On A New Path to Liquidity

Fred Wilson just put up a very provocative and interesting post concerning how successful start-up companies might garner liquidity for their owners. IPOs are great, but the market has largely been weak since the bubble burst in 2000 and is only available to companies of a certain scale. Fred and many of those commenting on the post also noted the big-company M&A option, but one that has often crushed the dynamism and the spirit of the company being acquired. Sometimes later-stage venture firms and private equity firms can also provide an exit, but these deals are few and far between. So is there a new way, a better way, of providing liquidity without the barriers of the public IPO market or the value-destroying tendencies of many M&A deals?

Fred cited the relatively new private exchanges, GSTrUE and OPUS-5, for example, as being a possible solution. This is a realm I know pretty well and have written about quite a bit. As currently structured and positioned with investors, these private exchanges are really just a proxy for going public, with the same types of revenue and earnings thresholds and scale requirements as companies listing on the NYSE. In fact, it is arguable that the barriers are even higher, since the disclosure requirements under the private exchanges are significantly less onerous than the public alternatives, requiring even greater comfort on the part of investors. Neither of these facts play well given what Fred is hoping to accomplish. But as Fred’s first commenter noted, some out-of-the-box thinking might be called for to deliver the benefits of liquidity to companies for whom the conventional paths are either unavailable or unpalatable. This assumes, of course, that the owners care about continuing to grow and develop the business as opposed to selling it in whole to a Goliath that may treat it as an afterthought once purchased.

What I have in mind is a private exchange for accredited investors that is not subject to some of the current restrictions plaguing unregistered vehicles, like the 500-investor limit. Here are some issues that a new structure might need to address:

1. The 500-investor limit

This makes an exchange where anyone other than large institutions can play completely unworkable: there is both the tracking issue (“When exactly did we trip up on this?”) and the sharply limited amount of capital that could be raised from non-institutional accredited investors. In order to create a liquid, robust market in companies that are either too small to go public, don’t want the hassles of being public or wish to avoid selling out to a big company but want some liquidity plus capital for growth, the 500 investor rule simply needs to go away. Why not, right? It is just a number.

2. The definition of “accredited investor”

My idea also calls for a re-visit of what exactly constitutes an “accredited investor.” Current rules are both archaic and backward: they are principally geared towards the ability to withstand loss, not investor sophistication. I once posted about hedge funds and externalities, and discussed the definition of accredited investors. One of my commenters, Jack Doueck of Stillwater Capital, made the very point I am making now. Those who have the knowledge and experience to invest in unregulated products should have the ability to do so, whether or not they have $1 million or meet the income tests. Plenty of people lacking both experience and ability have $1 million and shouldn’t invest in single stocks much less lightly-regulated private placements, yet they can do so under the current regime. This is an asymmetry that should be snuffed out by the regulators tomorrow.

3. The specialist function

if such an exchange is to be successful, it can’t simply be like a crossing network. There needs to be specialists providing liquidity in the market and finding the right price at which to clear the market. Especially early on in the exchange’s life, both liquidity and price discovery will likely be inadequate. This is where the specialist comes in. Over time, as the market becomes more efficient perhaps it could migrate more towards a Liquidnet model, where bids, offers and lot sizes are posted electronically and investors can trade anonymously without the need for an intermediary. But this is a ways down the road; the investment banks doing the initial placement should also stand behind their names and provide liquidity in the market.

The Benefits

A private exchange in this model would provide funds for both founders and investors to take some money off the table, raise capital for growth and afford entrepreneurs the chance to execute their business plans without either the burden of being public or the cultural issues of being acquired. Investors would likely be smart, savvy individuals or perhaps mid- and late-stage venture funds that want exposure to a particular business after it has been de-risked through earlier financing rounds. It could also serve as a feeder to the public markets, as companies deliver results and grow to a scale where they have the ability (and the desire) to do an IPO. It could also provide large companies with the chance of getting exposure to interesting tools and technologies that they might not be aware of, in a much lighter-weight, less committed manner than investing at an earlier stage or buying a company outright. And it would provide sophisticated individuals and institutions with access to a whole new asset class, one that is in many ways VC-like but with liquidity and entry/exit opportunities completely different than venture investing.

There is much more to say and do on this topic but Fred got the ball rolling and I wanted to share a few thoughts as well.

