Talk Your Book: Investing in Start-Up Equity

0:04Welcome to Animal Spirits, a show about markets, life and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:34Today's Animal Spirits talking book is brought to you by Vested. On today's show, we are talking with Dave Thornton. Dave is the co-founder, CEO, and chief investment officer of Vested, which is a company that is helping venture-backed startup companies, their employees, exercise their options when they leave the company. And he is raising money through investment funds to get access to venture capital. Isn't it interesting how these new ideas or these new services or funds kind of come about just because of the need. Like this is a solution that didn't exist 10, 20 years ago or whatever, and maybe didn't have a market for it.

1:13And now it's just a thing that people need. Yeah, one of the things that we didn't ask him on the show was when did they start doing this? And this is not, I think, what did Dave say? Is this their fifth fund? I mean, this is not brand-brand. Fifth fund, yeah, they've been doing it for a while. And it's interesting, the idea is, yeah, there's some people who have shares in a startup and because typically in a startup, you don't get a big cash salary, right? The whole idea is the whole company is a call option. And so your options are, that's like your payout someday, hopefully, if it works. So a lot of people can't afford the options if they leave the company or if they're investing in a certain amount of time.

1:46And Vested steps in with their investors and helps them essentially buy those options for a price. So they provide capital to the employees that are leaving so that they can not have their options expire completely worthless. and they do so by raising money from investors to do that. And then the idea is that the investors will get access to, let's just say the beta component of venture. So it's not going to be the fund that is in Fortune or on the cover of the Wall Street Journal for having that 30X upside, but it's also hopefully not going to be one of those companies that's in the cover of one of these magazines for lighting all the money on fire.

2:25You mentioned on this show, the range of returns from high to low in venture is huge. Yeah. So kind of narrowing that down, there's probably not a lot of options for that, which is interesting. And by the way, people think AI is going to take all the jobs. This is the kind of thing that is popped up out of nowhere, a new service that didn't exist in the past. This is the stuff that happens. Well, I'm glad, correct. And I'm glad to see that this is still, listen, it's imperfect. The private placement process, it is what it is. But this is not an ETF. Right. Yeah, this is still an illiquid venture capital fund structure with uncertain payoffs and timing.

3:03And the year that you invest in it is going to matter a lot because of the environment and how the exit stuff is going. And yeah, the investing side of things is – but it's interesting because it's essentially two companies, right? It's one company that's helping the employees exercise their options. And the other side of the company is picking the right places to do this with, right? The right firms and people to invest in, essentially. Interesting stuff. So here is our talk with Dave Thornton from Vested.

3:34Dave, welcome to the show. Thanks. Glad to be here. All right. Arnold Schwarzenegger voice. Who is Vested and what do you do? Vested. We help employees get out of the chopper. It's not bad, right? Not bad. We help startup employees exercise their typically expiring stock options. And we do that by raising capital from investors who want access to the VC asset class. And we kind of discretionarily put their capital against the employee stock option deals that we serve. So the idea is that there are certain employees who can't or don't want to use their capital, don't have enough capital to invest their shares and you help them out.

4:11Is that the idea? Yeah, that's the general idea. I'll give you a little bit more background because this is a, it's kind of an interesting market and we fell backwards into it. And so the background might be helpful on that question. So we were once upon a time running a very different business, which was a startup equity education business. We just, a lot of the people that work at Vested were aware of how badly startup employees make decisions around their equity. And so like Like the first version of Vested was a website with free content and free tools. And the theme was let's help startup employees not make disastrous decisions around their equity.

4:50And one day we'll have 3 million startup employees that are all running around our website and we will figure out what we can sell them then. So that was the original version of Vested. And in like early 2020, mid 2020, we started to get a bunch of inbound demand from our own user base. coming back to us asking us like poorly formulated questions around capital and equity. And when we started talking to them, we thought we would see a ton of different capital use cases. So like down payments on homes or unexpected medical bills, or I want to buy a car or whatever. And we ended up seeing almost exclusively one use case, which was I just left my startup.

