Derivatives 101: Forward Contracts and DXYZ (Destiny Tech100 Inc.)
A derivative, in a nutshell, is basically a pricing guarantee.
This is, one of many pieces, it’ll take to wrangle and disambiguate the complex topic of derivatives.
To put this into perspective (a la explain-like-I’m-five reasoning), when I was a kid, a few things that were deemed cool in elementary school and (early) middle school included Silly Bandz bracelets, Tech Deck (Fingerboard) skateboards, Webkinz animals, Keep-A-Breast Foundation bracelets, and Yu-Gi-Oh! and Pokemon cards.
Let’s take the Yu-Gi-Oh! market as an example. (What does that say about me?) In afterschool daycare, one of the other kids notices I have the coveted Blue-Eyes White Dragon (BEWD) card. He’s already used up his Christmas wish for the year, so he offers to buy the card from me based on his incoming allowance mowing lawns: “hey, when I get my $50 in six months, I’ll buy BEWD off you; just promise me you won’t give it to anybody else.” What a steal, I think, given the card is only worth $25. I like Yu-Gi-Oh!, but $25 is a lot of money to a kid (to go and buy candy)! We both write out our promises on a sticky note in colored pencils. Little do I know, six months later and the card skyrockets to $100, but I’ve already made the promise, so I have to sell the card to him, otherwise he’ll tattle to the daycare staff on me; then, they’ll tell on me to my parents and my parents will be disappointed that I broke my promise. (Of course, this story is not true.)
The promises, however, we wrote down on that sticky note represent the contract between a buyer and seller. That contract is ultimately derived from the value of the underlying asset (i.e., BEWD card). As you can intuit, derivatives are adding a whole lot more liquidity to markets by enabling more buyers and sellers to be involved with these types of contracts.
Disclaimer: As a reminder, none of what I write is investment advice, nor intended to be interpreted as investment advice.
Flavors of Derivatives
Before getting into the different flavors of common derivatives, let’s cover the elements common to all derivatives:
There is a buyer and there is a seller.
Value is derived from the underlier.
There is a future price.
There is a future (exercise) date.
Regardless of whether derivatives are “vanillas” or “exotics,” all derivatives are fundamentally derived from four basic types of derivatives (no pun intended):
Forward Contracts
Futures Contracts
Swap Contracts
Options Contracts
To truly understand each of the four flavors of derivatives, I’ll walk us through a timely event in the news cycle that relates to that flavor.
Forwards and DXYZ
First, let’s cover forward contracts. At a high level, “forwards” are simply agreements to buy something at a specific price on a specified future date. At present, that forward is just a placeholder for that item to be purchased in the future. Forwards have been especially popular lately with what’s called a Forward Purchase Contract (FPC).
Specifically, a new closed-end fund – Destiny Tech100 Inc. (DXYZ) – debuted recently, garnering a lot of (retail) interest and news coverage. DXYZ’s value proposition is appealing in that it’s basically democratizing access to invest in venture-backed, high-growth technology companies: in other words, I think of it as “hey retail investor, through this ETF, you can also get access and exposure to OpenAI, Stripe, and SpaceX – all this used to be far out of reach for you.” The sentiment for a product like this is equally appealing as is interesting: per Destiny’s website, “companies are staying private longer than ever before and achieving incredible growth” (and everyday investors are missing out on all this pre-IPO growth, only to, at best, get a lesser return in the publics market that has, frankly, not been wholly receptive of IPOs lately, as of writing).
Tactically, per its prospectus, how DXYZ constructs its index of all these high-growth private (technology) names is through “direct equity investments” and “private secondary marketplaces and direct share purchases.” They’re basically reaching out to current or former employees of the OpenAIs of the world, entering into contractual forwards for those folks’ shares, or utilizing private secondary marketplaces like CartaX to help find sellers.
For instance, putting aside DXYZ for a minute, let’s say a fella named Neal goes to his friend Hank – an early Stripe employee – and says “hey, sell me your shares of Stripe: I’ll give you $100 per share.” Hank goes: “perfect, to be honest, I’m not super bullish on Stripe and am thinking of leaving for this other startup called OpenAI soon and have 5,000 shares I can give you at that price.” Neal and Hank agree. The terms are codified in a forward contract, but the cash flows are ultimately settled today, and Neal pays Hank.
