I wrote this essay in January 2022 while considering starting to work on this problem which eventually led to starting Firm. Since writing this, some of my ideas have evolved along with deepening my understanding about a lot of concepts. I wanted to publish the original version without major edits regardless.
The joint-stock corporation is one of humanity's most important inventions. It has had more impact on increasing quality of life than any other form of human coordination. Even more so than sovereign states and nations, although corporations rely on them. Excluding military motivated inventions, private initiatives organized around a company drives most innovation.
The corporation allows pooling capital in a productive common enterprise. Others who might not be the owners, manage these resources, for the benefit of every party. For it to work, everyone's rights need to be well-known and protected by law. At the same time, everyone's downside is also known and limited. This construction is the pillar that sustains most of the modern world. Remove it and chaos follows.
Original publicly traded corporations date back more than 400 years. During all this time, few changes have occurred at the core of how they work, but that shouldn't be surprising. Corporate and contract law are very flexible, but they depend on human interpretation. If there's a conflict unresolvable by the parties, judges or arbitrators get involved.
Legal innovations add uncertainty and increased risk as there have been no prior conflict resolutions of this kind. This leads to inefficiency, as non-standard things need more lawyer time. So, by being rooted in the legal system, counter-incentives for innovation in the organizing form itself appear.
Personal computing and the Internet are a critical paradigm shift akin to the other major revolutions in History. Even though the Internet has a public and military origin, companies picked up on its mass deployment and development of services. The key organizational tool used to build the Internet hasn't evolved with it and it's hard for it to happen. At the same time, the Internet is stress-testing the corporation itself.
In the following essay, I will argue how the Internet is taking the corporation to its limit with negative side-effects. I will then explore how web3 allows to upgrade the corporation, making it native to the Internet.
The combination of Moore's law (the cost of computing halves every two years) and Metcalfe's law (the value of a network grows proportional to the square of the number of users) created the conditions for incredible company growth. The pace and scale of this kind of growth would have been unimaginable not so long ago.
As of December 2021, 8 of the 10 most valuable companies in the world by market cap are technology companies. These tech companies in the top 10, are worth a combined $11.19T. Apple, Microsoft, Alphabet, Amazon, Tesla, or Meta are worth more individually than the combined value of the top 10 companies by market cap in 1995, adjusting for inflation. 4 out of those 6 companies didn't exist in 1995.
Companies that have built networks enabled by the Internet have grown massively and still capture all the value for their owners. The main difference is that a lot of the value of these networks comes from the users that are part of the network. For their contribution to the network, users get 'free' services. Free services help virality and competition is hard once the network has reached a certain scale.
The companies that own these networks are run and organized in a way not that different from an early 1800s factory. The vast concentration of ownership doesn't differ that much either. Giving ownership as part of compensation is an exception in some very competitive talent markets.
Some of these Internet-enabled networks have incredible value. They are also of great utility and a key dependency in the everyday life of billions of people. They are also run like a business owned by a company. Company executives have a fiduciary responsibility to their shareholders to increase shareholder value. Everything else, from ESG to the mental health of their customers, comes only after.
The best business models for Internet networks have damaging side effects for their users. But as very few of these users are also owners and these practices are mostly legal, these business models have proliferated like wildfire. While we have seen animosity towards some companies and their leaders for this, they are just doing what their incentives dictate. And doing a great job at it. Blame the game, not the players.
Companies are staying private longer than they used to. This delays moment in which regular investors can invest in great companies to a later stage after a lot of the growth has already happened.
In the early Internet days, taking a company public 18 months after its founding wasn't strange. Today, an 18-month startup going public sounds like a crazy proposition. Apple, Amazon, Google, and Microsoft raised a combined $45m as private companies. That's a huge gap with more recent great companies total private funding such as Facebook at $1.3b or Stripe at $2.2b so far.
There are many reasons for why this is happening, some key points:
Companies are able to raise larger amounts without going public: Private capital markets have grown, funds are larger, and invest bigger amounts which could only be raised in IPOs before.