5:34uh doesn't matter why i google poaches me microsoft poaches me i'm going to business school i got fired like the entire set of reasons is on the table and because i never read my docs in the first place maybe because i wasn't an original vested user using your website the right way i just found out that i have 90 days within which i have to exercise my vested stock options or else i lose them and we were like oh well we're familiar with that as a like we're all startup people. We're familiar with that problem generally, but like, why on earth are you coming to us? This is a 20 year old problem.

6:07There's got to be a market, uh, serving this need. And when we did our research, we were like, oh, there is a market serving this need. It's basically, uh, Silicon Valley bank, first Republic bank, some of the bigger New York based banks that have gotten into the private markets and a handful of kind of independent players like, uh, SecFi and Quid and Liquid Stock and ESO Fund. But when we really dug into what their business models were, they were primarily serving senior employees leaving really late-stage private companies. It's like the canonical, I just left Stripe and I need$20 million. Like, everybody falls all over that deal.

6:48And the people that need 50 grand cannot find anybody to pick up the phone because what investment house or bank is going to pick up the phone and, like, write a ticket that small? So basically that was the set of users that kind of came inbound back to us. It was the rank and file startup employees. So to answer your question, a hundred percent, um, it is the case that if you need 50 grand after having spent three years being under cash comp at a startup, you almost definitionally do not have it. And even if you do have it, you should not be putting 50 grand of, you know, you should not be putting a material amount of your available capital into a single private company.

7:25That would be a, very risky thing for you to do, especially if you don't work there anymore. So that is the use case that we're solving. There's just like this very, very, very big long tail of people that need 50, 60, 100 grand to exercise their stock options. And we provide them the capital to do so. So what are they trading off then? What's the tradeoff for the person who's getting the capital from you? The specific thing that we do, the transaction is in the public markets, it would be called a sell the cover. But we're buying the minimum number of their future shares necessary to help them come up with all the money to do the entirety of their exercise.

8:03So like an easy example is you've got 100 ,000 options at like a$1 strike price. Pretend tax doesn't exist because that makes it complicated. So you need 100 grand. And let's say the current independently produced board approved fair market value of your company's common stock is$3. bucks. We will buy at three bucks until you have a hundred grand. So we'll buy 33 ,000 of your shares. We'll give you the money today. So a hundred grand goes out to you today. You use it immediately to exercise all a hundred thousand of your options. Now you're titled to a hundred thousand shares and you owe us delivery of the 33 ,000 that we bought whenever the transfer restrictions on those shares lacks or are nullified by some sort of an event.

8:45So that's the, that's the basic transaction. And to get back to like what the upside is for us, it actually changes deal to deal. If the, if the board approved fair market value is$10, we have to buy many fewer shares to help you come up with a hundred grand. If it's$2, we have to buy a lot of your shares to help you come up with a hundred grand. So it totally depends. All right. This sounds complicated. There's a lot of moving parts here. So you give somebody the money to exercise their shares, the shares are held in their name or do they get transferred to you? No, the shares are held in their name.

9:18And I'll come back to that in a sec, but keep going. Okay. So the shares are held in their name. And then when there is an exit X number of years into the future, whether it's an IPO or they get bought or whatever, what does the process look like of them transferring their shares to you? And how do you stay on top of all of that? Yeah, it's actually not particularly hard, especially since we've got tech company DNA to start. It was actually a good thing that we didn't start off as an asset management firm because we would have had a very different viewpoint on how to do all these things. So the least common case is there's some sort of a public exit.

9:59Like, you know, 5 % of companies actually go public. A lot of the private companies get bought at some point along the way. So in a public exit, after the lockup period, which is typically six months, our counterparty will just transfer the shares that we bought from their brokerage account to ours, and that's that. We will then typically liquidate them and distribute to our investors immediately. in the most common types of exits, which are M &A, like cash mergers and acquisitions, instead of getting shares because they won't exist anymore after like a full acquisition is done, we'll just get the cash equivalent of the shares that we were owed at whatever the per share price was in the acquisition.

