SECOND IS THE NEW FIRST

Secondary solutions to the problem of illiquidity of private companies — Part II

Part I of this two-part series on Secondary solutions not only introduced illiquidity and its many challenges, it also presented various solutions, whether it was anticipatory actions founders could take or more ex-post solutions like the Secondary market. Part I, therefore, focused on more conventional avenues, whereas Part II will focus on unconventional solutions to the challenges posed by illiquidity.

As mentioned in Part I, even just a few years ago, secondary liquidity was unspoken of, perhaps even unheard of. Alternative investments themselves e.g. in the venture capital market were difficult to access for the average investor. According to Bessemer Venture Partners, this is currently changing with the democratization of private markets resulting from multiple factors including regulatory changes, developments, and innovations in tech as well as other macroeconomic trends. Private markets are becoming more and more accessible to the masses with a plethora of recent platforms facilitating private market participation. These trends inevitably affect the perception as well as the tangible workings, or availability, of liquidity, for companies as well as the average investor.

This article specifically focuses on unconventional solutions to the problem of illiquidity, ever more relevant in today’s market. Three solutions, in particular, will be discussed: private market exchanges, equity crowdfunding platforms, and the tokenization of shares.

Section 1 — Private market exchanges

For a while now, companies could either be private or public, and they would therefore either be largely restricted in terms of raising capital and providing liquidity, etc, or largely exposed and subjected to public scrutiny and numerous regulations. For companies in the growth stage for example, who might not be ready to go fully public, there needs to be a third option. And today, private market exchanges for secondary shares provide this third option. In fact, even back in 2011, early pioneers of the secondary private exchange like SecondMarket saw many shares listed, including for companies like Facebook and other hot start-ups. Today, for example, Carta, a cap table management solution, is also providing this option.

Carta has veered off into developing a secondary market for private companies with their CartaX exchange. It started by listing its own shares on its platform and ended up selling almost $100m of its shares across 1,484 market orders, to 414 participants at a price of $6.9bn — a 2x premium to the last $3.1bn valuations of their Series F round in 2020. Henry Ward, CEO of Carta, attributes this to two reasons; first, they had high-profile investors who just led the big Series F round, and; second, instead of engaging with multiple VCs as they did for their primary round, they had 53 global institutional investors on the platform, which enabled better price discovery. This also meant faster execution and potentially more secondary sales.

How it works is that companies that list on CartaX will be offered secondary transactions where investors may bid in auctions of shares offered by sellers (who can be founders, employees, or any shareholders) while Carta makes a 1% commission off the buyers and sellers. Legally, CartaX is covered under relevant secondary market registration exemptions and only electronic certificates (that meet the certain requirements) can be transferred on Carta.

The wider secondary exchange market is characterized by a few key players. The early pioneer was SecondMarket, acquired by Nasdaq in 2015 and was later joined by a few players like EquityZen, SharesPost, and Equidate, with the last two mergings and rebranding to Forge Global. Last year, Nasdaq Private Market announced its spin-off from Nasdaq into a standalone company to scale its private market platform and develop it into an “institutional-grade, centralized secondary trading venue for issuers, banks, brokers, shareholders, and prospective investors of private company stock” and has received investments from the likes of SVB, Goldman Sachs, Morgan Stanley, etc.

The main takeaway is that these platforms effectively solve regulatory issues and the lack of information that secondary buyers were traditionally faced with, as well as enable efficient price discovery. However, on the other hand, the process does not always work seamlessly and in fact, much of it is still largely manual. In the case of Forge for example, while companies are listed on their platform with certain information available, the process of buying or selling does not occur with a few clicks.

Private market exchanges are more relevant than ever in today’s market. As significant declines in tech stocks, this year are having an impact on the private markets, secondary exchanges are experiencing a big uptick in activity. Forge’s COO mentions there has been a “huge influx of sellers” who have recently signed up to the platform, with the number of sellers reaching unprecedented levels. Not only this, but with the current demand for liquidity, sellers are unloading shares at discounted prices. The premiums to the last (historical) rounds have so far, over the first quarter of this year, reduced from 58% to 25%. The transaction volumes have also gone up significantly. Nasdaq Private Market has recently surpassed USD 40bn in transactions since inception.

Against the backdrop of today’s market, it is clear that secondary exchanges have solidified their legitimacy as a real solution to illiquidity.

Section 2 — Crowdfunding platforms for secondary

Traditionally, only professional investors would invest in start-ups, but equity crowd-funding has changed the game and democratized these opportunities. It has also created more liquidity — investors can sell these shares on an Alternative Trading System (ATS) now. Crowd-funding has gained much legitimacy as an alternative financing method since the JOBS Act in the US was introduced in 2006 and Kickstarter was launched in 2009. In the US alone, in 2017, a year after the act was actually implemented, crowdfunding gained rapid traction — the numbers of both successful campaigns and participating investors increased by 190% between 2017 and 2018.

