Moving Fast and Breaking Carta

This past week saw a very public - and costly - mistake impact Carta . Carta’s mistake was having 2 businesses with an inherent conflict and falling in love with the “disruption” trope. The result was predictable and a warning for the rest of us.

I’ve been working in and around finance for 20 years and specifically in the private markets since 2018. I was the CTO at 2 of the largest secondary markets for shares of $1b+ privately held startup companies (“unicorns”), Forge Global and SharesPost (they merged in 2020). I’m currently the CEO of Flow . Disclaimer: Flow’s SaaS Investor Lifecycle Management Platform competes with Carta’s Investor Platform. My experience working at marketplaces and a SaaS company in the private markets gives me an opinion and a unique perspective. Here it is.

What happened has been covered by others , but in summary Carta’s unicorn secondary marketplace business solicited the sale of shares in a private unicorn company, Linear. That company also happened to be a customer of Carta’s cap table business. Carta’s cap table business gives them access to sensitive data regarding the investors, value, sale, & purchase data of private unicorn companies.

The CEO of Linear saw a copy of an email which appeared to be soliciting the sale of shares of Linear without his knowledge or consent. The CEO published a screenshot of the email to the world, pointing out the conflict and questioning the ethics and behavior of Carta.

The disruption trope in action -> Secondary markets for unicorns are just one good tech company away from disruption

There are numerous secondary markets for unicorn companies - as mentioned above, I was the CTO of two of them. These markets have lower dollar volume and lower transaction volume than public markets. And that isn’t likely to change soon. Regulations and the preferences of the unicorns themselves have limited the size and liquidity of the secondary unicorn market and they will continue to do so.

There are 6 reasons why these markets are illiquid:

• Mandatory holding periods
• Only “qualified purchasers” or “accredited investors” can participate
• Maximum investor limit
• Unicorns fear price discovery
• Unicorns fear losing human capital/talent?
• Unicorns can block any trade

Private market regulations are written in such a way that most investors, because they aren’t “qualified”, cannot directly own shares in private companies. Moreover, holding restrictions and cap table investor limits make market-making impractical. And without market makers, secondary markets in VC-backed unicorns are likely to look a lot more like real estate markets than public stock markets.

Unicorns have 2 disincentives for approving transactions and unlike in public markets they have the right to block any trade. First, depending on the timing, unicorns sometimes benefit from a lack of short-term liquidity insofar as employee retention is concerned. Second, trading of secondaries can limit the ability of a management team to assert a valuation not supported by recent trading prices. I think both of these stances are more FUD than anything, to be sure in most scenarios unicorns should benefit from secondary market dynamics, but there is no doubt that leaders at unicorns have concerns and those concerns motivate them to block trades.

Despite this, many players in Silicon Valley and the financial sector seem to believe there is some “automated trading” solution which will change the pace of the secondary market from a low transaction volume market to a high volume market either through the magic of trading algorithms or - and this is where Carta comes in - control and/or have knowledge of the cap table.

Carta and Carta’s investors (not to mention many other players) seem to have believed access to cap table info, relationships with unicorns, and the ability to dynamically update the cap table were keys to unlock automation and scale the secondary unicorn market. They were wrong.

Having access to the cap table does not address any of the fundamental blockers to increased volume:

• The holding periods still exist (this is somewhat mitigated by the use of private funds vs direct ownership)
• Maximum investor limit still exists (this is somewhat mitigated by the use of private funds vs direct ownership)
• Only “qualified purchasers” or “accredited investors” can participate
• Unicorns fear price discovery
• Unicorns fear losing human capital/talent?
• Unicorns can block any trade

As a result, Carta’s business could only grow so big. Carta could only attract so many transactions from a market which already has competent players (The SharesPosts and Forge Globals were doing this long before Carta). Carta probably believed, as with crypto, if you build the trading platform, they will come. Yet crypto has no such headwinds?—?crypto creators want their coins to be traded and, until recently, there weren’t any regulatory blockers to hold back the trading?—?and hence the analogy fails.