10:36So we'll just take a wire afterwards. But what is it? But like how? How does that get enforced? Because it goes to the person and I assume that they have to take like they have a share of the upside and then you have whatever share you have. They basically have the entirety of the upside and they just owe us the portion related to the shares that we bought. So like if we ended up in that example that I gave Ben buying like a third of their shares, they would owe us a third of their proceeds when the dust had settled on the acquisition. But do they have to do anything or there's some sort of technology on the backend, whatever services you guys are using to make sure that that contract is executed on?

11:12They do need to wire, but that's not the hardest thing to do in this day and age. Dave sends them a Venmo. Yeah, they Venmo us. I imagine that you mentioned that a lot of people came to you and said, this is a problem. For some people, it's probably like either I get this and give you a share or I get nothing, right? Or I have to sell another asset, sell some stocks, cash up my 401k, borrow money from someone else or from a bank or something. So the sale for people is probably relatively easy, right? Yes, I'm giving up some of my upside, but the alternative is potentially nothing. Yeah, that's exactly right.

11:46This very large group that we're serving is otherwise underserved, which means they're making a zero or something decision typically. Michael, I'll give you a little bit of background on the question on the transferability thing. So this is kind of one of the most interesting early learnings in the business. When we first started doing this, someone would show up with like 10 days left on their clock. and it's super clear that you can't bring in, for example, a series B company to do a proper right of first refusal process and board consents and like share retitling or whatever in 10 days. So we would typically do this forward contract that I just described to you directly with the employee just to make sure that the clock got beat.

12:28And then afterwards we would go back to the companies and be like, hey, we just helped out Michael for$54 ,000. Do you mind retitling just the shares that we bought so that we can manage our delivery risk. And the companies were basically like, so you want me to explain to my board the new$54 ,000 line item on our cap table called Vested? And you want us to pay external counsel to teach us how to do a right of first refusal process? We don't have any problems with ex-employees exercising their stock options that they've earned. Just like, please don't make this an issue for us. It's such a pain in the butt.

13:03So the companies actually put us in this lane where they encouraged us for this one specific use case to use forward contracts. So we've gotten super comfortable with monitoring and delivery risk. It's actually never manifested for us. So, all right, last question on that side before we talk about the investor side, and maybe Ben has more questions. So you say, okay, I get to exercise the shares at$1, fair market value is$3. What sort of diligence do you guys do to make sure that fair market value isn't completely nonsense? Because there was a lot of fair market value marks in 2021 that are now looking like not so fair, maybe unfair market value.

13:43So how do you make sure that the transaction actually makes sense from your point of view? So it's a long answer, but the short version is we realized a couple years into doing this that we actually collect an incredible amount of private company data exhaust and signal just by serving a really broad startup employee base. And a lot of the folks on the team, myself included, have quant backgrounds. And so what we did was we built a machine learning based private company selection model that governs the companies that we choose to help their employees from. So the real answer to your question is basically what are the data sets that are underneath the model that helps us do our selection?

14:22Like how do we stay out of trouble? um there is table stakes stuff like uh companies financing trajectory and their financing terms and the quality of the investors behind them and the behavior of those investors over time like are they re-upping on you know from round to round there is fairly differentiated stuff uh which is out there in the world but i haven't seen it in a lot of private company models so um employee flows uh super predictive of how well a company is doing whether they're like net hiring or net firing, whether they just hired a bunch of non-founding salespeople, whether they just hired their first CFO, or whether they just fired 50 % of their people quietly and nobody knows about it.

15:02We also have some financial performance estimates that are built from state and local tax and labor filings, which are not particularly accurate, but they're also always the same level of inaccurate for a given company. So when they move up or they move down, it's meaningful. And then kind of most importantly, we've got the proprietary data that we collect in the normal course of business. And this basically comes like from our interactions with the employees. When we reach out to people, it'll typically be on LinkedIn with a connection request and we'll tell them who we are and they'll say the randomest things back to us.