Reporting overhead and operating costs for public companies haven't changed that much: Some other aspects of starting and running a company are way cheaper and require much less effort and headcount now than a couple of decades ago. But the cost to run a public company hasn't decreased. A 10 people team can now build at the pace of what a 100 people company could 20 years ago. A 10 people team cannot deal with the operations and overhead of a public company.
Running an early company is crazy and hard on its own already: Having a number valuing your company in real-time every day adds immense scrutiny and pressure. This takes a mental toll on everyone involved and is a distraction that gets delayed as much as possible.
Companies are harder to take public because they were private longer: This one is a bit self-referential. Company complexity increases as the company and the business grow. Companies are now able to grow their business more before having the need to go public. The more they delay it, the harder and more expensive it is, further incentivizing companies to look for ways to stay private longer. The increasing difficulty for going public has become very apparent recently as some companies are going public via merging with a SPAC which makes it a simpler transaction and a less uncertain transition for the company.
From the point of view of the company and its founders, their conditions and options have also improved. Incentives point towards staying a private company for as long as it is workable. Investors have more exclusive access to high-profile funding rounds in great companies than if they were open to the public. A system that is favorable to all the insiders with the most power is bound to perpetuate itself.
Yet, this is not the best for other actors involved:
Employees with stock or options: stock options are a significant part of employee compensation in high-growth companies. The promise of great riches is implicit in some early companies that demand tons of time and effort from employees. However, there's not a lot of liquidity for them while the company is private. If the company is doing well, the implied value of their equity becomes a significant part of the employee's net worth. But, they have very little control over it unless the company is sold or it goes public. Staying private for longer delays and removes employee agency over an important part of their wealth.
The public at large: retail investors can now invest in companies only at later stages. If the public could start investing in companies earlier on, ownership wouldn't be as concentrated in the hands of a few funds or wealthy individuals. A larger amount of people can share this upside if companies become public earlier.
The percentage of people that get a share in the future upside of the value they create with their work is laughable and reminiscent of the feudal era. Most people in the world work for cash on stagnated wages. A very large number of people don’t have any left at the end of the month to save and invest. Only a small minority owns assets that give them exposure to future growth. I believe this to be one of the key forces behind inequality.
The tech industry is a bit of an outlier in this regard as equity or options as part of compensation are common. It is also usual in other competitive talent markets, such as more senior executives.
Ownership numbers in general are lower than one would expect. Carta, which tracks private company ownership, reports just shy of 900,000 employees who have received equity or options.
This other report from 2009 calculated that there are only 328m total individual shareholders in the world. That's under 5% of the world population that have stocks. This figure varies depending on how rich the country is and how developed its markets are (Argentina – 0.52% vs Canada – 37.52%).
The digital nature of businesses has grown in the past decade. Some new companies are entirely digital, have no offices but live on the Internet, and serve customers all over the world.
Cryptocurrencies are internet-native money. Other assets can also be represented in a form native to the Internet as we are seeing with NFTs. Their most important properties are that they are sovereign (no one can forcibly move your coins) and programmable (money can move according to pre-established rules that no one can change).
Smart contracts are special accounts on a blockchain that are controlled by code. Using smart contracts, we can build internet-native companies by modeling how the company operates and how its ownership is structured. A company smart contract is also the equivalent of a business bank account for digital assets plus a digital cap table. The company has complete control over the assets held in the account and can automate and regulate all asset movements. Digital assets or tokens represent ownership stakes in the company.
An internet-native company is one whose own existence is digital and it's mainly defined by code instead of legal contracts. If needed, they can be 'wrapped' into a legal entity in an existing jurisdiction. However, the legal entity only exists to mimic the actual digital structure and interface with the physical world when needed.
Money-like cryptocurrencies and governance tokens for decentralized protocols have grown to incredible popularity. But equity-like crypto assets are notably missing or masqueraded to avoid legal trouble. In the United States, whether an asset is a security depends on some precedence from 1946 against an orange farmer.)
