma. Most big investors - pensions, endowments, and the like - used to state that the industry couldn't take on more capital, that there was a limited supply of startups to profitably fund. That line of thinking is now disproven. Average returns continue to be almost 20% per year, more than almost any other asset class.

Returns are not evenly distributed. Cyberstarts posted a 300% annual return on its first $54 million fund launched in 2018. At the other end of the spectrum, many venture capitalists fail to return most of the money back to investors when the startups they funded fail. That dynamic makes investing with a venture capitalist all the more emotionally appealing. No different than a slot machine, for many investors a venture capitalist is the chance to hit it big.

These dynamics won't continue in a straight line. The industry won't grow another 10x in the next 10 years and average returns will come back down to earth. But in absolute terms - the actual amount of new money raised and deployed, the number of startups funded - it'll continue to grow rapidly for years to come.

More venture capital money means more startup equity. And more competition to fund them.

More new "not venture capital" investors

The most active startup investor in 2021 doesn't look like a traditional venture capitalist.

Tiger Global Management backed 328 startups in 2021. They don't take board seats, they don't get involved in company operations, and they close deals in days not weeks. They'll even proactively approach startups with money to preempt a more public raise. All of this is taboo for traditional venture capitalists.

They're not alone. Investment managers of all types, from hedge funds to family offices and even ETF managers, are getting in on the action. Fed up with the high fee nature of venture capital firms, they're increasingly investing directly in the startups themselves. Just like with the distribution of returns among venture capitalists - a couple of the new investors will hit it big. That'll encourage even more to give it a try.

But these new investors aren't familiar with startups. Unaudited financials and limited disclosures sound fine today, but they could end up at the heart of court cases if the startup market turns south. The Securities and Exchange Commission (SEC) is already laying the groundwork to protect against such eventualities.

More investor-friendly regulations

The SEC oversees securities markets in the US. Their mission is clear:

The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public's trust.

The regulations that govern private markets - like those for startup equity - were written when the industry was a fraction the size it is today. Most of the changes in the past decade have expanded access. The 2012 JOBS Act expanded access to funding for startups and allowed non-accredited investors to invest in startups. The SEC also broadened the definitions for accredited investor and qualified institutional buyer in 2020 to allow more potential investors to qualify.

The trend towards broader access will continue. That will mean more, less sophisticated investors investing in startups. The SEC will push to do more to "protect investors."

The proposed changes are already underway. Last month, the SEC announced work on a new plan to require more private companies to routinely disclose information about finances and operations. Just last week, they proposed expanding the definition of an "exchange" to capture a much broader set of companies that facilitate trading.

These are the first salvos. Expect more. Yes, these changes will result in greater burdens for startups. But they'll also ensure more robust markets for the ever-growing number of investors already clamoring for liquidity.

These three trends together will underpin continued growth for the next decade or more - more startups, more equity, and more demand to convert equity into cash. They create a robust foundation on which to predict the future of startup equity liquidity.

Three Predictions for Startup Equity Liquidity

It's not just the trends that are "more," it's the predictions too.

  1. More liquidity: capital, marketplaces, and automation
  2. More complexity: options, indices, and asset-backed securities
  3. More bundling: shareholder registries, investor relations, liquidity venues

More liquidity

Prediction #1 - liquidity won't just increase, it'll accelerate. The growth rate will even outpace funding.

Demand is coming first and foremost from employees. The ever-increasing number of startups funded each year creates a multiple as many startup employees. The older startups are staying private longer while they continue to grow. It's a dramatic growth in employees at new-and-old startups alike, employees who need cash. That'll create opportunities for buyers to purchase startup equity in secondaries and lenders to help employees finance their options. All of it will be new capital flowing into the space.

Demand is also coming from the universe of new "not venture-capital" investors. Each investor comes with new expectations different than traditional startup investors. Some are used to public market equity investing where they can sell when they want and hedge trades. Others come from the "roll-up" private equity world where they combine many smaller companies into a single, market-dominant firm. These will be the same people competing as buyers in secondaries and as lenders to startup employees. Again, more capital.

Startups are already scaling marketplaces to match equity buyers and sellers or employees and lenders. CartaX, a secondary marketplace for equity, more than tripled the value transacted in 2021 to $7.4 billion. Equitybee grew the number of employees using its marketplace to finance options by 350% and the number of lenders by 430% to over 12,000.