15:37For example, like I've been early exercising my options with my own money at every available opportunity. So I'm good. like thanks for reaching out but I don't need you which is an incredible signal alternatively we sometimes hear people totally trash their company unsolicited don't waste your time with this bullshit we've heard people say to us I wouldn't exercise we're giving them money to exercise the options they don't need to come out of pocket I've heard and seen we wouldn't exercise options in this company even if you paid us to as in not just like prevent us from coming out of pocket but if you gave me money I still wouldn't do it So like we get a bunch of interesting signal from the employee base that we serve and we put all this stuff underneath a selection model that basically predicts the exit price of a private company's common stock as a ratio to the last round at which have raised preferred.

16:29So like the way to think about it is how much growth is left in the company. And that's what we do to stay out of trouble. We reprice 15 ,000 companies every morning with yesterday's data. We sort it by how much growth is left. We cut it off at the top 20 % and we say that's the set of companies whose employees were happy to help. And it's a large set of companies. So like if we can reprice, you know, 15 ,000 companies a day, then 20 % of that is 3 ,000. It's a fairly large cashman area relative to the 100 names that might trade on the secondary markets today. So obviously there's a ton of startups and there's so many more private companies and private capital.

17:07But what is the actual opportunity for you here? Like how much activity is there? what's the addressable market, I guess? Like how big of an opportunity is this? It is a monster opportunity. It's hard to address because of how diffuse and fragmented the small ticket, you know, employee base is, but it is a very, very, very large market. There's no way you could shop it where even staying in the lanes that the company set us, which is like, you know, if you're going to help out a few of the ex-employees per company per year, like, you know, please do it with forward contracts. Even staying within that lane, it is a minimum single digit billion a year market.

17:45And it's fairly structural. Like it just follows the labor flows of the startup market. It's not like the overall macro environment has a lot to do with it. And that is the smallest version of it. The biggest version of it is just employees own like 10 to 15 points of the cap stack of most private companies. And private companies, you know, even the US-based ones that are venture backed are worth like a couple trillion dollars. So this is like hundreds of billions of dollars that will end up going in smoke over the course of the market cycle. So big, big is the answer. So talk about the money raising process.

18:21How many are these funds that you're raising? These are private placements. Who are you raising money from? What does the education process look like? Talk about it. We've been raising funds and fairly accidentally, we've raised about one fund a year. So like it turns out that we run vintage funds, But the funds are private funds. We raise the money, we call it all up front, and then we discretionarily put it to work over the course of typically about a year. The putting the money to work part is not all that hard because of the size of the market. The raising the money is the part that I would say we spend more time figuring out how to do.

18:59We've realized that probably our best base of investors, our best LP base in these private funds, live in the independent part of the wealth management channel. It's just a bunch of high net worths that have never had access to venture, and this is like a genuinely good access product for them. And then we've got kind of a synergy with the wealth management channel, which is the fund itself that we run produces private company shareholders. And when they have their liquidity events, we're basically their last stop on the way to wealth management. That's kind of like a nice circular feedback loop.

19:35So we're focusing most of our attention for the next fund that we're running on the independent part of the wealth management channel. And it is a lot of education because on the one hand, it's very easy to say like diversified venture at discounts. That part's not a problem. But getting into the details of like stock option funding requires tons of education. Are people coming to you for tax advice as well? Can you can you offer that? Like what what other advice are they looking for? Are they just saying, no, I need help buying these these shares? Every so often people do come for tax advice related to stock option exercise, but mostly that's in the context of a stock option exercise, not like an independent question.

20:13So yes, they come to us for that, but that's our normal business. Separately, though, a lot of the people that we're helping are people who don't need the stock option funding now, but may have come for the educational content and the tools. And to me, we should be trying to facilitate their education in general, you know, on the way to their future liquidity event. And so we're hoping to partner with wealth management firms on that front because it's not something that we're ever going to do, but it would make for a better experience for our end client, like, you know, startup employee users.

