Transcript: An IPO drought pushes investors to a murky marketplace

This is an audio transcript of the Behind the Money podcast episode: ‘An IPO drought pushes investors to a murky marketplace’

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Michela Tindera
Over the last couple of decades, Silicon Valley start-ups have used one particular offer to attract new employees: company stock.

George Hammond
So early-stage Silicon Valley tech companies don’t have tons of cash, but they do have stock. And if you’re an early employee, you’re gonna get some of that stock. And that is often the golden ticket, much more so than what you’re earning each year.

Michela Tindera
That’s George Hammond. He’s the FT’s venture capital correspondent. And he says this equity can turn into a lot of cash if the business takes off.

George Hammond
For employees at the most successful early-stage start-ups, that can be worth ultimately tens of millions, hundreds of millions. That’s really the bet you’re making when you go and join one of these companies.

Michela Tindera
But regardless of how much equity an employee actually gets in their pay package, it’s not really worth anything until that company does an initial public offering. And lately, that hasn’t been happening as much.

George Hammond
Since 2021, we’ve seen a pretty dramatic slowdown in the venture capital market. Higher interest rates have caused institutional investors, who are the lifeblood of venture capital, to retrench. Valuations have come down, fundraising has dried up, IPOs have stopped, and it’s just left everyone stranded. So the way that money typically moves through the system has kind of come to a stop because the final exit of the IPO is no longer there. And that has caused everything else to pile up, including the employees’ ability to sell their stakes. 

Michela Tindera
So what do you do if, like George says, you’re stuck in this pile-up, if you’re paper-rich but cash-poor?

George Hammond
So one place you can turn is the venture secondary market.

Michela Tindera
The venture secondary market is a marketplace where ideally professional investors and employees trade tens of billions of dollars worth of stakes in companies before they go public.

George Hammond
So we think this market is gonna take off in 2024, and that is primarily for two reasons. The first is that start-up employees, who have a tremendous amount of their wealth tied up in company stock, are getting increasingly desperate to realise some of the value of that stock. If you’re a start-up employee and you want to buy a house or start a family or move abroad, this is the place that you have to turn in order to get some of that capital released from your stock and then take that step. The other group who are driving this market are the venture capital firms themselves and investors in those firms. And each of those groups are also facing their own liquidity problems.

Michela Tindera
But trading on this market isn’t as seamless as it might sound.

George Hammond
So in reality, it’s a little bit of a Wild West, because this is not a particularly developed market in the venture space.

Michela Tindera
And that sort of environment can have risks. While public markets are strictly regulated, these private markets are less developed, meaning that they’re potentially more prone to manipulation and fraud.

George Hammond
This was described to me by one investor as a messy world in which business is conducted by brokers over the phone.

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Michela Tindera
I’m Michela Tindera from the Financial Times. Today on Behind the Money, we’re diving into the murky space of venture secondary markets. They’re set to take off in the coming year. So we’re looking at how they work and what went wrong when one company tried to make the space more transparent.

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Hi, George. Welcome to the show.

George Hammond
Hey, thank you for having me.

Michela Tindera
So I think our listeners understand how trading shares on the public market works. You know, investors meet on exchanges like the New York Stock Exchange or the Nasdaq, and they buy and sell shares there. The price of those shares is set by supply and demand. But what about trading in these venture secondary markets? You’re trading shares of privately held companies. How does that even work?

George Hammond
So in some respects it’s very similar. The market is still governed by supply and demand. Hot companies are still hot. Bad companies are still bad. But it’s far less liquid. You have very infrequent trades in comparison to the public markets. And so you are in this secondary market where basically you’re having to transact with whoever is gonna come in and buy on the basis of quite limited information.

Michela Tindera
So it’s sort of like you’re putting your hand up and saying, I have these shares I want to sell. And you’re looking around the room waiting for someone else to join you. Is that how you think about it?

George Hammond
Well, the basis of value in companies in the private market is different to the public market. You have less sophisticated balance sheets. You have lower financial reporting requirements. So if you have stock in one of these companies and you’re looking to trade it, the person you’re trading with is gonna be making an appraisal of whether they think the company is gonna grow, whether they think it’s not gonna grow. And so it’s very different from the public market in that respect, where you’re trading on the basis of today’s valuation from pretty clear-cut financial information, which gives you a clear read on that.

Michela Tindera
So who’s in the venture secondary market? Well, George tells me that there’s two main groups who are selling here. One is people who own stakes in start-ups directly. That’s people like early-hire start-up employees or angel investors or venture capitalists. The other group is institutional investors. That’s things like pension funds and university endowments. They give money to VC firms and hold stakes in portfolios of start-ups indirectly. This is . . . So you’d say this is more of a marketplace where you have to know someone, right? It’s not like the public markets where I can just download Robinhood and invest in something now.

