Does the shifting tide in US capital markets create opportunities for digital assets?

TL;DR: The number of listed companies in the US has halved over the last two decades. To me, the underlying causes all scream “winner takes all”; in business, in capital markets, and in society. This is a problem against the backdrop of widening inequality. I am arguing that leveraging token structures can help growing companies avoid the “small size trap” while helping consumers benefit from wealth creation when it occurs.

This article is structured as follows:

• In “The number of public companies in the US has halved”, I will explore the situation — why there are less listed companies and the consequences for business, capital markets, and society. 
• “Why is this a problem?” discusses the challenges this situation gives rise to. 
• “How can we break this “winner takes all” spell?” walks through the suggested solution — introducing tokens into the capital structure of growth companies; how that would work, how that helps break the spell, and what we need to get there.

The number of public companies in the US has halved

Morgan Stanley analysts recently published an excellent report about the shift from public to private markets that has occurred in US equities in the last 25 years. I have been obsessed with this topic for a number of years and have done some research along the way.

Why are there less listed companies?

This is best summarized in a diagram:

What are the consequences?

For Business: concentration and larger, more powerful companies

The size of the US equity market has almost tripled in the last 25 years while the number of companies has more than halved, resulting in more concentration and larger, more powerful companies. The average public company size has gone up from $1.8 billion to $10.4 billion. In the private space, there are currently 225 unicorns worth a combined $662 billion, according to CB insights.

For Capital Markets: wealth creation takes place in private markets

As companies are staying private longer, more wealth is created in the private markets, and less in the public markets. According to Morgan Stanley “Virtually none of the $1.3 trillion in value that Amazon built was in the private market. 3% of the value created by Alphabet, which controls Google, was in the private market, and that percentage was about 17% for Facebook. The implied value of Uber in the private market was more than 100% of the total value created, as the company’s market capitalization is below what its IPO price implied.”

For Society: most people not benefiting from this wealth creation

Retail investors are not benefiting from this wealth creation, being largely shut out from private markets. In the public markets, according to the WSJ, “Stock ownership is increasingly concentrated among a sliver of the population. The top 10% of Americans by wealth owned 87% of all stock outstanding in the first quarter, according to data from the Fed”.

Why is this a problem?

In my mind, the overarching theme here is “winner takes all” on steroids, contributing to widening inequality. 

In Business: competitive dynamics, small size trap, monetization of user data 

It has become hard for small companies to survive on their own.

It is tough to compete with larger companies, and “survivors” are either dependent on them, as gatekeepers, or get purchased by them (M&A exit)

• Think no further than Big Tech and the web 2.0 S-curve problem. 
• Amazon is even providing financing to small businesses on its platform, and, reportedly, their VC is stealing startups’ ideas.
• The New York Times recently wrote “As the economy contracts and many companies struggle to survive, the biggest tech companies are amassing wealth and influence in ways unseen in decades”.

Small companies do not have the same access to capital, making it harder to avoid the “small size trap”. Researchers found a lack of R&D spending means small companies often stay small and don’t grow into medium/large companies.

On the customer side, large companies control user data without letting the consumers that helped their platforms grow benefit.

In Capital Markets: gatekeepers, no ecosystem for small caps

In private markets, VCs act as gatekeepers and are beneficiaries of wealth creation. There has been a huge amount of capital available via late-stage funds in particular, which has inflated private company valuations and has kept them from going public.

In public markets, investment banks have re-focused on the largest companies post-GFC, from a research, trading, and primary market perspective. At the same time, Dodd-Frank has led to the disappearance of the ecosystem for smaller IPOs, traditionally catered by smaller investment banks.

Society: top 1% vs. everyone else

The wealthy, benefiting from the above, get wealthier and the new rich tend to be the people that work for the large corporates and capital markets companies that dominate the landscape.

Meanwhile, the majority of US people work for Small and Medium-sized Enterprises (SME) and don’t benefit from the above.

All of this has contributed to rising inequality, once again exacerbated by the Coronavirus. This is a problem for society as a whole. We need to break this spell.

How can we break this “winner takes all” spell?

How can growth stage companies avoid the “small size trap” and get freer access to growth capital? How can retail investors benefit from the growth of the companies they helped create as their customers?

Digital assets offer an opportunity for smaller companies to raise growth capital from their customers.

How would that work?

Traditionally, the corporate finance lifecycle (from VC-backed startup to IPO) and capital structure, look something like this:

Simplified: successful startups raise seed funding from friends, family and angel investors, followed by several rounds of VC investment. At some point, the VCs exit through an IPO. At this point the investment banks take over and help the now public company raise capital in the public equity and debt capital markets. 

This process typically acts as a funnel with only a fraction of promising companies actually raising institutional VC capital and many dropping out along the way. It is highly subjective to the preferences of VCs with a small group of VCs dominating the scene. The backgrounds of decision-makers are also far from representative of the general population.

Now, what if a growth stage company would tap into a new source of capital by issuing digital tokens to its customers? These tradable tokens “live” on a public blockchain. The tokens have utility with respect to the goods and services the company provides within the token’s ecosystem. An example of utility would be where ownership of the token entitles the holder (customer) to receive discounts. The tokens have investment value too as they are designed to allow early adopters (customers) to capture value as the business grows and adoption within the ecosystem increases. 