Securities regulations 'protect investors' from companies that the public cannot properly assess. The theory is that by keeping a high bar (and strong reporting requirements for transparency) for companies in which non-sophisticated investors can invest, they are being protected. While one can argue for well-intentioned motivations, it has undesired consequences like the need to use arbitrary net-worth thresholds as a proxy for investor sophistication and what amount of investment risk people can take.
If you think about it, companies are a fascinating thing. In nearly every country in the world, it is possible to do a more or less tedious process that creates a thing that is recognized as a legal person independent from its creators or owners. A company can own a bank account, get into debt or buy property under a name someone could have come up with a few days ago. Do that under a fake name for yourself and you’ll be in serious trouble when caught.
Opposite to human beings, companies, while legal persons, don’t have a tangible corporeal representation that you can see and touch (or throw into jail). The company headquarters, factory, or flagship store are not the company itself. So what is it really? If you can’t see it, how do you know that it exists and what its current state is?
A company's whole existence is a stack of papers and legal contracts. It starts with its incorporation documents, which lead to a public record with the state. Then there's all the contracts and agreements signed in the name of the company or that affect the company.
The most real representation of a company for someone is the final result of personally reading and interpreting every document in order.
Contracts are written in legalese and not in a formal language (e.g. math or code). So, what the company is can be different depending on who you ask as their interpretation might be different. There might even be incentives for these interpretations to differ.
Let's do a little role play. Put on the hat of the owner of a small clothing brand. The marketing executive of a large company wants you to produce a large amount of merchandising for them during the next two years. You know it is doable, but it will require you to double your headcount and open a new factory so the rest of the business can continue as it is right now. If the company was to back down from their commitment, your company would go bankrupt. You negotiate a contract that forces them to a given order volume during the 2 year period.
The marketing executive will sign the contract in name of the company. This is a pretty big deal for you and your entire company is on the line. How do you know for sure that their signature results in a legal obligation from this company to yours?
Based on my experience signing contracts in the name of companies, no one ever asks that question nor checks (except for banks or financial businesses but they do mostly for anti-money laundering reasons). There’s the implicit trust that if someone has an @company.com email address, and they were to sign something while not having signatory power or clearance to sign something, they would be in so much trouble that they wouldn’t do it in the first place. At one point, I found out that one of my employees was signing contracts with providers in the name of the company. They just didn’t know they couldn’t do that, but no one ever checked.
Back to the clothing company, say you really want to check since there’s a lot at stake. How do you get absolute certainty that the marketing executive that will sign has binding signatory power? To begin, you need to start with the company bylaws to see how signing power even works in that company. Let’s say that in this case, the board of directors can resolve to give certain employees single signatory power in the company. Thus, you could ask the company for the minutes of the board meeting in which the marketing executive was granted this power, trust it is valid (and that some other people would get in trouble if not), and be done with it.
But in search of absolute certainty, you have to dig deeper and see if the board meeting was actually valid. This takes you right back to the bylaws to check how is the board constituted, how meetings need to be called, how quorum works, etc. You can also go a step further and check that the appointments of all board members are valid. Check whether properly elected in a shareholder’s meeting, which takes you to check how everyone acquired their shares and what their true voting power in the company was at the point of the shareholder’s meeting.
This whole example is extreme and at all points, you can be fairly certain that if something is not legit someone will have a big problem. This is really not a problem in practice. In the vast vast majority of interactions there’s no issue and everything is just business as usual. But when looking at it closely everything is surprisingly fragile, full of trust and assumptions. These lead to bureaucracy and inefficiencies to ensure a baseline level of sanity and security.
On the other hand, programmable public blockchains like Ethereum allow changing the core of a company from legal contracts to code. Getting a bit technical here, the properties that enable this are:
You get access to a public observable state to represent anything, in this case, a company.
