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.