Tokens offer significant structuring flexibility and there are many levers to play with to create economic value for all stakeholders involved (beyond the scope of this article).

Who would do this, is anyone doing this?

More and more companies are providing digital goods and services to consumers, which tends to require upfront investment for IP development, making this type of funding structure highly relevant.

So far, these type of token structures have primarily been utilized by (centralized) companies focused on the crypto ecosystem, including BNB issued by Binance and $HT by Huobi, two large crypto exchanges.

However, there are plenty of real world use cases that this could be applied to. A popular example that may resonate is Amazon Prime membership: if Amazon would have tokenized Prime membership at launch, early adopters (and not just shareholders) would have benefited from its growth, growth that they helped drive. All the while also benefiting from the tokens’ utility — the benefits of the prime membership. Members would be incentivized to become brand ambassadors, further benefiting adoption and growth — for both users as well as other stakeholders including shareholders and small businesses catering to the platform.

Why do you need blockchain technology for that?

Public blockchains offer multiple advantages: they keep a digital and immutable record of ownership, offer transparency (to prove scarcity of digital “files”), are trustless (no gatekeeper needed), global (like digital businesses), and allow for easy transfer of assets (tokens). 

On top of that, tokens offer significant design space for companies to tailor the instrument to their business model and the intangible digital goods and services provided.

How does all of this help break the “winner takes all” spell?

Back to our main question, how could this help break the “winner takes all” spell? 

For Companies: alternative source of capital to help avoid “small size trap”

From a startup’s perspective, issuing tokens to customers is a way to bootstrap growth by tapping into a new source of capital: customers. It is an alternative capital raising mechanism to fund R&D and help companies avoid the “small size trap”. At the same time, it is an opportunity for companies to put their money where their mouth is. Sharing wealth created by user adoption with early and loyal customers would show them how customer-centric the company really is, beyond a mere marketing quote. Furthermore, these token structures will yield more engaged and sticky customers. 

In the medium to longer term, more companies avoiding the small size trap will help increase competition and reduce dependence on, and the power of, Big Tech. 

For Society: customers benefit from wealth creation they helped create

Consumers will be able to benefit from any wealth creation when it is actually happening as opposed to at the tail end when little juice is left. They will be rewarded for their early adoption and any value they helped create, while benefiting from the token’s utility at the same time (e.g. prime membership). If the token is structured well, downside should be limited. Users will also be incentivized to act as brand ambassadors, bringing in new customers. 

For Capital Markets: less dependence on gatekeepers

Companies will have less dependence on financial gatekeepers like VCs, banks, and Big Tech acting as lenders.

At the same time, digital assets give some of the power back to retail investors who don’t need the existing financial system to enter this new ecosystem and benefit. All they need is some form of crypto wallet or app, and an internet connection.

What do we need to get there?

Token structures leveraged this way are still in its infancy and we have some strides to make to get there. 

Accommodative regulatory environment

At risk of sounding like a broken record, there has to be more clarity about what constitutes a security (and what not), what is a qualified custodian, etc. As we have learned from the ICO boom, retail investors have to be protected in some shape or form, against themselves, and bad actors, but without ruining the opportunity to benefit from this type of value creation. Efforts underway include the expansion of the “accredited investor” definition, but more is needed.

Governance

Token structures offer the flexibility to include the ability to incorporate “alignment” mechanisms for founders to act in good faith (and rule out bad actors). These could include voting rights involving important ecosystem decisions, and companies sharing headline numbers that reconcile with on-chain data and have received some level of audit. It starts with clearly defined token rights.

Industry SRO’s could institute best practices like a “code of conduct” or “token standards” for companies to adhere to when introducing tokens into their capital structure.

Education

More education is needed for a number of different stakeholder groups, including:

(1) Bankers: this is a broad term and large investment banks are unlikely to work with the size companies we are discussing here. However, there are boutiques focussed on digital assets, FinTech, and Tech that have a role to play here. 

In my opinion, it is key to have bankers enter the equation, who are trained to work with companies, regulators, lawyers, and other stakeholders to make things happen. In my prior life as a convertible bond origination banker we did this all the time: solving issuers’ problems by dreaming up new structures and iterating them until they worked for all involved. 

It will also be helpful to have more traditional finance people think through the economic models that will make these tokens valuable for all stakeholders. This will involve thinking outside the box. Not necessarily by analogy to equity and debt but by going back to first principles and basic microeconomic theory about value creation, and connecting the dots from there.

(2) Companies have to provide the supply. I believe this will be driven by a few innovative companies with a working product that have already gone through a few rounds of venture funding. These companies have some level of credibility and momentum with customers. It could be a free subscription-based app, something like Strava earlier on in its life, using this mechanism to fund a premium feature set.

(3) Consumers: smooth onboarding and a really simple and intuitive user interface will be key. Like being able to manage your tokens from your Cash App or Coinbase account. Millennials will play a key role here.

In Conclusion

It is still early days, but I can see opportunity here for real financial engineering that creates value for society at large. This is not years away, I would be surprised to NOT see any of this unfold in the next 12-18 months. Stay tuned for further thoughts about the intersection of capital raising and digital assets.

About me: I spent more than a decade on Wall Street helping public companies raise capital in the convertible bond market. I currently work for Omniex, a crypto trading technology firm. Views expressed are my own.

I publish an institutional crypto newsletter every weekday on https://itnt.substack.com/