FAQ on Carta, N-of-1 and atomic units

This is an FAQ for our essay: $1 trillion in equity: How Carta is set to unlock the private markets

What does “Network Effect” mean to us?

Loosely, a network effect happens when additional participants on a connected platform make that platform more valuable. The most canonical example of a network effect is the telephone, where increasing the number of users, increases the potential to connect to others, enhancing that network’s value (e.g., the ability to contact 100 acquaintances is far more compelling than the ability to contact 5). The telephone is a so-called “one-sided” network effect where every participant in the platform plays a similar role.

Network effects can also be “multi-sided” (two-sided, three-sided, …), with many distinct network participants that derive different types of value from the network. For example, a two-sided network effect is Microsoft Windows, where “consumers” (the first type of participant) and “developers” (the second type of participant) each derive more value from Microsoft’s operating system the more the other type of participant there is. If there are many consumers, developers have a large audience for their software. If there are more developers, consumers have a vibrant array of productivity tools, games, hardware support, etc. to choose from. As we’ll explain below, we believe Carta has a two-sided network effect.

Network effects excavate broad moats. Users receive ever-increasing value as more users join, creating a virtuous cycle that deeply entrenches a product. These networks, upon reaching critical mass (the point at which an incremental user on the network always derives more value there than anywhere else), become virtually impossible to dislodge without a fundamental change to the landscape or consumer.

Ultimately, network effects (a) transform industries, (b) deliver incredible value to customers, often in tandem with a change in user behavior and (c) create N-of-1 companies where the network platforms (Bell, Microsoft, Google, Amazon, Slack, Carta, …) are richly rewarded for changing the future.

Can you elaborate on what evidence of a Network Effect looks like for Carta?

Carta has a two-sided network: companies and shareholders. Shareholders are either investors or employees, and while their behavior is slightly different, fundamentally the way they engage Carta is similar in that Carta facilitates their equity stakes.

The network effect works as follows (so far … as Carta builds out it will strengthen and evolve):

Companies drive investor adoption. The more Carta Securities accepted from a company (i.e. the more companies an investor has that use Carta), the more likely that investor is to convert to a fund admin customer. This was observed in Carta’s raw ownership graph. New features for Investors include instantly known IRR.
Investor adoption unlocks new product possibilities in a newly forming ecosystem. Once investor adoption ramps, the two sides of the network can interact on the platform in a new ecosystem. While still nascent due to Fund Admin’s being under 2 years old in its more recent iteration, as more investors manage their holdings through Carta, new product features become available that were previously impossible. The clear line-of-sight here is CartaX, an entirely new pool of private market liquidity (discussed extensively elsewhere in this document).
Financial experts and decision makers accelerate the virtuous cycle. Financial experts, who make up many of the point-people using Carta and the decision makers for startup and fund financial matters, are some of Carta’s biggest advocates as evidenced by product adoption as observed in Carta’s referral networks.

As more companies join Carta, the gravity to join Carta grows for investors, both because their portfolio is all issuing Carta securities and because, in the future, new types of liquidity and transactions will emerge on the platform. For companies, the value of issuing through Carta will integrate into this ecosystem of liquidity and investors, on top of all the conveniences and innovation they experience from Carta’s traditional cap table management. The real market opportunity is not in getting startups to pay for Cap Table management, it’s the ecosystem that emerges from the initial seed of a critical mass of equity on Carta’s platform.

The surprising aspect of (3) is that one would naively think this group would oppose Carta, doesn’t it replace them? The answer is no, and this is one of the signals of a Network Effect and an N-of-1 company: the realignment of an industry around a newly captured atomic unit.

Within Cap Table alone, there wouldn’t be a significant network effect given the 2-sided nature of the network: technology can make the product more convenient and efficient, but it would not step-function the product features (though perhaps the product cost structure). The network effect will start to shine when new products or features previously impossible come to fruition. But the simplest evidence consistent with a network effect usually comes from a business performing in ways that confounded even bullish investors.

