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09-05-2017 - - 0 comments

The news yesterday that Seedrs will be commencing Trading Tuesdays with a limited secondary market opportunity for Seedrs funded businesses, following hot on the heels of Crowdcube’s buyers led secondary market, is the latest piece of activity in the obvious development of the next stage in the private investor equity market. Meanwhile, established secondary markets like AIM, Asset Match, NEX Exchange and JPJ Jenkins are seeing an upsurge of interest as more and more investors look to deal with the challenge of taking up the right to sell something they were previously given the right to buy.

Why should anyone want to sell shares in good quality private companies you might ask?  Well, the answer is simple – it’s about portfolio and risk management and every individual’s position on these issues will be pertinent only to them. 

Many investors find themselves holding shares in private companies not for 3-5 years but for 10, 15 or even 20.  Over that time not just the company’s circumstances change, those of the investor do too.  It does not matter that an investor can “afford to hold”.  The question is why should they have to hold if they don’t want to?  And as there is a corresponding desire by investors to purchase relatively de-risked equity in private companies too, the rationale only grows stronger. Asset Match where I hold a NED position has 1,000s of high net worth and sophisticated investors in the latter camp.  So, with potentially willing buyers and willing sellers who dares deny this market opportunity?

Before getting into the general debate, I have a message for the Government when it reconvenes after the Election.  Please give EIS and SEIS shares a special tag that makes them CGT and IHT free in perpetuity.  This will do wonders for the development of the secondary market and as you will collect Stamp Duty on any trades, whilst not losing out any more than you might have done on these other taxes, what is there not to like?

And now onto the meat of the topic. Let’s deal with the issue of buyers first.  Why do investors want to buy secondary shares especially when there are no tax breaks attached?  Well the reason is obvious – the shares are de-risked and offer good value; increasingly they offer the reality or opportunity of a dividend.  The wealthiest who use up their £1m annual EIS allowance also may have more cash to invest than the tax breaks allow. Sometimes it is just the fact that they missed out last time there was a primary raise.

Why would a company want a new investor on its shareholder register? This is unarguable. Would you rather have a new engaged shareholder (who might well invest in your next funding round) on your register or a tired old shareholder whose purse you have fully emptied?

Then there’s selling.  The stories I have heard about why people sell range from school fees and a decent holiday to funding a divorce or even as desire not to leave shares in a small private company after death to heirs who will not understand what they own.

Selling shares in unquoted companies (technically AIM shares are unquoted) can be an immense challenge, especially when it comes to those bought via the crowd or angel investment. The problems start with the restrictions that are placed in Articles of Association and Shareholder Agreements often by larger investors and management teams who have traditionally seen minority shareholders as just there for the cheques they write.  On markets like AIM, Asset Match and their ilk, these restrictions have been removed so trading can be achieved, but with both Crowdcube and Seedrs companies it appears that free transferability has not yet been addressed.  As these secondary markets develop, across the angel and equity crowdfunding markets, I suspect there will need to be a lot of shareholder resolutions to alter Articles of Association and re-engineer Shareholder Agreements (and indeed the way nominee arrangements work) to stop a revolt by private investors who WANT THE RIGHT TO SELL FREELY.  There are loads of options to introduce new clauses in both retrofit and new Articles creation.  One clue: make some classes of shares freely transferable, with others being more restricted.  

If you are a shareholder in an equity crowdfunded company expect a letter in the post on this issue soon, but more importantly from now on refuse to invest in a company unless the articles permit you to sell!

I don’t mean sell willy nilly, of course.  Just make sure you do not agree to transfer restrictions that effectively preclude you from selling – you know, the sorts of clauses that require you to ask the board, wait six years for them to decide….etc etc.  Take a look at the pre-emption provisions – pre-emption is ideal for primary fundraises – you need this protection, but when it comes to selling they can be punitive. 

Interestingly the market survey I have undertaken for Asset Match recently has revealed that the secondary problem can be just as acute for early stage VCs as for private investors.  And because I have been putting the word out, spontaneously I have taken several calls recently from founders (especially millennial founders) who have 100% of their wealth tied up in their entrepreneurial baby, but really do need to get on with buying their first home. Interestingly, smart VCs like Balderton are disapplying pre-emption on founder shares (in a limited way) to help their founders and if Balderton will do it, shouldn’t we all?