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COMMENT:

AUTHOR: Steven Goldstein

EMAIL: 

URL: http://profile.typekey.com/AlacraInc/

DATE: 04/10/2008 10:08:54 PM

Do you think there are enough of these companies which are of such high quality that they would trade on an exchange?  Although its a public exchange, AIM is trying to meet the needs of these types of companies.  It’s not very effective though.

I think there would be a lot of corporate governance issues (who gets Board seats) and lots of conflicts between remaining entrepreneurs and the new investor class.

If there is money to be made owning some of these types of companies when they’re past the seed or first round, perhaps the best option is a SPAC with plans to roll-up entities with somewhat related ideas.

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COMMENT:

AUTHOR: Roger

EMAIL: roger@informationarbitrage.com

URL: http://www.informationarbitrage.com

DATE: 04/10/2008 10:18:56 PM

Steve, I think you are mixing up a few concepts, that of quality and the threshold being a listing on an exchange. My idea is that many of these companies could not list on an exchange because of their size. This doesn’t make them of low quality. It makes them young and subject to a different set of risks than those meeting the criteria for listing on an exchange. I think the AIM isn’t more successful because it is neither fish nor fowl: it is trying to cater to a subset of the companies I’m talking about but in a public format. Kind of like the private equity firms that have decided to go public (for reasons other than the long-term good of the franchise), companies listing on the AIM are stuck between two competing worlds. 

I don’t think the governance issues you raise are that big of a deal. The types of investors that would be putting money in these companies are not looking for Board seats; they are looking for a good Board. It is a totally different mind-set than a company going public, except perhaps the current owners would ensure enough independent representation to enable them to uphold their fiduciary duties.

I think my idea has legs. It is gutsy and it will take time to catch on, but I truly think its doable.

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COMMENT:

AUTHOR: Rita

EMAIL: rita787@yahoo.com

URL: 

DATE: 04/10/2008 11:17:59 PM

Roger - or do we maybe just need an auction system or an exchange just like the ad markets have for companies?

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COMMENT:

AUTHOR: Yaser Anwar

EMAIL: yaser@yaseranwar.com

URL: http://www.linkedin.com/in/yaseranwar

DATE: 04/11/2008 11:51:49 AM

The type of exchange you talk about could be started as an oligopoly or an exchange by a few top firms, say, Sequoia, Founders Fund, USV and a few more (I’m not too familiar with top VC firms) initially, no?

If there is demand as you say, then its in the best interest of VCs to create this market, which could later be acquired by an exchange like NYSE, Nasdaq, LSE etc.

Its like the NYSE starting in early days where the big players were the banks (JPM himself) which over the decades has evolved as more companies have listed and increase in liquidity. 

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COMMENT:

AUTHOR: Antony Evans

EMAIL: antony@thestartupexchange.com

URL: http://www.thestartupexchange.com

DATE: 04/11/2008 01:54:52 PM

Roger,

Interesting post.  I’ve been working on a startup project (www.thestartupexchange.com - although the site is still being developed so nothing there yet) looking to solve exactly this problem.

We are looking at a slightly different approach (based on an aim listed cash shell) to the one you describe but the exact strategy is still in-flux so  its always interesting to hear different perspectives.

Another challenge I think lies within the complicated covenants which investors make with their investments (covenents, pref. shares etc).  The lack of standards remains another critical barrier to setting up an exchange as different ‘stocks’ would have different risk profiles.  Recognising this there are a few start-ups in the P2P venture space who are looking at creating some conventions (along the lines of the y-combinator  X% of the company for $Y’000’s).

The Start-up Exchange has a pretty funky approach to pricing as well - happy to discuss with you in private if you are interested.  Would be very interested in your feedback/advice on our approach.

Antony

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COMMENT:

AUTHOR: Kris Tuttle

EMAIL: kris@research2zero.com

URL: http://www.research2zero.com

DATE: 04/13/2008 08:51:42 AM

Glad to see this idea back in discussion.  These are all great points.  Especially the accredited investor one.  It will probably never happen but imagine if we created a scaled down version of the Series 7/86/87 exam for qualification.  It’s absurd to have it decided based on the sole fact of having plenty of money to lose. 

I think there’s a huge need for a different way to provide research coverage and ongoing visibility for these companies but that’s a topic for a separate post!

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