Making startup finance more efficient #2 - Liquidity
Begin trading. It is very difficult to value an asset in isolation. The efficient markets of today depend on each asset having closely comparable analogues to which its value can be judged on a relative basis (and hedged against).
With bonds investors start with a “riskless asset” – basically a very short maturity treasury bill. Then appropriate risk premiums are added to the bond to account for interest rate risk and default risk. For example, a newly floated government bond from Afganistan could be compared to the bond prices of other undeveloped countries, the appropriate premiums added.
In the language of stocks investors frequently talk about comparing P/E ratios or EV / EBITDA ratios to measure the value of a stock relative to that of another.
Having closely comparable assets allows speculative investors to engage in arbitrage, which makes the market for such assets more efficient. The liquidity in one asset can trickle into nearby assets.
Begin by establishing a market-traded index based on aggregate venture capital returns. An index already exists - it would be trivial to begin trading an option based on the value of that index each year. It would simply settle for the value of the index at the end of the year. Venture returns have some very desirable properties for portfolio managers, and there are a wide range of people in the venture industry that could benefit from some hedging, that I believe such a contract would generate enough liquidity.
Then start trading options based on the ultimate sales price of a handful of startups. Focus on those which have lots of public information available – namely those that are planning on an IPO in the next several months and therefore have already published financials in an S-1. Investment in such options could be hedged with the overall venture market contract described in the prior period.
Then trading could begin in a few very public startups such as facebook, where there is a lot of public knowledge available.
So on and so forth, once liquidity is established in a more visible asset, liquidity can be established in a smaller and earlier companies, with the prices kept in line relative to one another by arbitrageurs and the wisdom of the crowds. Eventually we will get early enough that the market can reasonably estimate the value of early stage companies.
Such an option does not need to exist for each and every startup to be useful in valuing that startup. If the market value for a comparable startup is available then metrics can be used to draw a comparison between the startp without a market value and the startup with a market value.
