What are the regulatory barriers preventing the emergence of a liquid market for equity in seed stage startups?
Posted by David S. Rose on November 15th, 2012
Parts of the answer are that (a) there are enormous regulatory requirements relating to secondary markets, and (b) there are no analysts tracking private company stocks.
But by far the biggest issue is that the very essence of public markets (and what makes them “public”) is that the SEC mandates an enormous amount of transparency, including complete quarterly financial statements, complete publication of the company’s cap table including all significant shareholders, and so forth. NONE of that is available with seed stage startups, so that even IF it were legally and economically viable to trade them, and even IF there were analysts who followed every public move the company made, there still would be no way whatsoever for anyone outside the company (or Major Investors, if they have Information Rights) to have the slightest idea as to what a realistic price should be for the stock.
In my own portfolio I have companies that are generally perceived to be extremely successful with high profile customers and lots of sales…but they just happen to have a liquidation preference ladder of $25 million! And there are others that people think are teeny little wannabes with a dozen or so employees…that have $25 million in highly profitable revenues with hockey stick growth and zero debt!
So while we may (and probably will) eventually see the emergence of a secondary market for private stock (and I’m not talking here about things like SharesPost and SecondMarket, which are essentially bulletin boards that attract people in as lead generators for registered broker/dealers), it is going to require some significant changes to the practical, legal and economic sides of seed investing.
*original post can be found on Quora @ : http://www.quora.com/David-S-Rose/answers *
Written by David S. Rose
David S. Rose
Founder and CEO,Gust
David has been described as "the Father of Angel Investing in New York" by Crain's New York Business, & a "world conquering entrepreneur" by BusinessWeek. He is a serial entrepreneur & Inc 500 CEO who chairs New York Angels, one of the most active angel investment groups. David is also CEO of Gust.
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It seems to me that the government imposes two classes of regulations: those for public securities, and those for exempt private securities. I don’t think those two sizes fit all.
Presumably some amount of regulation is better for the market than none, and too much regulation is counter-productive. I think we need a system that does two things: 1. optimizes the regulation, and 2. divides securities into appropriate categories. I think that’s the kind of system a competitive market can achieve, not the SEC.
When it comes to securities, I think the correct measure of whether the regulations are good is the performance of an index over time. If two competing exchanges each impose different regulations on the companies they list, we will have a good idea which set of regulations is better by which portfolio performs better overall over time. In a competitive field of private exchanges, we would see lots of regulatory experimentation and lots of experiments with different regs for different categories of securities. For instance, there’s a serious unresolved problem for film producers trying to make their financial projections conform with NASAA’s SCOR form. A private exchange tailored for film productions would not make that kind of one-size-fits-all error.
Competitive exchanges would optimize their regs and their portfolios in order to maximize the situation for all parties. The SEC is a blunt instrument with no mechanism for optimizing the regs. Therefore it provides neither the optimal protection to investors nor the optimal regulatory environment for entrepreneurs. It seems to me that nothing is more important to exponential growth than the efficient allocation of resources to innovators, so this is a really big deal. Equity financing is one of the greatest innovations of the modern age. Why on Earth have we permitted a regulatory regime that restricts such a fundamental tool to a handful of coastal capital markets and the top 2% who qualify as “accredited investors”? My understanding is that the SEC was born out of a misdiagnosis of the crash of 1929. I think we would have been much better off if there had never been an SEC and regulations had evolved in a competitive market.
If I’m way off on this stuff, I hope somebody will put me in my place, because I just can’t understand why nobody else seems to feel the way I do about this stuff.