George Hammond
Right, which is part of, I mean, this is a truism of the private markets in general, particularly in venture capital. It’s as much about who’s in your network when you’re seeing companies, as it is about, you know, can you do a financial analysis? It’s a very different game to the public markets.

Michela Tindera
Opaque, murky — however you want to describe them, George tells me the venture secondary markets have been around in a meaningful sense for about a decade. Before Facebook’s IPO in 2012 — which, remember, that was back when Facebook was Silicon Valley’s hottest private start-up — these markets were in a frenzy, to say the least. Independent brokers were facilitating so many trades that the company, in some cases, actually lost track of who owned what shares before they went public.

George Hammond
It complicated their preparations for the IPO as a result of that. And at some points there were, you know, thousands of trades in Facebook shares with pretty limited oversight.

Michela Tindera
This market is lightly regulated, and that hasn’t stopped investors from diving in head first. The FT reported in 2021 that hedge funds and mutual funds at the time were routinely purchasing new stakes in companies worth tens of millions of dollars. That year, in 2021, an investment firm called Industry Ventures estimated the global transactions peaked at $105bn, just before interest rates went up. This lack of transparency, however, did leave room for some people to think, maybe there’s a better way to set up these markets.

George Hammond
One company called Carta had exactly that proposition. They made a promise to clean up the market, to formalise it and make it more transparent. In doing so, they would make it easier for individual start-up employees to sell their shares.

Michela Tindera
But what happened with them recently has highlighted some of the pitfalls of this market that’s still pretty new.

George Hammond
They are a very, very important part of the Silicon Valley ecosystem. They serve tens of thousands of start-ups, and they basically help those start-ups manage their cap table, which is a register of their investors.

Michela Tindera
So the cap table management is where Carta started. But then they decided to go beyond that.

George Hammond
Basically what Henry Ward, the founder of Carta, had identified was what he called the liquidity problem, which is that if you’re in the public markets, fine, you can access liquidity anytime. But if you’re in the private markets, that’s very, very challenging. And that meant for a lot of the workforce of Silicon Valley that he was servicing, they really had no option to do anything with the theoretical value of their stakes. They were paper-rich and cash-poor, in his phrase. And they said in 2020, we’re gonna add to this service by creating a marketplace for you to trade your stake in start-ups.

Michela Tindera
This new division of Carta’s business — this marketplace that promised simplicity and transparency for tech employees looking to offload their shares — it would be called CartaX.

George Hammond
So Carta’s plan was to host auctions for the stock of companies who chose to sell their shares in the secondary market, and in doing so, it would provide a kind of reliable, trustworthy, transparent place in which to conduct a secondary transaction, taking away some of that risk and randomness that you might otherwise be exposed to as a secondary investor.

Michela Tindera
CartaX would make money on this by taking a cut from both the buyer and the seller in these transactions.

George Hammond
The idea is that, you know, individually these stock sales would not be massive, but in the aggregate they could be a huge market, hundreds of billions of dollars. And if Carta got even a chunk of that, it would be far more lucrative than its primary business.

Michela Tindera
And big-time investors loved this idea.

George Hammond
The company, when it floated the idea in 2020, had just been valued at around $3bn, and in 2021, it raised a new round of financing from massive private equity investors, including Silver Lake, banks including Goldman Sachs, Andreessen Horowitz, the big venture capital firm, and dozens and dozens of other investors. They valued the company at that point in mid-2021 at $7.4bn. So a huge step up, and that step-up in valuation was really a bet that CartaX, the secondary marketplace, was gonna be the golden goose for Carta. And Ward himself, the founder of Carta, said at the time, you know, if this is a success, it’s gonna kill Nasdaq. It’s gonna eat the New York Stock Exchange. And investors definitely bought that line at the time.

Michela Tindera
So this idea seemed to have a lot of promise, but that initial pitch was never really fulfilled.

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So there’s this company that was supposedly set to kill the Nasdaq and eat the New York Stock Exchange. Well, things worked out differently. And that reality set in earlier this month.

George Hammond
So on Friday a couple of weeks ago, a founder of a Silicon Valley company called Linear posted to Twitter to say that a Carta employee had approached one of his angel investors — an angel investor in this company Linear — and asked them if they wanted to sell their shares in Linear. As the founder pointed out on Twitter, there is no way that anyone could have known this angel investor — who is a family member of the founder — was an investor in the company if they weren’t party to confidential information. And what the founder alleged was that Carta held this confidential information on one part of its business, its cap table management business, but had used it to facilitate trades via its secondary business.

Michela Tindera
You heard that right. This start-up founder had accused Carta of taking customer data from its core business, the cap tables, to boost its new business, CartaX.

