Silicon Valley Wants to Build Its Own Stock Exchange to Challenge Wall Street. Here Are the 9 Ways It Would Be Different

For now, it's called the Long-Term Stock Exchange (LTSE)

Except for occasions like dining with heads of state, Mark Zuckerberg is basically always dressed casually, most of the time in a gray T-shirt. The T-shirt has even become a fixture of feel-good stories: people who do great things should care about more important matters than what they put on every day.

But five years ago, when Facebook was preparing to go public, what Zuckerberg wore seemed to matter more than the company's numbers.

Facebook went public in 2012, and Zuckerberg showed up at the roadshow in a hoodie. Michael Pachter, an analyst at Wedbush Securities, said on camera for Bloomberg TV: "I think that's a mark of immaturity. He has to realize he is courting investors, and he has to show them respect."

Wedbush Securities had been named the brokerage best at picking stocks the year before, and traded 700 stocks on Nasdaq. Plenty of people on Wall Street held the same view, and Facebook's share price began sliding not long after the IPO.

Wall Street probably wasn't really bothered about the hoodie. What it cared about was whether that 28-year-old CEO would play by the Street's rules.

Silicon Valley also puts money into companies, and it thinks differently. Facebook's first investor, Peter Thiel, author of Zero to One, wears suits himself, but has a rule against investing in founders who do.

Another Silicon Valley venture capitalist, Tom Perkins, mocked the Street in his memoir, writing that "'toll-collecting middlemen' is obviously a less attractive term, but it comes closer to describing their [Wall Street investors'] actual function."

Margit Wennmachers, a partner at a16z, put it this way: "Wall Street doesn't care about virtual reality, self-driving cars, or what your long-term strategy is. All they care about is what you're saying and doing right now."

Wall Street really doesn't care much about long-term goals. The average investor holds a stock for nine and a half months — less time than Apple needs to go from settling on the technology for a new iPhone to actually building it.

The relationship between Silicon Valley and Wall Street is a delicate one today. The five biggest companies listed in New York are Apple, Google, Microsoft, Amazon and Facebook, all tech companies out of Silicon Valley and Seattle. Three of them — Google, Amazon and Facebook — had a rough time around their IPOs. Now Wall Street hands more money to them than to companies run by managers who behave themselves.

But smaller Silicon Valley companies haven't earned that standing. James Freeman, CEO of Blue Bottle, described what it takes to go public today as "like living in hell with no end in sight." He sold his company to Nestlé instead.

Among those that did list, both Fitbit and Snap have fallen below their offering prices.

Startup stars valued at tens of billions of dollars, like Uber and Airbnb, keep pushing their IPO timelines back, or simply say they have none. No one wants to go public and then watch short-term results drag the market cap below the private valuation — that hits the fortunes of investors and shareholders directly.

After a few years of preparation, a plan to challenge Wall Street has taken shape: the tech industry wants to open a stock exchange on the West Coast.

The plan, called the Long-Term Stock Exchange (LTSE), comes from Eric Ries, a Silicon Valley star author who wrote The Lean Startup, and is about to be filed with the SEC.

More than 30 people have already put money in. The big-name backers include Netscape founder Marc Andreessen, who founded the famous VC firm a16z; LinkedIn founder Reid Hoffman; former Twitter CEO Dick Costolo; and AOL co-founder Steve Case.

So what will Silicon Valley's own stock exchange actually look like?

The most basic thing: there will be nowhere to ring a bell

The NYSE handles tens of billions of dollars of trades a day. Almost none of it is done on the floor at 11 Wall Street, but the exchange keeps the old way of trading alive anyway — traders on the floor waving paper tickets and shouting prices at each other.

Nasdaq was founded in 1971, and never had a trading floor at all. Its trading was electronic from day one. It quickly became the NYSE's strongest competitor.

Nasdaq's financial services arm, NASDAQ OMX, has no exchange floor — it doesn't even have a server room.

It owns and runs 23 markets, three clearinghouses and five central securities depositories in the United States and Europe, trading equities, options, fixed income and other products. It supplies technology to more than 70 markets worldwide and supports a tenth of all securities trading on the planet. Its systems run on Amazon AWS.

There is no reason Silicon Valley couldn't use the same technology.

Big exchanges do usually build all of that infrastructure themselves, so that trades never lag and data stays secure.

But the Long-Term Stock Exchange doesn't want frequent trading — that would cut against its "hold for the long term" philosophy — so it may well put the whole system on a cloud service like AWS, or simply apply to become a NASDAQ OMX customer.

It serves more than listed companies

The Long-Term Stock Exchange has already released some trading-related services and algorithms, such as Captable.io, a tool that lets private companies look up who owns their stock and their stock options. But that isn't enough — it also wants a trading system, trading data centers and storage centers.