CartaX hasn’t launched yet, but these network effects can be expressed and observed using existing engagement metrics as proxies. This is what we saw in Carta’s Fund Admin. Carta had experimented with Fund Administration for years, but in April 2018 Carta made a committed iteration on the product (see “What are Carta’s core Cap Table and Fund Administration products?” FAQ for more details) and begun a moderate effort to grow that business line. What happened was indeed confounding: before even any level of refinement on UX and sales motion, the business became the fastest growing fund administration business in history by an unbelievable margin (as discussed in the main text). It’s hard to say exactly why that happened, but we can give some color with an example. With VCs already holding securities issued by Carta for their portfolio companies on Carta, when a funding round happens their portfolio valuations are instantly updated. That was impossible before Carta, and was just one expression of Carta’s network effect into a previously impossible product feature.

Fund Administration was a step function in an existing market, but their capture of the atomic unit of value in entrepreneurship and the associated network effect could enable them to construct a new market and ecosystem centered around this network: liquidity.

What is 409a?

The IRS instituted protections against equity loopholes in the mid-late 2000’s through “section 409a” which constitutes a series of frameworks and standards to value shares of equity in a private company. A key piece of this framework is the role independent parties play in determining that valuation: if an independent party conducts the valuation it is considered more reasonable by the IRS as that party is less likely to have significant conflicts of interest in determining share prices. In this case, valuation is said to have “safe harbor” (meaning the IRS considers it reasonable unless it’s “grossly unreasonable”).

A company can’t offer equity without knowing how much a share is worth: if the valuation is incorrect or questionable at the time equity is granted, the IRS can assess taxes and associated tax penalties on that equity. This is an especially pertinent risk for early-stage startups that don’t have liquidity for the equity offered: if the fair market value is assessed to be higher than the value when equity is granted, the difference is taxable and, because of liquidity constraints, the shares can’t be sold to cover the bill. Hence before a company can offer equity, it behooves the company to have their 409a’s filed according to industry standards.

Further, 409a’s need to be current: they need to be updated after a material event (such as a round of financing) and at least once every 12 months.

While there are many resources available that discuss 409a’s, Carta’s blog (link) is actually one of the best out there for more information on the history and context of section 409a.

What are Carta’s core Cap Table and Fund Administration products? What opportunities are immediately adjacent?

Answering this question benefits from the context of Carta’s journey and the problems they were solving on the way. Carta has stuck to their initial vision of the market since their Series A in 2014 to capture the service of equity and ownership in private markets. They began by becoming the first SEC-registered electronic transfer agent for the private markets, allowing them to issue electronic shares, debt and derivatives. One remarkable observation is that Henry Ward and the early Carta (then called “eShares” for electronic shares) team had the vision early-on to rally around private markets equity, and ruthlessly stuck to it for years as it continues to be the unifying thread of their broader strategy.

They were then able to automate the approval and compliance of equity and option grants while also starting to build what today is the largest equity ownership graph in the private markets by orders of magnitude. The model was originally highly transactional, charging for cap table management and 409a filings. But later, as they leveraged technology to bring down costs to file, Carta bundled 409a for free with their Cap Table management products for which they charged subscriptions. It’s easy to miss the elegance of this move: Carta took 2 headaches for founders, managing their shareholders’ equity and staying in compliance with the IRS, and made one of them automatic and free (409a) and making cap table management automated, convenient and (effectively) amortized (useful for founders with possible cash flow crunches).

In the meantime, Carta was experimenting with fund administration, which are an equivalent suite of products for investors (who could be VCs, PE, LPs, and so on). Many investors started creating accounts on Carta to accept the electronic securities Carta was issuing on their portfolio’s behalf. Originally this was largely bespoke, and much like the status quo of how investors managed their holdings. As Carta started reaching critical mass in their cap table line, they rolled out a new, consistent product experience for Fund Administrators circa April 2018, replacing the hairball of excel spreadsheets and loose documents with a new interface for an investor’s “source of truth:” instantly up-to-date valuations, cap tables, equity holdings and IRR. The rollout was indeed part of Carta’s longer term vision of a complete ecosystem around their capital ledger, but Carta wasn’t ready for this product getting ripped out of their hands as we discussed above in “Can you elaborate on what evidence of a Network Effect looks like for Carta?”