Despite the growth, the marketplaces are almost comically small relative to the funding startups are now raising. Compare it to public equities. Just over 1000 companies went public in 2021 and collectively raised $315 billion, but over $400 billion was traded on exchanges in the stock market every day. That's over 300 times more! Yet with startups, it's a small fraction of the $600+ billion raised. There's huge room for growth.

With the growth will come automation. Blockchains with tokenized shares, natively digital transfer agents that automatically update ownership after trades, and standardized options financing agreements are just some of the many tools that decrease friction between startups and investors, buyers and sellers, and borrowers and lenders. Automation inevitably leads to lower costs, further reducing friction. It's a flywheel built on demand for liquidity.

That flywheel will keep accelerating for many years to come.

More complexity

Prediction #2 - startups will build new financial products around equity and debt that attract even more investors to the market.

Buying and selling startup equity is just the beginning. More and more complex instruments will be built as liquidity continues to increase.

Options are a cash-efficient, high leverage tool to bet on the price direction of a security. They could be used by investors to hedge startup equity price movements or get exposure to price movements without paying the full cost of acquiring equity. But they require successful delivery of payment and the underlying equity. No one wants to buy an option where they aren't guaranteed settlement.

Companies will emerge that do it - they'll play the middleman role to structure the options and ensure payment and securities are exchanged. They'll likely start as standalone startups and grow to partner with the major startup equity marketplaces like Forge Global and shareholder registries like Carta. Their initial clients will be hedge funds and other "not venture capital" investors for whom options play a key role in their public equity investment strategies.

Other investors will want broad exposure to the entire world of startups or large subsets like all US fintechs. Companies like Prime Unicorn Index have already created the first indices that track the changing prices of startups worth $1 billion or more. That's a critical step to creating funds that track the index.

Index-tracking funds rely on liquidity - they have to be able to transact shares of the companies that are included in the index. Such a fund could even programmatically track the index, thus minimizing the investment manager's discretion. That's an avenue that opens up funds to the much larger world of non-accredited investors. Expect better indices and new index-tracking funds to launch and compete for wallet share.

Debt will also get more complex. Loans provided to help startup employees exercise their options can be packaged into asset-backed securities, no different than how mortgages are packaged into mortgage-backed securities. The upper, safer tranches might be sold with the rights to the startup equity. The lower, riskier tranches might just collect the origination and annual interest fees. Such a structure allows small investors to diversify their lending across many startups with whatever level of risk they choose.

Other types of startup debt will also be securitized. Companies like Pipe facilitate marketplaces where startups can sell their annual contracts that customers pay monthly in return for cash from lenders today. Pipe could create the "SaaS-backed security" to provide broad exposure across multiple startups or an enterprising investor could buy up many loans and do it themselves. As the debt market grows, expect to see new products emerge.

There's a whole world of financial products that only work if you have adequate volume and liquidity in the underlying securities. Startup equity is rapidly maturing to a point where many of those products are viable. It'll bring entirely new types of investors to the market who indirectly create even more demand for startup equity.

The flywheel will continue to accelerate.

More bundling

Prediction #3 - the new financial products and marketplace capabilities will be more valuable bundled than apart. Startups will experiment with different bundles serving different market segments before the market consolidates around a handful of massive winners.

These innovations happen bit by bit. A startup launches a new marketplace for equity. Another launches a digital, automated shareholder registry.

But that's just the start. These innovations become more valuable when they're bundled.

Carta is the dominant shareholder registry for startups. The registry tracks who owns which shares and options. They've already bundled it with a marketplace for startup equity, now branded as CartaX, via an acquisition. That makes trading equity much easier - Carta's a one-stop-shop for trading and updating the shareholder registry.

Morgan Stanley is headed down a similar path. They acquired Solium, a competing shareholder registry, in 2019. In recent months they announced participation in a joint venture that is taking ownership of Nasdaq Private Market, a competing startup equity marketplace, and an in-house program for ultra-high net worth clients to invest in startups.

The other competing shareholder registries and startup equity marketplaces will bundle or die. And the bundles won't just stop with marketplaces, they'll expand to support the entirety of investor relations. Once a trade is complete, investors need to manage payments and track their portfolios. They need to calculate taxes and generate reports. Most investors have their own investors. Helping them will be yet another bundle.

Andreessen Horowitz's David Haber paints a compelling picture of the investor relations bundles. But other bundles will emerge too.