At a traditional exchange, whether the NYSE or the Shanghai Stock Exchange, a company has no relationship with the venue at all until it starts preparing to list. Private companies get their listing documents ready on their own, and the exchange looks at the company's equity structure only after those documents are filed.

What the Long-Term Stock Exchange is doing amounts to serving Silicon Valley's private companies, handing them the tools they need before they ever go public.

A relationship that long might, when the time comes, draw small and mid-sized startups to list on the Long-Term Stock Exchange too.

Three new ways to sell newly listed shares

Under the traditional IPO underwriting system, the underwriter sets the IPO price itself, based on how much its clients order.

There is usually a price range and a cap on how much each buyer can subscribe for. If investors oversubscribe, the underwriter will normally price the IPO at the top of the range.

Facebook's 2012 IPO timeline

2012.2.1

Facebook announces it will file a registration statement (Form S-1) with the SEC

2012.3.7

Facebook files Amendment No. 2 to its registration statement

2012.4.23

Facebook files Amendment No. 4, adding its first-quarter results for the year

2012.5.3

Facebook files Amendment No. 5, setting the IPO price range at $28-35

2012.5.7

Facebook begins its roadshow in Manhattan

2012.5.9

Facebook files Amendment No. 6

2012.5.11

Facebook's roadshow ends in Palo Alto, California

2012.5.15

Facebook files Amendment No. 6, raising the IPO price range to $35-38

2012.5.16

Facebook files Amendment No. 8, raising the number of shares on offer to 421 million

2012.5.17

Facebook's IPO is set at $38 a share, raising $16 billion — the largest US IPO at the time

2012.5.18

Facebook starts trading on Nasdaq; its market cap reaches $115.2 billion that day

Within the existing rules, tech companies have already tried several different ways of listing on the NYSE and Nasdaq.

The first to break the investment-bank underwriting model was Google, in 2004.

Google picked Morgan Stanley and Credit Suisse First Boston as its underwriters, but sold shares to the public through a Dutch auction.

In a Dutch auction, bidding starts at the highest price and falls until someone takes it and the sale closes. US Treasury bills are auctioned this way.

In Google's Dutch-auction offering, investors had to open accounts at banks involved in the IPO and submit orders stating how many shares they wanted and at what price. Google then set a price based on the auction, and every investor who had bid at or above it got a chance to buy.

In the end, Google got a slightly higher price than expected: successful bidders received shares at $85 each.

"We looked at the first trade, and investors bid $100 instead of the $85 IPO price. Up 18%. The stock didn't go down the rest of the day. It closed at $100.30," Eric Schmidt recalled.

In 2015, Square — another company founded by Twitter's Jack Dorsey — went public and offered the people who used its product a chance to buy shares at the offering price. Users paid on a dedicated website rather than placing an order in a trading app.

Then there is a company like Spotify. It plans to list on a mature market such as the NYSE or Nasdaq, but it is seriously considering selling its stock straight to investors instead of running a bank-underwritten IPO.

Listing that way, Spotify would keep its current shareholder structure, issue no new shares, raise no new money, and simply find an exchange that allows direct listings.

As long as existing holders are willing to sell, investors can buy directly. For the company, the benefit is that it needs no investment bank to underwrite the shares, no prospectus running hundreds of pages, and it saves at least tens of millions of dollars in underwriting fees.

Money isn't all the same — you only get a say if you've held the stock long enough

From what is known so far, the heart of how the Long-Term Stock Exchange will work is how it hands out votes. Ries will introduce a "tenure voting" structure, in which an investor's voting power rises in proportion to how long the stock has been held.

How many votes you have decides how much control you have over the company.

None of the world's major stock markets works this way today.

Listed companies generally use one of two voting structures: one share, one vote, or dual-class shares.

Under the first, an investor gets votes in proportion to the shares bought. The Shanghai and Shenzhen exchanges in China, the Hong Kong Stock Exchange and the London Stock Exchange all require listed companies to use one share, one vote.

Dual-class structures separate equity from votes. That makes it possible for a founding team to hold 10% of a company's shares and still control more than half the board seats or a majority of the votes. Both the NYSE and Nasdaq let such companies list.

Under this structure, investors get more equity and higher financial returns, and the founding team gets control of the company.

When Google went public in 2004, it had Class A and Class B shares. The founders sold Class A shares to outside investors, one vote each, and kept Class B shares for themselves, ten votes each.

That left Sergey Brin, Larry Page and Eric Schmidt holding 38% of the votes between the three of them. Together with the stock held by other executives who had come up through the early years, that gave them firm control of the company and left outside capital unable to sway Google's decisions.