Discussed at length above, Carta is making a concerted effort into transforming how liquidity happens in private markets through CartaX, but Carta has more natural adjacencies in financial products (e.g. credit lines and financial reporting.) These new lines will bootstrap off of, and, should they succeed, feed the central asset registry and network in a virtuous cycle.

What are some examples of other atomic units of value? Do N-of-1 companies always rise from network effects?

While network effects are incredibly powerful characteristics that can give rise to N-of-1 companies, especially at scale, this is not exclusively the case. We’ll briefly discuss a few examples of other atomic units of value. For this we provide many examples of historical companies, partially to appreciate the rarity of N-of-1 outcomes, but also to appreciate the role these companies have played throughout history transforming the world as we know it today.

Dutch East India Company

Founded: 1602
Atomic unit: trade
N-of-1 characteristic: supply chain and government lobbies

The Dutch East India company was a monopoly that provided stable trade routes for both import and export across the world, but mainly to and from East and Southeast Asia. They were granted privileges by the Dutch government to begin wars, prosecute convicts, negotiate treaties, build forts among other semi-governmental powers. To get a sense of some of the innovation and success of the company, the Dutch East India Company became the first company to offer shares of stock. Their dividend averaged a staggering 18% over the course of the Company’s 200-year existence.

Standard Oil

Founded: 1870
Atomic unit: energy
N-of-1 characteristic: economy of scale and vertical integration

Standard Oil was an American oil producing, transporting, refining, marketing company. Starting with a focus on refining oil, Standard achieved scale by horizontally integrating rivals. Standard next moved to vertically integrate distribution and consumer sales. Simultaneously, the business expanded internationally, becoming one of the world’s early multinational corporations. Standard was able to dominate its market through a combination of being a first/early mover, aggressive (anti-competitive) pricing, efficiency and extremely high startup costs for those that followed.

Bell Telephone Company

Founded: 1877
Atomic unit: electric circuit
N-of-1 characteristic: network effects

Bell Telephone (later AT&T) was the first company to monetize the IP developed by Alexander Graham Bell. The company succeeded in building a private network of ‘Long Lines’ between New York and other cities, allowing people to talk with distant colleagues, friends and relatives for the first time. As it grew, it created a system of closed switches and exchanges, ensuring any competitor would have to replicate the entire network infrastructure. AT&T dominated telephony in the US for the better part of a century. It was helped on this journey by network effects, a first mover advantage, proprietary technology and the massive costs required by a follower building an alternative system.

Ford Motor Company

Founded: 1903
Atomic unit: industrial manufacturing
N-of-1 characteristic: economy of scale

Ford Motor Company is an American automobile manufacturer famous for introducing scientific management, limited SKUs and interchangeable parts to car manufacturing. Ford was not the inventor of any of these elements, but he was the first to combine them in an assembly line. The assembly line’s incredible efficiency allowed the company to sell a vehicle that was inexpensive enough for the mass market. Benefits of scale and competitive pricing soon allowed Ford to dominate US automobile sales.

Airbnb

Founded: 2008
Atomic unit: trust
N-of-1 characteristic: network effects

AirBnB started as a website with postings for short-term rentals, allowing people to monetize partially used or empty spaces. Airbnb succeeded in uniting these potential short-term landlords and renters in one location, a difficult problem for which Craigslist etc. were only partial solutions. AirBnB’s novel features: user reviews, well manicured and consistent photos, search, etc. sufficiently decreased renter hurdles and made it a user favorite. This network effect resulted in a virtuous cycle as landlords flocked to the site, driving growth from users attracted to new options, driving further landlord interest, etc. The result is the creation of a highly liquid short-term rental market that delights users all over the globe.

Are atomic units always in big markets?

In short, yes. This is part of the distinction of what an atomic unit is. Though there are countless “resources” out there, they can each be independent and each can serve as the building blocks for some amount of value to the world. For example, an illustrator’s atomic unit might be a particular type of artistic creativity, and they might capture it through a small business that creates ad copies. But to us as Venture Investors or to the world at-large seeking change, we focus the framework on once-a-generation resources, initially hiding in the shadows that when cultivated by insightful and visionary entrepreneurs bring about massive change. This helps us focus our frameworks and thinking on the types of opportunities and markets that will matter the most. In this lens, we view atomic units as being the rare versions of raw resources that have the potential to power large markets.