20:48Okay. So I have questions about what the portfolio ends up looking like. We talk a lot about how the S &P 500 is so concentrated. The top X are 40 % of the market, whatever it is. It's pretty bananas. I would imagine that the problem is problem. I don't know why it's problem. I would imagine that the same dynamics exist in private markets, venture-backed companies, but maybe even more so. I would imagine that OpenAI and SpaceX and Stripe and the other giants, ByteDance, are like 80 % of the market. So how different does the portfolio that you give to investors look from the market cap weighted version of private markets?

21:34And is that good? Is it bad? Talk about some of those dynamics. Wow. It's probably one of the most interesting topics on the investor front. So you're totally right. The biggest, latest stage names that have reasonably active secondary markets are the ones that are hogging all the attention and a lot of the private capital. If you look at the Forge Private Markets Index, it's fairly dominated by a handful of names. it actually does feel like the mag seven to me the only deals that we end up winning from those companies that make it into our portfolios are the very very small ticket like executive assistant just left rippling and needs help uh type of deals so most of our portfolio lives in the early and mid-stage part of the asset class where there's a significantly lower amount of total competition and i mean that's that's the point that's the underserved people that we like identified in the first place five years ago that need the most help.

22:32So on portfolio construction, there's a lot to say. The first thing is venture is a power law asset class. Like worst thing you could do in a venture portfolio is not be in Facebook or miss Facebook to the extent that you had the opportunity to be in it. Right. But as distinct from the later stage, like pre IPO names where you know who the winners are and the question is just like, can you get into them? In the earlier stage of the asset class, it's way, way, way harder to pick winners and do it confidently. Like there's been a ton of writing on this. So just to give examples about why it's often the case that a founding team that can get from zero to one and like bring a new thing into existence is not the team that is the right team to scale a business and operate it.

23:21Like they get bored. Founders get bored of, of, of attempting to scale and running, running like full-scale businesses. It's also frequently the case that the macro environment changes and a whole bunch of companies that are all awesome just get nuked. Like wind and solar is out these days, I hear, right? Kind of sucks. There's a bunch of great companies that are doing wind and solar stuff and now they're just going to live in zombie land for the next two years until the macro wind shifts. So picking winners is super hard, but you have to not miss the winners. And between those two things, I actually think it requires a diversified portfolio.

23:57I think that the vested portfolios not being cap-weighted, maybe not having any exposure to these giant companies is actually a good thing. Because to me, that's not venture investing. If you're investing in open AI at a$500 billion valuation, you're investing in, that's mega cap growth. That's mega cap growth. It's Oracle, right? That's mega cap growth. That is not venture. I guess the question that I would have is, I wonder if in today's venture markets that are fundamentally different than the past, there's more liquidity, there's more visibility, there's more capital wanting to get into these names.

24:39I wonder what sort of opportunity you'll have to be in the next OpenAI because a lot of these companies are being funded by the large venture investors with deep pockets. They know every employee and should any employee leave, there's a line 100 investors deep that would love to not get in at a discount, but would overpay for their shares. I'm sure you've thought a lot about this more than I have. So what do you say to something like that? Yeah, you're totally right. The only thing is the set of investors that are interested in the greatest names, even the earlier stage names that they happen to know are greatest, are not getting out of bed for$50 ,000 tickets.

25:20There's a lot of plumbing that you need to put together to serve individual employees at a very small scale. And so to the extent that founders have not yet realized that there are massive recruiting and retention benefits to doing basic employee liquidity programs, they mostly don't exist. And even though the demand could be there if they existed in a programmatic way, like it's just not there in most companies. So we're still here helping the individual employees as they kind of leave job A to go to thing B. And I don't anticipate that the folks that you're thinking of are likely to be our biggest competition until a lot of the plumbing problems get solved about making these making these programs easier to run.