When Alibaba went looking to list in 2014, it had already adopted a "partnership" system, under which Jack Ma and more than 20 other partners held a minority of Alibaba's shares but 5 of the 9 board seats, and so controlled the company. That broke the listing rules of the Shanghai, Shenzhen and Hong Kong exchanges. Alibaba listed on the NYSE instead.

The point of what the Long-Term Stock Exchange is doing is that money alone shouldn't buy an investor a say in the company. Besides putting in a large sum, they have to hold for a long time. And the holders who stay longest are, obviously, the founding team and Silicon Valley's early venture investors.

No using this quarter's numbers to promise the next one

Every three months, the investor relations department of a listed company uploads its quarterly results to the company's server at an agreed hour.

Along with the operating numbers, the report carries "guidance" — the company's own forecast for the next three months or even the full year. This is usually the number Wall Street cares about most.

The Long-Term Stock Exchange won't let companies do it. It worries that short-term pressure on results drives executives' decisions, at the cost of chances that would serve the company's long-term potential.

Guidance caught on in the 1990s. The law allowed it, and shareholders were asking for more transparency. Boiling a company's prospects down to a single earnings-per-share figure or range won praise from Wall Street analysts.

The idea was that a CEO would set a profit-growth target, making the company more accountable to the market and keeping management focused on delivering real results for shareholders. In time it turned into executives timing their operating decisions to the earnings calendar.

Look at Tesla's electric car deliveries: every time, they spike in the month before the reporting cutoff and drop sharply the month after. For a carmaker, a production line runs smoothly only on smooth planning — monthly output is set in advance.

Apart from Tesla's Model S and Model X, the other three best-selling electric cars in the US market — the Nissan Leaf, Chevrolet Volt and Ford Fusion plug-in hybrid — all showed fairly steady month-to-month sales growth.

There is only one sensible explanation for Tesla's pattern: pulling deliveries that belong to next quarter forward, so the current quarter's numbers look better.

Even Elon Musk has said as much. In September this year, Musk sent Tesla's staff an internal letter telling everyone to push for a good number.

He wrote: "The third quarter will be our last chance to show investors that Tesla has positive cash flow and profitability before Model 3 reaches full production."

Executives can't sell stock for five years after listing

Companies usually impose a lock-up on executives, employees and investors who hold shares before the IPO. When Alibaba listed in 2014, the shares held by Jack Ma, Joseph Tsai, SoftBank and Yahoo were locked up for a year.

Once the lock-up ends, they can do as they please. Shareholders who believe in the company, or who aren't in a hurry for cash, usually keep holding. In 2015, Jack Ma, Joseph Tsai and SoftBank all said they wouldn't sell down. But in 2016, hit by a short-term debt problem, SoftBank sold about $8 billion of Alibaba stock to pay it off.

Meitu listed in Hong Kong last year. When its six-month lock-up ran out this year, the stock was dumped on the first day it could be — it fell 6.37% that day.

The Long-Term Stock Exchange's answer is to advise listed companies to stretch out the vesting of stock options. Executives would have to wait at least five years after receiving options — the exchange recommends ten — before exercising them.

The point of the rule is to get executives to hold for the long term in earnest, and to let companies grow up in a market that doesn't treat high growth as the only goal.

Tesla, listed on Nasdaq, already judges its CEO, Elon Musk, on exactly this kind of long-run performance.

Under a 10-year option plan launched in 2012, Musk can buy 5.3 million Tesla shares at an option price of $31.17 each (Tesla's stock now trades at $304).

The options come in 10 tranches, each tied to one of 10 operating targets. Nine concern launching new cars and building capacity; the last requires Tesla to hit a 30% gross margin for four straight quarters.

A CEO's bonus can't be judged on one year's numbers

By July 2009, after the financial crisis, AIG's market value had fallen from a 2006 peak of $190 billion to under $2 billion. That didn't stop Martin Sullivan, the company's CEO at the time, from collecting $40 million in bonuses for 2005-2006, because his performance was assessed year by year.

Stan O'Neal, then CEO of Merrill Lynch, is a similar case: his bonuses for 2005 and 2006 were $36 million and $47 million. After Merrill ran into trouble, Bank of America bought it for $50 billion.

But the subprime crisis didn't appear out of nowhere in 2008. It was a huge bubble, built up over years, that burst all at once.

Under the plan Ries and his backers have in mind, companies listed on the Long-Term Stock Exchange would be barred from tying executive pay to short-term financial results — the assessment period can be no shorter than a year.

