Today there is no active, generalised secondary market for startup equity. Such a secondary market exists, however, for Blockchain projects, and has positively impacted the financing ecosystem for all parties involved: the founders, team members, and the investors too.
To demonstrate to both the startup hubs and to the Blockchain community that this concept actually works in practice, at Neufund we have put our own skin in the game and converted the 10% pool of Neufund stock reserved for our employees into Ethereum-based tokens.
Everyone could take a look at the code – we have open-sourced the project on Github, and any incorporated startup can use the solution to implement their own Employee Stock Option Plan (ESOP) on the Blockchain. In addition, you can find a more in-depth discussion of the idea in a Medium post published earlier today by my co-founder and CTO Marcin Rudolf.
So what does this actually accomplish?
For startups there is a number of advantages to pursuing the blockchain ESOP option.
Firstly, there is a certain opaqueness surrounding option grants and their potential value. Most startup employees do not have enough information to properly evaluate the offer they receive, nor compare it against industry benchmarks. One way that employers can mitigate this is by granting and managing options on Blockchain, in an immutable and transparent smart contract. This way the organisation can take advantage of the trustless trust that blockchain technology makes possible.
The second advantage is related to the difficult recruitment issues and employee incentives. Today many startup employees see options as a bonus that may or may not arrive, at a potential exit in 5–10 years. This is a quite intangible incentive, accessible only over a very long time horizon, causing employees to often completely ignore stock options when evaluating a job offer. Tokenized ESOP solution tackles that problem by converting these rather illiquid assets into a liquid asset position, by making these vested stock options tradable on exchanges (like Kraken or Poloniex).
Another possibility is converting these options into tradable tokens in an ICO. This creates a secondary option-token market from which both employers and employees benefit greatly — employees would likely be a lot more incentivised by options which they can monetise within a much shorter time frame (e.g. 1–2 years).
If the idea catches on and more startups begin tokenizing their options or shares, the opportunity arises to create an overall secondary market for startups. This in turn is likely to attract more money to ventures that previously weren’t attractive enough.
Today, to attract capital, startups are forced to promise very high rates of returns (10x or more) to compensate investors for the substantial liquidity risk, regardless of whether they can actually make good on those promises. The investors, on the other hand, are hesitant to lock the capital for the long periods of time expected until exit (typically 5–10 years), which limits greatly the amount of investment that goes into high risk ventures.
In comparison, in the blockchain world a seed round size ranges between $ 2.000.000 — $ 10.000.000 on average, which is 10 times more than most classical off-chain startups can raise in early stages. While it is reasonable to assume that this is partly due to the novelty of the ICO system and the “hype” around it, our expectation is that investors will hesitate less to acquire shares and invest in primary startups market if they know they can subsequently sell them in the secondary market within foreseeable periods of time.
To recap, here’s how everybody benefits:
- Team members gain an asset they can sell on this newly established secondary market and cash in earlier, thereby lowering their risk of reaping no reward when the startup fails
- Investors are happy to invest more readily in projects they wouldn’t have otherwise thanks to the same decreased risk profile
- As a consequence of the above, founders gain the ability to attract better talent earlier and raise more money more easily