Here's a recap of the basics, in addition to some important considerations during the lifecycle of this forward:
There is a buyer and there is a seller.
Buyer: Neal
Seller: Hank
Value is derived from the underlier.
Value is derived from owning Stripe early and capturing some of this “pre-IPO” return.
There is a future price.
The future price is effectively $100 per share in six months, but the cash settlement ultimately takes place today, so Neal immediately pays Hank $550,000 for promised future ownership of Hank’s Stripe shares upon a liquidation event (e.g., M&A, IPO, etc.).
The extra $50,000 is the result of common 10ish% broker transaction fees common in forwards.
There is a future (exercise) date.
Six months from now, Hank should be delivering the 1,000 Stripe shares to Neal.
As you can intuit, there are evidently some risks inherent to forward contracts like this. Bringing DXYZ back to the forefront as well, here are some important considerations:
Oftentimes, high-growth private tech startups preclude selling shares of their issued stock, or transferring them to potential buyers. Stripe explicitly does. These companies want as much agency and exclusivity over their shareholder base, especially if the company intends to raise a fresh round of financing, to go public soon, to buy another startup, etc.
Unlike typical secondary transactions, forwards like these FPCs don’t really have share certificates that can be amended to demonstrate the buyer’s new ownership and the seller’s proof of sale. In six months, Hank could easily just “forget” this transaction ever took place if, say, there’s a liquidation event and the price skyrockets to $500 a share. (Of course, Hank should realize in that situation that this costs their friendship, and Hank has now put some quantifiable price on the cost of that (former) friendship with Neal?)
Insurance is increasingly being offered for buyers at an additional 200-300 bps, rounding out the total transaction cut to 13ish%. It’s unclear, however, how protective these insurance contracts are and if they’ll actually pay out since the sellers are often dissimilar to typical market participants: they’re not repeat players entering the market time and time again. In other words, these sellers may not care about reputational rating or harm from a one-off failed settlement.
All this cognitive dissonance is admittedly highlighted and summed up well in DXYZ’s prospectus, and here are a few fun bullet points under the section “Risks associated with forward security transactions”:
“We may invest in “forward contracts” that involve shareholders (each a “counterparty”) of a potential portfolio company whereby such counterparties promise future delivery of such securities upon transferability or other removal of restrictions. Should counterparties breach their agreement inadvertently, by operation of law, intentionally, or fraudulently, it could affect our performance.”
“In cases where we purchase a forward contract through a secondary marketplace, we may have no direct relationship with, or right to contact, enforce rights against, or obtain personal information or contact information concerning a counterparty.”
“In cases where we purchase a forward contract, because each underlying portfolio company may not have necessarily approved or endorsed the transaction, it offers no warranties or other promises as to the validity or value thereof, and no promise that it will agree with, approve, or facilitate transfer of shares to us.”
“The portfolio company may not be a party to and may not have approved or been informed of the counterparty’s transactions with us, and, should the portfolio company object to the existence of the forward contract, it may take any number of steps to discourage or obstruct the transactions.”
“To mitigate some of the risks inherent in purchasing forward contracts, we may purchase insurance (at additional cost to us), which may be inadequate, and coverage limited or denied due to (among other things) liability limits, exclusions, the scope and limitations of coverage, the good faith and compliance of the insurer in honoring claims, the performance of the pool in making claims, among other things.”
Though the DXYZ launch is paradigmatic of a closed-end fund utilizing forward contracts to construct its hot-private-tech-startups index, there is still a lot of cognitive dissonance to resolve. Specifically, DXYZ’s net asset value (NAV) per share was approximately $5 in its first days of trading, yet the stock’s market price on the New York Stock Exchange (NYSE) neared $100 per share – that’s a premium of well over 1,000%. For reference, most closed-end funds will trade at a discount to their NAV (i.e., Pershing Square Holdings – Bill Ackman’s publicly traded closed-end fund launched in 2014 – has generally traded at a discount to its NAV), so DXYZ’s retail reception is a bit precarious and (extremely) overpriced for retail investors, it seems.
Disclaimer: None of what I write is investment advice, nor intended to be interpreted as investment advice.