Pre-IPO Stock Trading: A New Fintech Opportunity?

The Rapid Pace of Startup Dealmaking in 2021

Industry analysts are observing an exceptionally high volume of deals currently. As 2021 nears its midpoint, startups are frequently finalizing new funding rounds within months of each other, often experiencing valuation increases of three to four times with each successive round.

Introducing Caplight: A New Approach to Private Company Investment

While the potential for all these startups to reach trillion-dollar valuations remains uncertain, Caplight, founded by Javier Avalos, aims to address this possibility. Avalos, previously an investment banker with experience at Forge, is leading the development of technology that will allow institutional investors to establish both long and short positions in private companies through synthetic, cash-settled derivatives.

This means investors can speculate on the future performance of startups without necessarily owning shares in those companies.

Competition in the Private Company Derivatives Market

Caplight is not alone in recognizing this opportunity. Apeira Capital, another New York-based startup, is also exploring ways to “short” overvalued startups. Avalos and his cofounder, Justin Moore, a former engineering manager at Forge, may also encounter competition from their former employer, as well as from Carta, a venture-backed company specializing in equity management software.

Caplight’s Progress and Funding

Despite the competitive landscape, Avalos believes his company is offering a unique solution. He reports that Caplight has already garnered $400 million in expressed interest from over 30 institutions.

Recently, the company secured $1.7 million in pre-seed funding, led by Fin VC, with additional participation from Susquehanna Private Equity Investments, Clocktower Ventures, and Dash Fund.

Interview with Javier Avalos: Insights into Caplight’s Vision

TC: During your time at Forge, which facilitates the buying and selling of pre-IPO shares, what key opportunity did you identify?

JA: Platforms like Forge have excelled at creating technological solutions for startup employees, founders, and the companies themselves. However, we are concentrating on the needs of larger institutions that require genuine liquidity.

This includes a higher frequency of trading, such as buying and selling option contracts or entering into swap agreements, and the ability to quickly adjust positions and mitigate risk.

Caplight as Infrastructure for Private Company Investment

Caplight intends to function as the foundational infrastructure for any fund seeking to take directional positions in private companies.

It will provide the necessary “plumbing” to connect funds to the market, encompassing prime brokerage services, efficient transaction settlement through clearinghouses, and data provision for accurate contract valuation.

Caplight’s Core Offerings

TC: Could you elaborate on the specific services Caplight provides?

JA: We aim to empower institutional investors to hedge their private company stock holdings, generate income through the sale of out-of-the-money option contracts, and establish both short and long positions.

All transactions are conducted synthetically, meaning the underlying shares do not physically change hands.

Collateral and Startup Permission

TC: Is private company stock used as collateral, and is startup permission required?

JA: Pre-IPO stock can serve as collateral, but it isn’t always necessary.

The advantage of a synthetic platform is its ability to introduce liquidity by working with sellers who may not even own the stock. A hedge fund can express a negative view on a pre-IPO company without owning shares, using other tradable securities as collateral.

Facilitating Short and Long Positions

TC: If a hedge fund wants to short a company, does it simply need to find a counterparty willing to take the opposite side of the trade on your platform?

JA: You need two parties: one interested in a short position and another interested in a long position.

Beyond that, a model is needed to establish an agreed-upon valuation, a future contract strike price, and a methodology for valuing the contract over time.

Essentially, we provide a methodology for marking the contract to market – determining its value at any point between initiation and settlement.

Developing the Valuation Methodology

TC: How is this valuation methodology developed, and how automated is the process?

JA: We are currently building this out, which requires significant effort.

A key focus of our pre-seed funding is to recruit top talent to contribute to this development.

Data Inputs for Valuation

TC: Considering inputs like fundraising announcements, revenue data, and secondary market trading prices, what other data sources might be surprising?

JA: A less obvious source is the reporting of private tech company stock holdings by public mutual funds on a quarterly basis. This information is publicly available and represents another valuable data set for our platform.

The Timing and Enabling Technologies

TC: Why is Caplight launching now, and does it rely on technologies like smart contracts?

JA: Smart contracts are certainly an enabling technology, but the timing is more closely tied to market conditions.

Forge alone processes nearly $1 billion in quarterly volume, and the total pre-IPO trading market is estimated at $20 billion annually. The absence of hedging and derivative options in such a large market seemed illogical to us.

Addressing Potential Competition

TC: What prevents Forge or Carta from replicating Caplight’s offerings?

JA: This is a question I consider frequently.

Carta and Forge have successfully built technology solutions for companies, and their future growth is heavily reliant on maintaining strong company relationships.

Creating a marketplace that allows institutions to short the same companies they are working to build relationships with presents a direct conflict of interest.

Featured above, from left to right, are Caplight founders Javier Avalos and Justin Moore. For a more comprehensive discussion, including the legal challenges Caplight faces and its strategies for attracting buyers and sellers, listen to our full conversation here.