Thinking and planning for a secondary solution needs to start with at the time of the first primary fundraise, as a later retrofit is hard.  Typically, the requests to start selling start to happen just at the time when management teams and larger investors are focused on growing out the business with a mind to a big exit; they have little interest in serving the needs of their fellow shareholders, but if the arrangements are already in place, everything becomes possible.   We need to end the behaviour, as I have seen, where a board of directors actively disregards the desires of small investors on the register “for their own good.”  This is not an approach to be admired.  

A significant advantage in putting in place the ability to sell, is that it will encourage the founding team to think about the investor relations issue.  After all, if they know their investors can sell they will not want them running for the door at the first possible opportunity.  And who will want to buy shares in a company that does not treat all, and not just some of its shareholders, with respect. This means the market will force companies to communicate better and be more transparent with investors.  Good!

I hope to see the rapid development of a new wave of Articles of Association which re-engineer the pre-emption rights, drag and tag along rights and transfer provisions which fundraising companies will need to adopt if they are to raise primary funding.  If not, we can expect the crowd and angel markets to choke up again and crash badly and die for a long time when the next big equity crash comes.  We need to address the issue quickly as the evidence is that the market is slowing already with EIS investment falling and deal volumes, according to Beauhurst, facing challenged times, despite all the growth in investor clubs and groups.

 

Lawyers, rise to the challenge please and give us better model Articles and Shareholder Agreements in future. If you want to find out about how you can help, give Stuart Lucas, the co-founder of Asset Match, a call 0207 248 2788, as he has some ideas to help you.

How to price a trade in the secondary market is fascinating.  Seedrs say they are going to go with a set price based on BVCA valuation guidelines (a very lawyerly approach reflecting the DNA of the founding team).  At the other end of the scale is a full stock market with market makers in place, like AIM.  And there is everything in between from bulletin boards, to matched bargain solutions to auctions.  Different strokes for different folks of course, but if all the buyers and sellers are in the same place at the same time, it is likely that the fairest price will be achieved.  The availability of market makers is one solution, although to earn their crust they will set a spread that can make the trade unattractive.  Auctions do much to address the challenges of relatively illiquid stocks that need occasional trading. 

When you think about which solution is best it is also worth thinking about the costs of the spread and the trading fees.  Stamp Duty is payable except on AIM and NEX Exchange so bear that in mind.  Settlement, if the shares are not registered on Crest, is a costly pain.  It’s not just processing the paperwork, it’s issues like KYC rules that apply before money can be transferred between the two parties.  All this takes time and needs people so as night follows day, bills are likely to follow.   Many investors I have spoken to have not ever had to think about these issues but they will have to now.

Fundamentally I believe in free markets, so inevitably I think that setting the price should be set by the market.  I am uncertain the Seedrs solution is workable and infers that investors will meekly accept this type of valuation even though the market price might be much higher or lower.  We will soon find out as investors will start to operate grey markets if they find the Seedrs pricing model too authoritarian. 

One thing is certain to be an ongoing debate.  Can platforms that actively promote primary fundraisings also act as a neutral secondary market maker or operator?   I am not sure they can in the long term.  If you are pushing a funding round for a new company but have responsibility (if not legal, then moral) for prior fundraisings for companies that subsequently trade at a lower price than people originally pushed the shares, you immediately have no credibility, especially if a large chunk of the other companies whose equity you have pushed have failed.   If you trade only some of the stocks you can be accused of favouritism.  If you do not offer full market coverage, your competitors will set up their own markets and it will be a race to the bottom on fees.

There is a reason why the London Stock Exchange was originally owned by all its members and then set up as an independent organisation.  As always Wikipedia provides some history which provides lessons for everyone!  https://en.wikipedia.org/wiki/London_Stock_Exchange

 

But back to the desires of private investors to sell.  Asset Match has produced a useful guide to selling your shares in private companies.  It explains all the options and is well worth a read http://bit.ly/am_business_angel_guide.  And if you send a copy to the board of the companies (and especially the founder) in which you have invested, you might just find someone willing to listen and to start serving your needs in tandem with their own.  And come along to share your views on the issue at The Great British Private Investor Summit on 25th May in London www.privateinvestorsummit.com.  

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