George Hammond
This is a huge scandal for Carta. In the very tight-knit world of Silicon Valley start-ups, it sparked a crisis for the company. And a day later, the founder of Carta, Henry Ward, took to Twitter to apologise. He said on Twitter, we fucked up. I’m sorry. We fucked up. I hope you’ll forgive us. He blamed it on a rogue employee and said it was a clear breach of company policy. These two parts of the business are meant to be separate, and according to Ward, someone basically went off their own back and took this data, approached investors, and that’s how this whole thing spiralled out of control. It shouldn’t have happened and it won’t happen again, was Ward’s line. That could have been the end of the story . . . 

Michela Tindera
But ultimately it wasn’t. George tells me that these details coming to light were a massive breach of trust for the thousands of start-ups who use Carta’s main business. And in the end, last week, the company’s CEO shut down the CartaX division.

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So, George, what do you think we can learn from CartaX’s attempt to formalise these markets?

George Hammond
I think we can conclude from Carta’s failure that these markets remain risky, that they’re murky and they are open to abuse. I think we can also look at this and conclude that it’s very hard to impose order on this market. Partly that’s because start-ups themselves are opposed to the regular trade of their stock, and if they haven’t been, there might have been no issue with Carta using that data to facilitate that trade. But because they don’t want that trade to be happening, there is this conflict in incentives that is built into this market. And I think that made life for Carta very difficult.

Michela Tindera
Mm-hmm. Another thing you learned while you were reporting on this last week was that even in the few years that CartaX was operating, it wasn’t really taking over the world in the way that investors have probably hoped when they put money in a few years ago. It turned out that CartaX’s revenues were just about $3mn. That’s not exactly rivalling the Nasdaq, is it? What went wrong?

George Hammond
2021 was the top of the venture market. And since then, we’ve had massive declines in fundraising. We’ve had massive declines in initial public offerings and acquisitions, and really the whole venture market has ground to a halt. That has been a problem for all participants, and not least Carta, because it meant that the trade in secondaries really went off a cliff. That was partly because the valuation of private companies just became so unclear that it was very hard for buyers and sellers to meet anywhere on price. So it didn’t take off in the way that the company expected.

Michela Tindera
Yeah. What does that tell us?

George Hammond
It says one of two things. Either it says this is a great business and Carta just didn’t do it very well, which is possible. Or it says this is a business that was just never gonna work. And there are pretty good reasons to think that might be the case. Companies are gonna be very averse to any kind of formalisation of employees selling stock on a regular basis, in a way that brings attention to declining valuations. So it could just be that Carta got unlucky with the timing, and this was never gonna really take off as a business. There are plenty of sensible people who think that is the case.

Michela Tindera
Mmm. So I mean, do you think there’s something to the idea that some parties in these markets just don’t want them to be more transparent and less opaque?

George Hammond
I think that’s right. And in fact, it’s a massive virtue to a lot of the people in this market that it’s not transparent because they have particular bits of information which are valuable to them. And so I think that’s partly why, when you’ve seen efforts to try and formalise the trade in venture secondaries, they’ve kind of been resisted by a lot of companies who don’t want their whole business exposed to the harsh light of scrutiny, or who see value in having information that others don’t. Yeah, I think that’s a feature rather than a bug.

Michela Tindera
Mm-hmm. So how are you expecting this market to actually look in 2024? What have your sources told you?

George Hammond
We are expecting that we’ll get a crossover in what buyers are willing to pay and what sellers are willing to sell for. That could lead to a big step-up in the amount of trade that there is in the secondary market. And the previous peak in this market was 2021, when about 105bn was transacted overall in the secondaries market. Investors, marketplace providers think that this year could be even bigger than that, the biggest ever.

Michela Tindera
You mentioned that with CartaX, part of the reason things weren’t working out for the business were these competing incentives — employees want one thing, start-ups want another. Do you think as the year goes on, we’ll see more tensions like this?

George Hammond
Yeah, I think so. I mean, I think this is a market that is more often than not driven by necessity. And it’s . . . the people who are turning to secondaries market are often doing so because it’s the only release valve. So there is a kind of implied tension there. You’re not turning up in the secondaries market often that willingly. And there are these conflicts between start-ups who don’t want regular trade in their stock, the start-up employees who are desperate for some kind of way to realise the value of their stock holdings. Then there are buyers who are coming in and wanting to go fishing for discounts, and they’re obviously, you know, that’s contrary to the interest of some of the sellers. So there’s a whole set of incentives. They don’t always align. And so yeah, I think you are likely to see some tensions in this market in the year ahead as trade picks up.

Michela Tindera
All right. Well, George, thanks for being here.

George Hammond
Thank you very much.

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Michela Tindera
Behind the Money is hosted by me, Michela Tindera. Saffeya Ahmed is our producer. Topher Forhecz is our executive producer. Sound design and mixing by Sam Giovinco. Special thanks to Murad Ahmed. Cheryl Brumley is the global head of audio. Thanks for listening. See you next week.

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