This state can only be modified by deterministic code (the code can also have deterministic rules for upgrading or amending it) that reacts to specific inputs (transactions). In this case, the code is a program that defines the corporate structure.
The inputs to the code that can change state are cryptographically signed transactions (way better than scribbles in ink) and their chronology is ensured by their inclusion on the blockchain (way cheaper than notaries)
With these properties, a program defines how a company works and its most core agreements (ownership and corporate governance). Every change in the company (every share purchase, board meeting, or shareholder vote) directly modifies this neutral public state according to the company’s code.
By looking at the artifacts of the company state like tokens for equity ownership, NFTs for board membership, or signatory powers, you get a definitive answer over the current state of the company and the rights of someone over the company. This always-up-to-date state and its artifacts are the company, and it is more real than what ‘real’ companies are.
The clarity and transparency into a digital Internet-native company are higher than what the public can read in the quarterly reports and other fillings that public companies have to produce. At no cost, anyone interested can check a real-time view of the company’s full ownership structure, corporate governance powers and all its assets and liabilities. Since every event is recorded on-chain, it is also possible to see how all those have evolved over time. This alone can help investors make informed decisions when assessing a company.
On top of this, it is possible to program-specific rules for different important actions such as moving a large part of the company’s treasury. In the current system, practically every CEO has the ability to transfer every dollar from the company’s bank account into their own. Again, this doesn’t happen in practice because of the trouble that this person would get into, plus the ability to revert the transfer for a few days if someone catches it. But nevertheless, the ability to do it is there. With digital companies that run on code, some critical actions can be impossible or require greater consent like a majority shareholder approval. There’s a lot of trust that can be removed from digital companies’ operators. They move from a trust-based “Don’t be evil” to a trustless “Can’t be evil” reality.
Given the mess and fragility, intermediaries had to pop up in order for the current system to be usable. Less than 60 years ago, to settle some trades, some guy in a suit would walk across lower Manhattan with a briefcase full of stock certificates shackled to his wrist. As trading volumes increased and internationalized, the send-stock-certificates-by-post and shackled-briefcase-walk system were scaling poorly. In 1968, the New York Stock Exchange started closing on Wednesdays to give a day a week with no trades to allow brokers to deal with the backlog of paperwork.
In 1973, the Depository Trust Company (DTC) was created with the idea to have a central entity that would keep track of every broker’s holdings of different stocks. All stocks are deposited into Cede & Co (an affiliated company to the DTC) and whenever a trade occurs the DTC can settle it by changing some numbers in their database. Stock certificates no longer needed to move for most transactions.
Individual investors are still the actual beneficial owners. But for companies, their shareholder of record is Cede in most cases and the investor owns the stock via a record in their broker's database. Nowadays Cede holds an estimated 75% of all shares of public companies.
For example, if you own 10 Apple shares you bought using Interactive Brokers, the ownership chain looks something like this: Apple’s share ledger → Cede → DTC → Interactive Brokers → You. Even if it seems complex, this was a massive improvement that helped make trading completely electronic. Nevertheless, it came with some disadvantages and complexity:
First, all of those intermediaries are companies with employees that need to be paid. There’s a cost that investors end up paying some way or another.
Second, because there are many parties involved and the system has grown quite complex, trades take days to fully settle (the current industry standard is a three-day settlement known as a T+3 settlement). This introduces collateral requirements to make sure everyone involved in a trade will be solvent 3 days after the trade happens. This also has a cost that is bear in some way and can break down when the system is put under extraordinary stress. Robinhood, with the surge of WallStreetBets, halted buying some specific stocks that were soaring as they didn’t have enough liquidity to meet their raising collateral requirements.
And last, because there’s no direct link between the company and its shareholders, there’s the need for yet another type of intermediary. They bridge the gap when the company needs to know who its shareholders are, such as when holding shareholder votes or paying dividends.
