Is share liquidity a problem to be solved for crowdfunding investors?

After an admittedly late start, crowdfunding is certainly coming of age in Australia.

As was rightly pointed out recently by Birchal Co-Founder Matt Vitale, that Australian crowdsourced funding (CSF) platforms have raised $240 million for 320 start-up companies over the past five years is an unqualified success.

Accessing otherwise unavailable investment opportunities in high growth companies has proven to be attractive to retail investors who, irrespective of the lack of tax benefits enjoyed by wholesale investors, have been increasingly participating in equity crowdfunding campaigns. 

In Australia, around 10 million people own shares directly in ASX-listed companies, more of them do so indirectly through their super funds. In contrast, the number of Australians having invested in equity crowdfunding campaigns is estimated to be under 200,000. 

There is a strong argument that implementing tax benefits available to professional venture investors and allowing more flexibility around the type of investment securities would increase participation. Some argue that creating a secondary market in crowdfunding shares would also draw increased participation.

Whilst there is little doubt that more investors would participate in crowdfunding campaigns with increased secondary trading opportunities, any change to liquidity measures should benefit the entire crowdfunding ecosystem, not just the investors. 

Here are four areas for consideration when it comes to creating a secondary trading market for equity crowdfunding shares.

A medium to long-term investment horizon

When investing in early stage or growth companies, venture investors expect to hold their shares for a period of 5+ years. This timeframe normally allows for the company to fail or reach a significant value inflection point and create a liquidity event for investors, either in the form of dividends, sale of the business, or listing its shares on a stock exchange. Professional venture investors are provided with tax incentives such as the Early Stage Venture Capital Limited Partnership (ESVCLP) regime to compensate for the higher risks and longer time horizons of these investments. 

Companies raising funds through equity crowdfunding are not too dissimilar in nature to those funded by professional venture capital, and often require several years of development and growth before they reach their next value uplift. It is therefore important to the company’s growth and stability that investors fund these companies with the intention to hold their shares medium to long term. 

Not only does this provide for stability of ownership and predictability of control of the company, it also allows management to focus on growing the business, without distractions around secondary trading of their shares.

Growth companies are difficult to value

When venture investments are traded through secondary funds, the transactions happen between two professional investors with expertise and experience in valuing growth companies. 

There are a large number of unknowns in growth companies and even professionals can get it wrong sometimes. Trading the shares of crowdfunded companies would invariably occur with at least one of the parties (the original retail investor) not having the expertise to properly assess the value of the company. An inequitable transaction could negatively impact the retail investor together with the company. 

If investors liquidate for personal reasons independent from company performance, their primary consideration will not be valuation and they may trade their shares at significantly below the underlying value of the business. 

Crystallising valuation too early could be detrimental 

Once a portion of the company’s shares are traded, its entire valuation is crystallised. This could be great if there is a buoyant market with a lot of demand for the company’s shares. However, it could be detrimental if trading occurs in a thin market by distressed sellers.

The founder’s ability to raise future rounds of capital could be impaired and fund raisings may take longer, at less favourable terms, and by surrendering additional equity. 

Trading of the company’s shares in a thin market is likely to be incongruous from its performance. Irrespective of meeting customer acquisition, revenue, and/or profitability targets, shares may trade at a significant discount to their calculable value. The ASX microcap index is a very good proxy for what can happen to startups in a thin market.

Of course the opposite may also happen where shares get traded at a significant premium to the company’s underlying value, a scenario that is just as perilous to the ecosystem in the long term. 

Crowdfunded companies often provide additional benefits

The rarely discussed benefit of investing through equity crowdfunding is that shareholders may become entitled to discounts or free products pursuant to making an investment. Investors are often customers of the companies’ products or services already, and special discounts or product giveaways often accompany an equity crowdfunding campaign. How you value these rights when trading shares, if at all, lands the ecosystem with an additional complication.

Whilst proposals to tokenise crowdfunding investments, thereby allowing them to be freely traded on the blockchain, might go some way to address the issue of liquidity, this will require a significant shift in investor mindset and regulation, neither of which is likely in the immediate term. 

In the meantime, we must think globally and consider the best interests of the entire start-up ecosystem including investors, companies, advisors and intermediaries. Emerging businesses must be given the opportunity to succeed (or fail) in a timeframe that is realistic and not be put under the type of pressure that companies on stock exchanges are exposed to.

Secondary trading of shares acquired through crowdfunding should be limited to buy-backs or handled by regulated secondary funds similarly to the venture capital industry. 

The broader venture market exists to provide patient capital to companies that need time as well as money to grow. 

This is why professional venture investors enjoy tax benefits and more flexible investment terms.

If we want the same tax benefits and flexible terms made available to crowdfunding investors, we must be prepared to be similarly patient.