Investors can now buy equity in private companies through online platforms, which has led people eager to invest in startups to consider purchasing shares through these portals. But before people become invested in equity, they should think about how they will get their money out. We don’t yet have an efficient secondary market for private company shares.
The Challenge of Exiting Crowdfunding Investments
Business angels and venture capitalists usually achieve liquidity when the companies they finance are acquired or go public. But it’s not likely that most investors in crowdfunding portals will achieve liquidity that way. Most of the companies raising money through these platforms aren’t the type to go public or be acquired.
Moreover, crowdfunding will lead to a smaller fraction of private companies having these types of exits. Crowdfunding will increase directly the number of young companies getting financed, but won’t influence the number of IPOs or acquisitions very much at all. If crowdfunding leads more companies to receive investment, but doesn’t alter the number experiencing an IPO or acquisition, it will exacerbate the startup investment liquidity problem.
Strategic and institutional investors might someday become buyers of crowdfunding shares, David Freedman and Matthew Nutting argue in their book “Equity Crowdfunding for Investors: A Guide to the Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms.” But, these investors aren’t going to do much to make a market for those shares initially. Strategic and institutional investors focus their financing activity on the highest performing fraction of businesses backed by angels and other early investors in private companies. They aren’t likely to be interested in the shares of most companies that raise money through equity crowdfunding.
Other individual investors might want to buy these shares, Freedman and Nutting explain. But that won’t happen while the startups are still selling shares through crowdfunding. Just as people don’t buy previously lived-in homes while builders are still offering brand new dwellings, investors won’t buy shares from others when they can purchase them from the companies themselves.
More importantly, for these shares to really trade between investors, we need a secondary market where buyers and sellers come together. The intermediaries that currently match buyers and sellers for private company shares probably won’t create these secondary markets. The currently market-making entities typically seek the approval of the companies that issue the shares before accepting transactions, making them a better fit for selling employees’ shares than investors’ equity. In addition, these transactions are labor-intensive, which will deter most entities from making markets for small lots.
Then there is the information problem. Potential buyers will have a difficult time getting accurate data on the private companies they are considering buying. No analysts cover these companies or provide reports about them. Few of the businesses have audited financial statements to provide to potential investors.
Before investing in private companies, investors should consider how they will liquidate their holdings in the future. Right now it’s possible to buy shares in private companies quite efficiently. But it’s not yet possible to sell those same shares easily.