Startup valuations have shot sky-high in recent years. Now they’re taking a breather — but there hasn’t been a way to bet on startups getting less valuable the way you can with publicly traded companies.
That’s because shorting a company typically requires borrowing the stock, selling it, then buying it back at a lower price. That’s almost impossible to do, as private companies can often block sales.
In the current down market for tech, the long-sought idea of shorting startups — a safe-seeming bet, since most startups fail — may be coming to fruition. Companies are offering synthetic derivatives and options so investors can take the equivalent of a short position.
This isn’t about monetizing Silicon Valley schadenfreude, though. Solid financial reasons for wanting to short a startup range from public-market hedge funds hunting for alpha in private markets to VCs looking to hedge their own investments.
Synthetic derivatives trade in concert with an underlying asset’s value, even though they are not directly tied to that asset. Synthetics first grew popular in other parts of the investing world; though they got a black eye in the 2007-2009 financial crisis, they’ve made something of a comeback in recent years.
As Silicon Valley minted unicorn after unicorn, synthetics that let investors take long positions in startups without actually investing were sought-after alternatives for those shut out of hot deals. But providers of startup synthetics say the interest has strongly tilted to the short side recently.
Selling interest increased to 80% of open order interest at Caplight, while the buy side has dropped to 20%, according to Javier Avalos, CEO of the private-market derivatives marketplace. It was previously fairly even or a 60/40 split, he said. “We basically saw the demand side of the Caplight marketplace go away for the past few months,” he said.
Javier Avalos and Justin Moore co-founded Caplight, a private-market derivatives marketplace.Photo: Caplight
Family offices, private equity, sovereign wealth and hedge funds previously took the long side of these bets, but many have dropped out recently, said Natalie Hwang, founder at Apeira Capital, which has a long and short investing strategy in private companies.
The short interest, meanwhile, is still there, typically from hedge funds or public-market investors. Hwang calls it an opportunity to “capture negative value,” either to defend a portfolio or take advantage of volatility.
The trade is risky — and involves complex investing strategies, and collateral is required. But this trade is being done largely by sophisticated institutional investors, Avalos said.
The startup-synthetics sector has gone through several iterations. Two previous attempts at this were shut down by the SEC. In 2015, Sand Hill Exchange settled with the SEC for offering illegal derivatives to retail investors. And in 2016, Equidate, now Forge Global, settled SEC charges and agreed to shut down a service offering unregistered swaps on pre-IPO startups to provide liquidity for private company employees.
Avalos said Caplight, which has a broker-dealer license, is different because it offers options, which are regulated differently than swaps, and because the options are offered only as private placements between institutional investors, typically with at least $100 million of assets.
Apeira Capital founder Natalie Hwang.Photo: Apeira Capital
Companies whose names are involved in the trades are not affected because their shares are not touched and the information rights and governance rights are not affected, Avalos said.
Most of the investors now seeking to short startup stock are investors or shareholders who already have a sizable position in a company and don’t want to sell it, Avalos said. They see these derivatives as a hedge.
Venture firms are among the groups doing this, taking some money off the table without having to actually sell a portion of their stake. This could be a growing strategy, especially for firms sitting on a large, aging stake in a company.
Meanwhile, the companies generating most of the short interest are well-known private companies worth $10 billion or more that have a relatively strong amount of liquidity, often where investors are sitting on large gains, Avalos said. On the buy side, investors are often looking for earlier-stage companies worth $1 billion or more, he said.
While the buy side has collapsed, some investors are starting to come back and place orders on certain targeted names that they’re interested in, Avalos said.
He doesn’t expect the broader startup market to really take off until the prospects of IPOs return. In the meantime, options provide trading strategies that will bring in new investors who aren’t necessarily betting on the company’s long-term prospects.
“The really cool part about introducing optionality like call and put options into this market is it gives you the opportunity to now invest without just needing the IPO window to be opened,” he said. “Because for really sophisticated institutional investors who are comfortable using options you can find really attractive option pricing, even if you're not necessarily making a bet on the fundamentals of those businesses.”
That could make the startup market more like the traditional public markets — with all the speculative good and bad that goes with it.
