Arriving to the startup world from a stock exchange always makes me think about whether the traditional trading platforms have anything to do with very early-stage enterprises. When I talk to people still working on a stock exchange or just follow the news on regulated markets for SMEs, it seems that the answer is “maybe yes”. Wearing my other hat, the VC hat, also reveals the question from my side, how would startup IPOs as an alternative way of early-stage financing would affect the role of the classical infrastructure?
The need factor
There are a lot of startups looking for funding, and let’s be honest, in a very early stage it is not easy for entrepreneurs to convince investors whether they are business angels or incubators or VCs. There are grants available as well, but applicants still have to meet certain requirements to obtain funding from national/international money pools. There is a lot of truth in how the founder of Start-up Stock Exchange (SSX) based in the Caribbean sees the situation:
“Outside of perhaps Silicon Valley, raising money is a full-time occupation in itself,” says Haet. “Entrepreneurs are already working 24//7 to build businesses. They don’t have time to create connections and many don’t know how to do the process anyway.”
(Source: Start-up Stock Exchange: Covering The Funding)
I agree, but I wonder how would these premature companies be ready for organised trading when they even struggle for getting money from their natural environment? At a stock exchange you have to follow rules and regulations, formal processes, for which these “youngsters” are probably not prepared yet.
All the same wrapped up differently?
There are a lot of attempts to formalise the fund raising process and organise it to a single platform. It makes sense, because then demand and supply are concentrated on the very same place making the whole system more frictionless. Angel investor clubs, equity and donation based crowdfunding all try to build themselves around the same core concept mentioned above. They attract entrepreneurs by offering an extended investor network and vica versa (luring investors with diverse investment opportunities) while the whole process is streamlined by providing all the related services (documentation, admin, payment, etc.). It is also a secure way of investing because you are not alone in the deal, you share risk with other investors or supporters. So to what extent a dedicated section of a stock exchange can revolutionise startup financing?
Wow, they have a baby! — This is what happens when you alloy the stock exchange with crowdfunding
I was looking for existing startup exchange models for a while, but there are not too many early birds (Startup Stock Exchange, Cadia Startup Exchange, GREX, in the US, in India) out there. The most advanced example I could find was Startup Stock Exchange, launched in 2014. It provides securities exchange related services, such as brokerage and listing advisory, while the trading itself takes place on the Dutch Caribbean Securities Exchange. So here is SSX’s value proposition to entrepreneurs:
“The Startup Stock Exchange combines the social basis of crowdfunding with the benefits of a regulated securities exchange. This means that all companies listed via SSX get the attention a company running a crowdfunding campaign does but in a wider extent. To start, all listed companies get immediate exposure to a pool of global investors from over 100 countries and an international group of SSX Advisors from different places around the world, all with high net worth contacts.”
Source: Wall Street Meets Crowdfunding with Startup Stock Exchange
Navigating through the listing process you will find nothing surprising. The key steps are basically the same as in case of a traditional IPO. Startups have to hand in their basic documents such as corporate documentation and business plan for approval, and if everything is fine, the IPO takes place. Then the company has to meet regular requirements, which in addition to standardised trading, ensures transparency to investors.
On the investor side, gaining access to listed startups is not complicated either. They just need to open an account (approval is needed here as well), fund it and start to buy and sell.
Advantages are quite self-explanatory…
FOR STARTUPS:
· There is a standardised process of listing, which makes principles equal to each counterparty.
· Companies get access to a widespread investor network, so they do not have to do a long-lasting “roadshow” in order to find the proper investors to raise capital.
· Moreover, they are not dependent on one or a few investors’ preferential rights, but are funded by a diverse community instead.
· Not an obvious element is that applicants receive mentorship, which makes the listing process similar to being part of an incubation programme. Besides that, listed companies can take advantage of the international investor pool, which can contribute to the team’s success by their contacts or industrial & business experience.
· Having an IPO & being listed on a stock exchange gives companies visibility and helps spread the word. It definitely has a marketing & PR impact, increases trust towards the company and strengthens the brand.
· If the startup is doing well, it will be even easier to raise more capital or take a loan due to its transparent operation and measurable performance (via stock prices).
· SSX states that it has a fee structure tailored to the budgets of startups (the total listing cost in their case is USD 5,525 + 1.5% of the IPO offering value).
FOR INVESTORS:
· Investors can create their startup portfolio from various industries, maturity phases and locations. It gives them a tool to diversify align these factors.
· Trading is regulated and transparent.
· Even a small amount can be enough to become shareholder in a future success story.