What is Carta’s edge in private markets liquidity?

Liquidity in private markets is a blue ocean in our eyes, with no dominant player or solution yet emerging like how public exchanges emerged in the 1600-1700’s to initiate the first wave of equity liquidity. There is a shadow market transacting secondaries within the limitations of word of mouth. Also, a few early players are attempting to change this, but a closer look reveals that the opportunity is currently unclaimed.

One reason is that we believe the winner needs to be “issuer-centric” (the issuer of the stock to be transacted). Other products struggled because they did not give founders and existing investors the level of visibility and control that they view as essential for their governance and business goals. If the process doesn’t sing for the issuer and its board, where large fractions of equity are held, those who wish to transact remain on the sidelines and liquidity opportunities get killed. From that perspective, it could be that an issuer-centric approach would never capture the market. Carta is the only participant taking this approach who owns the necessary infrastructure and has a massive head start regarding that infrastructure.

Today, the primary forms of liquidity for private markets is either through IPO or Acquisition — only then is equity value transformed into cash. There is also a small secondary ecosystem that also transacts during primary events or in between rounds. These are the status quo, and as discussed above present a massive opportunity to the first body that can facilitate enough liquidity to allow for efficient secondary transactions in private markets.

There are and have been a few others that have attempted or are attempting to tackle this. One of the earliest was SecondMarket (now Nasdaq Private Markets), which was founded in 2004 and acquired in 2015 in a joint venture between Nasdaq and SharesPost (another player in the space). Nasdaq Private Markets still operates today facilitating secondary liquidity, stock repurchases, RSU liquidity and other liquidity services, but in relatively low volumes.

Other players are EquityZen and Forge. EquityZen provides a marketplace for private company stockholders, like startup employees, to sell shares to buyers on the platform. Forge (formerly Equidate) is similar. Many of the options financing players are now framing the options financing products as a secondary product / way to get into the private markets as well. These circumvent the original issuer, compounding transaction and holding complexity over time. That is, instead of transacting shares, they issue work-arounds to provide a similar net effect. Some of these work-arounds layer on additional risk by leveraging insurance products to protect the buyer since they’re not actually delivered the shares until a liquidity event, which could be years away. In the meantime, the seller could still sell the shares, or might have never had them to begin with. Or, liquidity never comes and both parties are left hanging. It’s in ways like this that work-arounds and delayed settlement of the underlying assets build in additional risks.

Zanbato has another approach with a brokered model, though it is still not centered on the issuer but can transact in secondaries with reduced work-arounds. In this case, buyers and sellers access opportunities through brokers on the platform, where neither the broker nor Zanbato have direct relationships with the issuer. In general, the issuer hasn’t given permission for such a transaction, nor has it in general been closely involved in disclosures or information sharing to facilitate price discovery.

Aside from the important fact that issuer-centricity is important for price discovery and liquidity, the early entrants above lack the infrastructure key to creating products that solve problems facing private market shareholders today. Such infrastructure is also key to doing so at acceptable prices. They are also top-down, yet to facilitate company-initiated liquidity events: it’s push, not pull. They understand the market opportunity but might be taking a shortcut instead of paving or inventing the private market infrastructure needed to effectively facilitate liquidity.

The only way to rebuild Capital Markets is from the ground up, and Carta simply gets this. Carta has spent years building the vertically integrated financial infrastructure necessary to facilitate liquidity that many others lag on. Carta’s foresight to become the first SEC-licensed electronic transfer agent in the private markets (before anyone was even paying attention) gave them over a half-decade head start on the infrastructure needed to facilitate liquidity: Carta is the registry of asset ownership, a depository institution, offers lines of credit, and, most importantly, has aggregated more early-stage capitalization than any competitor by multiple orders of magnitude. They offer much of what is needed to complete a secondary transaction in a single package and can facilitate transactions that don’t balloon in complexity. Most importantly, Carta is issuer-centric, they can give issuers the transparency needed to bring them on board with any transaction, they control the mouth of the river as a channel to express liquidity and are positioned to catch a bottoms-up push for it.