Wall Street banks do the opposite. An investment bank's portfolio managers start their record from zero every year; the previous year's results have already been settled up as a bonus, and if the new year brings no good returns, they are left with base salary.

Most of the trading money will still come from the East Coast, but it could pull in tech workers' savings

Five West Coast tech companies hold the top five spots for market value among listed companies worldwide.

But the money pushing those valuations up is firmly in Wall Street's hands. The trading volume of those five tech companies over the first two days of November alone matched all US venture capital spending for the year.

A Silicon Valley venture partnership typically manages a few hundred million to a few billion dollars — nowhere near enough to fight Wall Street in the stock market, where firms have not only their own funds but also client money handed over to manage.

In 2015, for example, Goldman Sachs put $1.6 billion of its private wealth clients' money into Uber.

In the 1990s, the handful of boutique investment banks that had a near-monopoly on financing Silicon Valley's tech startups were bought up one after another by Wall Street: JPMorgan Chase took Hambrecht & Quist, Deutsche Bank took Alex Brown, Bank of America took Robertson Stephens, and NationsBank took Montgomery Securities.

The fight over who gets a say in Silicon Valley investment is still going on. Wall Street's financial institutions look able to do almost anything, but Silicon Valley is trying to keep its distance.

Of the US tech acquisitions worth more than $100 million in 2014, only about 30% used an investment bank. In 2004 the figure was 90%.

The most direct reason is that investment banks are best at two things: valuation analysis and negotiation. Silicon Valley weighs a target's long-term potential heavily and its short-term financial effect lightly, and most targets were founded recently and make no money, or barely any — which makes the bankers' advantages matter less.

Apple paid $3 billion for Beats, Facebook $2.3 billion for Oculus, Microsoft $8.5 billion for Skype. In none of those deals did the tech company hire an investment bank as financial adviser.

That kind of tussle could carry over into the stock exchange.

Uber, Airbnb and companies like them, wary of how their share prices would swing after listing, keep putting it off — and to invest in a company like that, you generally have to become a limited partner. At Silicon Valley's current scale, the price of admission as an LP is $1 billion.

Take SoftBank, which has been investing everywhere lately: the LPs in its 100-billion-dollar fund are more likely to be Richard Branson, Apple or Foxconn, writing billion-dollar checks.

The Long-Term Stock Exchange would let these companies go public earlier. That means people who have grown richer as the tech industry has grown — but not so rich that they can pull out a million or ten million dollars on a whim — could invest in them too. And if they hold long enough, they get more votes.

But there is a lot it can't change

However inventive the rules are, anyone setting up a stock exchange in the United States still has to accept SEC supervision.

The quarterly disclosure policy the Long-Term Stock Exchange inherits is an SEC requirement. Trading hours need SEC approval as well.

With new ways of listing available, companies planning to go public on the Long-Term Stock Exchange may be able to route around some investment banks, but hardly all of them.

Google pulled off a Dutch-auction IPO, but afterwards only a few small companies — New River Pharmaceuticals, Overstock — listed the same way. Not every tech company can draw a crowd the way Google did. And even Google faced doubts when it listed.

Marianne Wolk, an analyst at Susquehanna Financial Group, said on the eve of the IPO: "Although Google is growing faster and is more profitable, we believe its valuation faces several risks, which could mean the stock eventually trades at a discount."

Investment banks also still hold enormous rosters of clients.

Nor can the Long-Term Stock Exchange do without brokers.

A securities exchange doesn't buy or sell securities itself; it stays neutral in the trading process, to keep trading fair. Its main job is to provide the infrastructure that securities trading needs.

But an exchange can set up a brokerage of its own to serve investors, which is exactly what the Startup Stock Exchange and the Investors Exchange do.

The first has a brokerage called SSX; the second registered a brokerage under the same name as the exchange, IEX.

What can't be avoided in the end is Silicon Valley's own chase for valuation, profitable or not.

"We're in a period of recklessness — valuations have gone too high," Silicon Valley venture capitalist Bill Gurley said in 2015. "Running companies that lose money forever is not a good business practice."

Taking in hundreds of millions of dollars, reaching a valuation in the billions, and still not making money: that has become a common problem among Silicon Valley startups.

Outward-facing, while still private, they give away all kinds of things — shares, votes, board seats — in pursuit of a high valuation.

Inward-facing, to hold down cash costs, they pay employees with a structure heavy on options and light on cash.

At a startup, investors and executives are usually protected: they hold stock with guaranteed returns, and ordinary employees do not. If the company hits trouble and has to raise money at a lower valuation, some employees who joined later find that the stock they hold is worth nothing at all, or less than nothing. It has happened more than once.

However the way of trading changes, what makes a company healthy is not something that can be redefined.

Cover image/Forbes