Nevertheless, from Carta’s perspective, the investment had been made. Carta’s valuation and upside were sold partly on the idea that this new financial market could be made and Carta would control it. Carta built an automated marketplace relying on and integrated with the cap table software. And, it needed to produce…

The Conflict

Anyone who has run a regulated marketplace can tell you that - even with the best of intentions - it is no simple task to adhere to SEC, FINRA, and other regulations. The regulations are blunt instruments created in the aftermath of world-impacting events like the great depression and the financial crisis of 2008. These regulations were created to protect the economy and investors, regulators were only marginally concerned with making it easy for one to start a new marketplace. When regulations fail, you get ICOs and crypto; when they work, you get the greatest economic engine the world has ever seen?—?the US Economy. But adhering to them isn’t cheap or easy.

Adherence to these rules means compliance teams, software, security, archiving, attorneys, management structures, separation of duties and concerns, need-to-know access, and on and on. And doing these things right has to come before profit or success. These things are table stakes and, even in the best of organizations, are hard to control. It is a constant battle on the part of compliance, technology teams, and regulators to maintain the right balance of doing business and adhering to the letter and spirit of these regulations.

I won’t speculate on any internal machinations around following the rules within Carta. There is no need to. Even if Carta were to follow all the rules to the letter, something like a solicitation to the wrong party could easily happen. It doesn’t even have to be a bad actor. A new broker with minimal experience who thinks solicitation to qualified investors is fine, which it is to some degree, sends the wrong email to the wrong person… and - “poof” - trust is lost in an instant.

This is where the inherent conflict in Carta’s business comes home to roost. One side of the business is charged with securing the most secret of secrets: who owns shares in the privately-held company, what did they pay, when did they buy/sell, how many shares do they own. The other side, the marketplace, is desperately in need of that information to determine what the right price is, who might be interested in selling, how much they can sell, and so on.

Any compliance officer or technologist trying to keep these things separate will be in conflict with those trying to leverage these obvious synergies. As a customer of Carta’s cap table software,? would you want them to use this information to help the marketplace? You might if you were forward-thinking on secondary markets, but if you aren’t - and many are not - then Carta or anyone with this conflict are walking a difficult tightrope.

The secondary market for unicorn companies is a tricky thing. In my opinion, Carta never really had the right model because they never addressed the core problems. Selling software which holds sensitive customer data and buying & selling those same customers on your marketplace creates conflicts of interest.

What next?

Those of us who care about private markets and their efficiency need to do things differently going forward. Here are a few thoughts:

Secondary marketplaces for unicorns aren’t going away and they offer benefits to early investors and employees looking for liquidity prior to IPO. They also benefit the companies themselves by allowing them to stay private longer without losing core employees. Likewise, fund managers can use them to acquire industry leaders at a later stage without elite Silicon Valley connections. But a complex financial marketplace is not to be taken lightly. It needs to be run with integrity and discipline - disruption is secondary. That means avoiding conflicts of interest and focusing on the core work of making the marketplace efficient, while also benefiting all of the stakeholders.

Solving for liquidity through automation is a worthy goal, but there is no free lunch. The 6 bullets above must be addressed. This means educating VC-backed unicorn leaders to the benefits of leveraging secondaries. It means matching legitimate buyers and sellers without the use of solicitation techniques or leveraging data without consent. Market-making might be possible, but it won’t look like public markets. It means making price discovery easier and more accurate through industry wide market data & analytics. It means the streamlining of private fund creation and fund management, the primary vehicles for investment into private companies. Whoever can solve those issues is likely to increase liquidity and further democratize access to the late stage unicorn and sub-unicorn asset class.

Those of us selling software in this space need to focus on keeping our clients’ data secure and remembering it is the clients’ data, not our own. This means we shouldn’t sell a software product to clients and then appropriate our client’s data without explicit consent for our own ends?—?I’m not insinuating Carta did so, but clearly some are concerned that is the case.

At Flow , we sell an investor lifecycle management SaaS product which allows GPs to work closely with their LP investors. We offer virtual data rooms, digital investor onboarding, and a secure investor portal to VC, PE, REIT, any fund type or industry in the private markets. Our software is designed to make markets for private companies more efficient. Our clients’ data is their own, hopefully others see it this way too.

Nick Grabowski is a technologist and executive leader and has worked for Charles Schwab, Forge Global, and SharesPost. He is currently CEO of Flow . Flow supplies investor lifecycle management software to private market funds. You can reach him at [email protected]

DISCLAIMER: Flow’s Investor Lifecycle Management Platform is a competitor with Carta’s Investor platform.