In 2017, Seedrs, a UK equity crowd-funding platform, established a secondary market. In 2020, it had its best year yet, delivering nearly 14,000 investor exists and offering up to 400 companies monthly. Towards the end of 2020, it also opened up its secondary market to all private companies, not just those which already previously crowd-funded on Seedrs. A notable success story was a secondary sale of Revolut. One can argue, however, that this was a one-off as Revolut’s high growth and multiple raisings prior to the listing also helped set a reliable share price.

To find out more about Seedrs, how their secondary platform works, and their various successful campaigns, we spoke to Jasmine Lynn, portfolio manager at Seedrs.

Investing in a company through Seedrs is done via a nominee structure — once you buy or sell shares through Seedrs, the legal title remains with Seedrs. This means that it is Seedrs’ entity that is on the company’s cap table and the investors hold (and trade) commercial interest in this entity, and thus indirectly in the ultimate company. Such structure solves the usually stringent share transfer rules of companies, giving a liquidity option to investors or employees, while keeping the company cap table “clean”.

The actual share transfer process is also interesting. Seedrs first ensures the company is happy with the potential sale and subsequently collaborative in the process. When the seller signs an agreement on the sale of a given amount of shares, Seedrs launches a ‘campaign’. Jasmine also reiterated the importance of adequate information on the company for potential investors “…which is why it’s important that the company is involved in the process,” she reminded us. The price is discovered in the campaign process using Seedrs’ dynamic pricing function and also by reference to the last round of the company. If the company hasn’t raised in the last 3 years, Seedrs makes them ineligible for the secondary market. The campaign is then open until a minimum target of the amount of shares to be sold is reached.

Going back to our previous point on the benefits of creating liquidity, on the Seedrs platform, it is usually the founders who sell, as well as employees who exercise their options. Buyers range from retail investors to people who are familiar with the company, family, friends, etc. who invest in smaller ticket sizes. Sellers sell for multiple different reasons. Founders and early employees primarily sell because they’ve spent years of their life with the company without often realizing any of its value and the full exit may be still a long way ahead while life moves on.

Currently, Seedrs has only worked with UK-based companies but was already in talks with companies in different jurisdictions at the time of the interview. For a phenomenon that only gained traction relatively recently in 2017, it is highly interesting that secondary solutions to illiquidity are already being incorporated into equity crowdfunding.

Section 3 — Tokenization of Shares

Another interesting secondary solution is blockchain technology. Blockchain is in the financial and investment industry mostly known due to cryptocurrencies and, more recently, due to non-fungible tokens (NFTs). Yet the transparent and distributed nature of the core technology offers many potential benefits beyond speculative investment or store of value (depending on which side of the crypto barricade you stand).

One such potential benefit is the ability to convert any asset (anything from a physical object like artwork to an intangible object like a carbon credit or a share in a private company) into a digital asset, ‘a token’, which is governed by a pre-determined set of rules that are triggerable at specified circumstances, ‘smart contracts. This process of converting an asset into a digital asset is called ‘tokenization’ and is in essence not that different from the securitization process known in the financial industry. The tokens thus created are ‘security tokens’ and they are effectively a derivative, a digital image, representing the underlying asset, but also acting in its stead in a legal sense — change of ownership of the digital asset can mean effective change of ownership of the asset it represents.

The main benefits of tokens are their security and the ease with which they can be traded. Security tokens may also eliminate the need for middlemen and therefore lead to faster deal execution. The challenges, however, lie in the fact that such tokens are regulated differently in each jurisdiction, and complying with jurisdictions where the tokens are issued and then distributed is not necessarily a straightforward process, particularly given that blockchain platforms are decentralized. Research by Deloitte even indicates that “international regulatory alignment is an unlikely milestone in the near future.”

That being said, there are quite a few platforms already in operation that enable the tokenization of assets and their subsequent trading. The process of ensuring these tokens are compliant from the very beginning can be tedious; yet again this is where the transparent nature of the technology helps, as the smart contracts that govern the tokens are auditable. One such platform that enables compliant token issuance and trading are Securitize, which offers an end-to-end solution enabling the tokenization of securities issued by funds, companies, and other entities, as well as streamlining KYC/AML requirements and customizing smart contracts. Securitize operates by embedding compliance during the token issuance stage. This means that the regulatory requirements are embedded into the tokens themselves with the goal of allowing regulated trading of these tokens across centralized and decentralized exchanges globally (e.g. investors from jurisdictions that do not allow trading of digital securities would not be able to purchase such tokens).

Although it still has a long way to go, blockchain technology is making much progress in this regard, providing liquidity in private capital markets where illiquidity is the norm with transparency and security.

Founders must realize the importance of creating liquidity, eliminating dead equity, and maintaining a clean cap table. Hopefully, it is evident that there are multiple solutions to these problems, whether it is an anticipatory solution for founders to think about in the early stages of the company’s life, or a later stage solution involving the secondary sale of shares to specialized secondary funds, or other more unconventional methods.

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