Is trading bad for entrepreneurs?
As we build out the market for tokenized securities, we are rushing to create more effective ways to trade private securities. Is this a good idea? Liquidity is always good for investors. They gain an option to cash out. However, liquidity can be bad for issuers. Small securities issuers often find that liquidity leads to a loss of money and credibility. Why do security issuers run into this problem, and how can we fix it?
Investors want liquidity. They want the option to sell their assets and raise cash. However, this type of liquidity may be bad for the companies that offer it. The decline in listed public companies provides powerful evidence that issuers are avoiding liquid markets. According to Topdown Charts and the World Bank, “The total number of listed companies dropped from just over 8,000 in 1996 to 4,336 at the end of 2017”. Entrepreneurs that can take their companies public are deciding not to do it.
IPO’s were once important for young and growing companies. Intel did an IPO in 1971 that raised $6.8M. Microsoft did an IPO in 1986 that raised $61M. In 1980, Apple raised $100M in a hot IPO that was banned by Massachusetts regulators as being “too risky”. Since then the stock has risen more than 400X.
David Weild has spent 20 years studying the IPO market. He thinks the decline in IPOs is a problem that is suppressing the funding of new business in America. Weild explains that a small issue will naturally trade down to a lower price, because it has limited information flow following the initial offer. This motivates entrepreneurs to avoid IPOs, and it reduces their funding.
An entrepreneur gets into trouble if his/her stock is trading below fair value when he goes to raise more money. The same principle holds for a VC fund manager that is going to raise a new fund. If the old fund is trading at a disappointing valuation, nobody will want the new fund.
Why trading causes price declines
Trading can cause price declines for three reasons:
- It would happen consistently if investors pay less for securities which they don’t have much information about. Information flow usually declines after the initial offer.
- It would be true half the time if prices fluctuate for reasons unrelated to the issue.
- It will always happen if someone with a large holding tries to sell. Let’s say you have a loyal investor who bought 1M shares. They will get punished if they try to sell those shares in a market that only buys 5K shares per order. As the large investor tries to sell the shares, the price will move down each time it hits a bid, until it unloads the shares after 200 bids at a huge discount.
This is a market failure. Liquidity is better for investors, and theoretically neutral for issuers. So, issuers should offer it. But, issuers have an incentive to avoid liquidity.
Weild’s counterintuitive solution is to pay extra spreads to a marketmaking and sales team to mediate this process. If a marketmaker can control the market and make a good profit on each trade, the marketmaker can afford to help sell big orders and support the price. The marketmaker would control the flow of offers. During this time, a sales team can educate the market about the value of the shares. The marketmaking team can take a big sell order, call around for interest, and sell it when the market is ready. In the 90’s, this type of marketmaking was legal in the US. However, the SEC issued rules reducing the spreads that marketmakers could charge. According Weild, these rules lead directly to the decline in small IPOs.
The crypto anomoly
Cryptocurrencies and utility coins can have high liquidity even if the amount offered was small by stock standards, less than $50M. Why is that?
- Activity is publicly exposed on the blockchain, so information flow ramps up after a public sale.
- Wide holdings from a crowdsale increase the number of traders.
- Often, money for many years of product development is raised up front. Compared with an equity offer, there is a lower probability that the issuer will come back to the market and deflate the market by issuing new coins.
[We should check to see what happens to crypto projects lacking one or more of these]
We can see several ways to provide liquidity without excessive price declines:
- Pay for marketmakers to market and sell the security by allowing them to control the offers and make a good spread. This is Weild’s proposal.
- Use openly visible blockchains and commerce to share information automatically.
- Sell a large issue. Avoid smaller issues. Roll up funds and companies into bigger entities before selling their securities.
- Sell a large issue that attempts to raise all of the money required by a project up front. This reduces the possibility that you will come back for more funding that will inflate the supply of securities.
- Sell to a lot of shareholders. Favor crowdsales over private sales before offering trading. Streamline governance with automated proxy voting, or nonvoting securities, so that you can handle a lot of shareholders and still move quickly on governance issues.
- Batch up trading into a small number of days and hours per quarter. This will bring in buyers and sellers at the same time and create opportunities to trade.