I’ve been wondering how to short Snapchat since they passed up on Facebook’s offer to acquire them and raised capital privately which valued them at $3 billion. My curiosity was driven in part because AOL Instant Messenger, MySpace, and MSN Messenger were all once worth tens of billions of dollars before ultimately going out of fashion, and I believed that Snap wasn’t immune to this fate. I also naively have never understood the value prop of their product even though an entire generation of millennials seem to love it. Thankfully I never actually bet against them at a $3b valuation. And with Snap now a public company, the price will be set more accurately by market forces. But with other privately held companies like Uber being valued at a $68b, Theranos at $9b, and Zenefits at $5b, my curiosity continued.

One summer morning in 2015, I was having breakfast with a friend who works as an institutional sales-trader sitting on an equity derivatives desk at a major investment bank. He was telling me about how many of their tech clients would call them to try and structure hedges for their private company portfolios in order to protect themselves from a potential downswing in the tech market. Unfortunately, this was such a bespoke contract for the bank to structure that they would purposely over-charge their clients to enter them into such trades. I asked why there wasn’t a standardized way to do this, and referenced the credit default swap market as an example.

He said it’d be impossible to do so.

Since then there have been several detailed write-ups on this topic here, here, and here.

This is the story about how we made it possible, while also outlining the challenges and path we took to do so.

Venture Default Swaps

There are 5 elements to creating this product while complying with SEC regulations

Regulatory and legal restrictions Market structure: counterparties and market participants Collateral Management and circumventing stock transfer restrictions Contract structure Marking to market

To start off, one of our investors introduced us to Arthur Levitt, a former Chairman of the SEC, and we brought him onto our Board of Advisors to help us navigate the regulatory path. We then had multiple conversations with the SEC as well as with regulatory counsel on how this would be regulated. The SEC classifies these transactions as security-based-swaps, which are derivative contracts that are only available to eligible contract participants, or institutions that have at least $10 million in liquid assets on their balance sheets. Right off the bat, that informed us that our audience would be limited as we weren’t allowed to go to retail investors or even accredited investors since this would be a product that was only legally consumable by VC’s, hedge funds, family offices, and ultra high net worth individuals.

Over the course of the following months, we met with 65 of these prospective counterparties and narrowed down the major use cases of our contract to 3 core propositions for counterparties:

Group A: Hedgers

Counterparties that owned the underlying stock (most likely from an earlier investment stage in the company where they had been marked up substantially) that were interested in hedging their investments, effectively locking in a floor and a ceiling on their position.

Hedgers typically want to be able to post stock as collateral (which is challenging to do given pledging restrictions set by stockholder agreements) while also wanting to receive the proceeds of the trade immediately.

Group B: Net-longs

Counterparties that were interested in getting net-long in the underlying company, either to add to an existing position that they already had, or to get access synthetically due to not getting access in the primary rounds of financings.

Net-longs typically want an unlimited upside and long term expiries.

Group C: Naked-shorts

Counterparties that were interested in getting net-short in the underlying company, mainly due to a belief that the company was a fraud or just mis-priced and overvalued.

Naked-shorts typically want short term expiries and capped upsides for the longs; e.g. they don’t want to be on the hook for a stock that all of the sudden gets marked up 5x in the private market. They were also at the biggest information disadvantage considering the companies they were interested in shorting were privately held and not required to publish performance metrics.