It would be naive to state that by representing stocks with tokens every single problem would disappear. The current system is not just complex by design, but with so much going, incidental complexity appeared. Although it’s hard not the see the great benefits in simplifying the ownership chain down to Apple’s share ledger → You.
To summarize, by having Internet native companies defined by code, we have up to date and easily and cheaply modifiable state which is neutral, impossible to tamper with, and observable by anyone. This transparency allows operating with less trust, allowing more ‘risk’. It is still a more efficient way compared to the current system in which intermediaries had to be patched in to keep the machine running. This free efficiency and reduced need for trust can make even the smallest companies as secure for investors (in the sense of not being scammed) as of current public companies. This can finally unlock an unprecedented broadening of ownership in all types of companies at the earliest stages.
In the western world, there’s a generalized sentiment that the system is rigged and everything is a scam. For the first time in generations, people are not doing better off than their parents. There’s generalized pessimism about that situation ever-changing. The increase in wages has been lower than the price increases in other assets such as homes or stocks. Trust in institutions is very low and at every critical chance to prove themselves, people feel institutions failed them.
In parallel, in the last few years, we have seen several examples of the general public investing in specific alternative assets en mass. As these investments produced outstanding returns, they were written down by incumbents as uneducated people gambling or even rat poison. While there’s some truth to that, and less sophisticated investors are making wildly speculative bets in massive volumes, we can dig deeper into why this might be happening.
Regarding the gambling aspect, I believe that a big factor behind it is more and more people growing convinced that it is their only way to do well and escape from the rigged game. It’s interesting to watch how those most responsible for the current state of affairs are the most critical and paternalistic towards those who lost faith and are looking for a different path in order to make it.
However, I think there’s something even deeper about it. As everything is going digital and with the rise of crypto, an interesting clash is occurring between finance and culture. As Mario Gabriele put it in his The Generalist article on Robinhood, this investment mania can also be explained by investment and ownership becoming a means of public self-expression. It’s not just the potential financial upside of an investment, but also the belonging and purpose of holding certain assets and being an owner of things one believes in.
Crypto and public stocks have had huge surges in the number of retail investors invested in them. The same doesn’t apply to an earlier stage or private companies in general with regulatory reasons to blame. It’s shocking that it is absolutely fine from a legal standpoint to launch an explicitly valueless meme dog coin and pump it to teenagers on TikTok, but one would get in great trouble for selling a token that represents a claim on future cash flows of a legit business.
Moving to a world in which smaller and earlier companies can have a massive number of regular people as owners would unlock new value distribution and ownership models. They are just too expensive and burdensome to do legally with the current structure.
Token airdrops that award ownership to early users of a product or network are quickly becoming the norm in crypto. Those that don’t do it, or appear not to have plans to do, look illegitimate. They are also at great risk of forking as we saw in the vampire attack of Sushi to Uniswap.
Being able to give away ownership in companies to early supporters will be an incredible tool that can create incredible customer loyalty. Imagine if instead of getting a free latte for being a loyal customer, you got a small ownership share in this coffee shop. The same applies to employees in any other industry. The early team of any business has an incredible influence on its future success and a ton of lasting value gets created at this stage (from ways to interact with customers to coming up with specific menu items). By removing all friction and cost from making everyone who helps a company out become an owner, I hope that we will be able to make it the norm. People everywhere will demand to be an owner on everything that they help create and grow.
From the investment side, there’s the obvious benefit of allowing the general public to invest in earlier stage companies with more growth ahead of them. There's also the democratizing force that changes who decides what even gets funded and built. Introducing regular people at the earlier stages of funding will get companies funded that are important to the public but perhaps not so much so to venture capitalists. There’s definitely more risk investing at this stage than buying a share of Microsoft. But I believe that with the inherent transparency and trustlessness digital companies, which will reduce scams and protect investors, people should be allowed to invest their money wherever they want.
Thank you for reading all this, hope you found it interesting! If you’d like to work on this with us, check out https://firm.org/careers or DM me @izqui9