· Price changes, turnover indicators and regular reports are good source of information on their potential unicorns.
· Exit becomes easier as those investors, who are not in love with their selected projects any more, can sell them to other market participants.
??? Here are my questionmarks
? Liquidity
Of course, my biggest question is related to liquidity. Let’s say that an early-stage company raises a few million dollars, which is not negligible in a newcomer’s life, but how it will provide enough liquidity pool for investors? Because of the nature of the business, I guess most of the investors would typically invest in a startup on a longer run: if they get in the deal, they probably want to hold on to their shares for a while (at least months if not years) to see how the project improves and how valuation multiplies. I can hardly imagine day-trading with startup shares, and it might even be banned to avoid huge price fluctuations. I do not see the willingness of a market maker to join the startup trading floor either, because of the littleness of the market. I might be wrong, but I have to note that on those few startup exchanges that I came across, I could not find any remarkable trading activity.
? Valuation
Who and how will define the value of the company? Let’s be honest, even if institutional investors do proper financial calculations, in many cases valuation is the result of negotiations between the founders and the investors. Not even these early-stage companies mean lucrative business for brokerage firms, so they are unlikely to analyse startup shares and prepare the listing procedure. Shall the stock exchange itself define the IPO price during the due diligence process? It does not sound an unbiased and independent solution.
? Price manipulation
Liquidity and valuation are both a big questionmark on their own, but together they reveal another issue. What if the startup stock is illiquid, so it gives opportunity for price manipulation or at least big price diversions with a single transaction? It does not take a rocket scientist to figure the possible consequences on valuation out: an investor can divert the price to influence the valuation.
? Economies of scale
Taking into account the listing fee and the administrative burden, a listed company has to bear, I am not sure this alternative is attractive for startups. You can argue with me that in many cases legal costs in a standard VC round, which are eventually charged on the investee, are also very high. I have to agree, and it would be definitely worth a comparison… Probably only over a certain company size it makes sense to get listed on a startup stock exchange.
? Supervision
Who will be responsible for thorough monitoring of the company? If you invest in a startup, you would like to see how and for what your money is spent. Regular reports can help with that. However, if a team does not meet the milestones, you as an investor, might need to intervene or give them some support to pivot. A stock exchange gives a framework being advantageous in many ways, but it will be hardly able to handle these hurdles, which are quite common in startups’ life.
I also wonder how these fresh entrepreneurs will be able to meet reporting requirements (even if the stock exchange and the supervisory authority ease their pain by lower administrative burdens), when with most of them there is always an argument about the format and the regularity of their reports.
? The value of investors
For bright founders it matters who their investors are. They want angels, incubators, VCs to get on board, from whom they can benefit more than just the money. Giving out their shares to basically anyone will not serve this purpose. Even if investors are accredited, they might not fit the startup’s needs in terms of network, industrial knowledge and experience. I must add that the charm of this business will fade away if there is no personal contact between founders and investors.
So can stock exchanges disrupt the VC industry?
Having worked at a stock exchange, currently working at a VC, I cannot be accused by being biased. Above I simply tried to collect the main aspects of whether it is reasonable for traditional stock exchanges to launch startup platforms and take over the conventional VC infrastructure’s role or at least bite a slice from the cake. I could not really find existing examples, just a few early initiations, “startups” themselves.
However, there is something happening here, and I really look forward to see how they overcome the challenges. There are several SME exchanges (e.g. AIM, Chinext) all over the world, which can help pave the way for a similar platform focusing on startups.
As I emphasised, one of the biggest issues is to provide liquidity, which I do not see compatible with the nature of early-stage companies. Nor do I think, that operating as a public entity would serve the interests of an early venture, because there are so many other priorities at this stage. Finding the right investors have more added value than getting rid of the funding process by a “simple listing”. Smaller amounts can be also obtained from valuable investors, such as angels or incubators, while crowdfunding is also a way to get financing, validation and maybe a little bit of fame. I believe that stock exchanges can demand a spot for themselves in startup financing if they can provide a regulatory structure — including simplified administration, lower costs, favourable tax environment and consultancy/mentoring services — tailored to early-stage ventures similarly to their SME focused peers. If they can find economies of scale here, why to exclude them from this space? Actually, they are the most legitimate pretenders to the throne. Meanwhile, I am not worried about VCs either, if their value proposition is attractive enough and implies hands-on approach with their portfolio companies. And the million dollar question is, whether VCs could and would be willing to invest into startups via a stock exchange?
My intention was to write a thought-provoking blog post, because I would be happy to learn various opinions on this topic. If you have your own, please feel free to share it with me! Thank you!