A registry can double its focus on startups and their employees rather than investors. They'll bundle options financing to not only allows startup employees to track their options vesting schedule, but also take ownership of the actual shares. It's a registry plus debt marketplace bundle. Securitizing the debt will become an embedded feature.

An equity marketplace can become an onramp to going public. The roadshow among potential buyers at the IPO, the workflow for SEC filings, and enforcing equity lockups can all be bundled. Or the marketplace can double their focus on still-private startups and enable options trading on the startup equity. Both bundles will be tried.

Across the board, expect bundling. Most will be via acquisition - larger, more established startups will buy earlier stage startups that sell near-adjacent capabilities. It'll be new revenue that shares the same technology, driving the cost structure ever lower.

More acceleration for the flywheel.

The Future of Startup Equity Liquidity

The future is more.

This is a market that has the potential to grow to trillions. It won't happen overnight or even next year. It'll be a decades-long growth story.

That's a tremendous opportunity for founders, employees, startups, investors, lenders, and anyone else who wants to build or provide labor and capital. There's room for many multi-billion dollar fortunes to be made, both by building the future and supplying capital to those who are doing so.

Even for startup employees, the growth will be hugely valuable. Assets like startup equity that can't be easily converted to cash are worth less than equivalent assets that can. All this growth means startups equity will become more liquid. That'll make it more valuable.

The opportunity will continue to grow by double digits for years to come. We'll see it in the value of startup equity traded, the value of options financed, the value of debt securitized, and so much more. Even what appears to be small niches today will grow to be sizable opportunities tomorrow.

Warren Buffett quipped that when management with a reputation for brilliance tackles a business with a reputation for bad economics, it's the reputation of the business that remains intact. This is the opposite - it's a rising tide.

You don't have to be brilliant. You just have to get started. Trust that growth from the flywheel will lead you to success.

Cocktail Talk

  • ATMs are a lifeline for low-income families in banking deserts. The number of banks in the US has halved in the past 20 years leaving ATMs as the primary means to withdraw cash in many rural areas. Most of those ATMs are independently run. They're increasingly under fire as the banks they rely on shut them down in the name of preventing money laundering. But don't blame the banks - they're just following regulatory guidance. The same guidance that cut off the sexual wellness industry. (WSJ)
  • Cathie Wood is having a terrible, horrible, no good, very bad day. Her flagship ARK ETF is down almost 60% over the past 12 months. But that hasn't stopped her from trying to attract more capital. ARK recently launched a new Venture Fund structured as an interval fund. Internal funds allow the fund manager to reduce investor redemptions - getting your money back - to just 5% of all fund monies per quarter. Buyer beware. (Morningstar)
  • When Charlie Munger speaks, it's always worth a listen. This year's 2022 Daily Journal Annual Meeting was no exception. Munger is Warren Buffett's longtime business partner and the second half of the Berkshire Hathaway duo. He is a true polymath who speaks bluntly in nonsense terms. You don't have to agree with everything he says (I don't), but rarely will you find a better opportunity to expand your thinking on the world. (Junto)
  • You burn more calories when you're physically active. Or so the theory went until Herman Pontzer actually measured it. Lazing about your home, you burn the same number of calories as a Hadza hunter-gather who travels an average of 14 kilometers per day. It's a wildly unexpected result that's stood up to repeat testing across populations. The question remains - if not for physical activity, where do all of those calories get used? (Science)

Your Weekly Cocktail

The weather way was cold, then it was hot, now it’s cold again. It’s enough to make anyone sick.


2.0oz   Blended Scotch
0.75oz Lemon Juice
0.75oz Honey-Ginger Syrup
0.25oz Laphroaig 10 Year Single Malt Whisky

Pour everything into a shaker. Add ice until it comes up over the top of the liquid. Shake for ~20 seconds, until the outside of the shaker is frosted. Add ice to a rocks glass. Strain into the glass.


Last week it was the Painkiller. This week is yet more medicine. I seem to inadvertently be on a trend. Like last week’s, this too can be enjoyed as a slushy, although it becomes a Penichillin when you do so. Both on the rocks and as a slushy, this cocktail combines well-trafficked flavors to create a wonderfully delightful drink that captures 50% of the pleasure from being sick (the delta being chicken noodle or matzo ball soup). Lemon, ginger, and honey. Plus the peatiness from an islay scotch. Sick or not, this medicine goes down smooth. No spoon full of sugar needed.


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