At CFX, we’ve talked a lot about the many positives that equity crowdfunding offers for investors, but we’d be remiss if we didn’t discuss one of the challenges of private investing. All investments have their risks, and one of the risks of private securities has been a lack of liquidity. Investors can typically sell publicly traded stocks at will on national stock markets, but when it comes to private placements there have historically not been many liquidity options. These types of private assets are generally illiquid, meaning that an investor cannot sell their shares after purchasing them.
Historically, there have been two reasons for this lack of liquidity – SEC regulations and the lack of a secondary market. To (very) briefly summarize SEC regulations, securities acquired through private placements generally cannot be resold unless the conditions of Rule 144 are met. This article will discuss the other issue, which is the lack of a secondary market.
The equity crowdfunding industry may be new, but private placements aren’t. Industry experts have long noted the lack of liquidity of privately placed securities. These private placements were generally only available to affluent individuals who were in a position to hold the investments for a number of years. With the passage of the JOBS Act and the advent of crowdfunding platforms, though, these investments are now available to anyone who meets the definition of an accredited investor. While these individuals are obviously affluent compared to the general population, in many cases they lack investment experience and are unpleasantly surprised by the lack of liquidity in crowdfunded investment offerings.
The liquidity problem extends to all crowdfunded securities offerings. Indeed, many of the most outspoken proponents of a secondary market are entrepreneurs who hope to use crowdfunding to raise capital for their own startups. Many of the biggest critics of equity crowdfunding, including Mark Cuban, cite the lack of liquidity as their biggest concern. In a recent blog post, Cuban wrote that “there is ZERO liquidity for any of those [crowdfunded] investments. None. Zero. Zip . . . [i]f stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it?”
Although Cuban also criticized the SEC for failing to provide some form of liquidity, it appears that the SEC has taken notice of the issue. In a speech that SEC Commissioner Luis Aguilar gave last month, he noted that ““[t]he lack of a fair, liquid, and transparent secondary market for these securities is a longstanding problem that needs an effective solution.”
Many observers have suggested “venture exchanges” as a possible solution to the liquidity problem. There are several different proposals, but in general, venture exchanges can be considered a stock market for small companies. Of course, this raises the issue of regulatory hurdles that a small company would have to meet in order to be listed on the exchange. Given that these companies would obviously be much riskier investments than traditional publicly traded companies, it seems clear that some hurdles would be required. However, too many hurdles would defeat the entire purpose of the exchange, since most startups won’t have the resources to comply with stringent regulations.
In his speech, Commissioner Aguilar concluded that venture exchanges “need to be considered . . . in a thoughtful and measured manner—fully cognizant of benefits, costs, and challenges—and always with the needs of investors at the forefront.” Despite the cautiously optimistic tone, though, there is no indication that the SEC is taking any affirmative steps to help create a secondary market. For the moment, the crowdfunding industry faces a situation where everyone acknowledges the need for liquidity, but no one has done anything about it to this point. It now seems clear that any liquidity solutions will need to come from within the crowdfunding industry itself.