The Liquidity Crisis

There is a problem that is solvable when it comes to startups. It’s liquidity. Over the past couple of years, I have seen Fund of Fund managers like Chris Douvos, Michael Kim, and Lindel Eakman talk about this problem on their blogs. I have also seen funds like Calpers talk about the liquidity problem in articles and documents.

Why is it a problem?

If you put money in, and can’t get out, it’s going to disincentivize investing. That means less money flows to innovation. Less money into innovation and that means society doesn’t propel itself forward. In a capitalistic society, it is critical to have creative destruction.

It also means that ordinary people cannot invest their money in public companies that are innovative. They have to wait and that means they can’t build wealth as easily. This also might explain the ICO craze. Risk capital is being invested in it by non-accredited investors because they are prohibited from investing in private markets.

Why is there a problem?

This is not an easy question to answer. One clear reason is public policy. When the internet meltdown happened and Enron happened, public policy for going public changed. It became more expensive. Because of the expense, companies need to attain a higher valuation. Microsoft went public at under $1B.

There are plenty of companies in the market today that are highly innovative that could be publicly traded and open to public investment so the general population could build wealth. My friend Rendel Solomon is teaching young children about investing by having them buy one share of stock. Imagine if one of them had been able to buy a share of Facebook at a sub $1B valuation? Life changing.

I certainly appreciate the SEC and lawmakers concerns. But they have gone way too far insulating the public from the private marketplace. The other day on CNBC, Interactive Brokers founder Thomas Peterfly hypothesized that if Bitcoin were to crash in price it would likely take the broader stock market with it. How insulated is the market really?

Certainly, it didn’t ripple when Theranos, UBeam, Zenefits, and other companies blew up. They weren’t public and only hurt the private investors. But, would the market have stuttered had they been public? It’s hard to say but public valuations are a lot better than private ones. The frauds would probably have been exposed sooner rather than later and the fall would have been less precipitous.

I have been involved in deals where a new or existing investor is willing to buyout all the equity at a price.  They simply want to get more of the company and are willing to pay for it.

Recently, later stage firms flush with cash are rushing to buy the stock of companies that normally would be on an IPO track.  Softbank has spent billions buying up stock in Uber and WeWork.  Back in the day, some startup employees used to try and get liquid at places like Second Market.  I am all for people getting liquid but because of SEC rules, there are limits to how many outside shareholders you can have before reporting requirements change.  These sorts of transactions have extra costs that wouldn’t be there if US IPO regulations/policies were correct.  It also bugs me a little because the little guy has no chance to enter into a market like that.

The one bright spot is currently firms that are buying pre-IPO companies are working at the top of the market.  Eventually, I think they will start to go down the value chain.  Especially if they are successful in their current strategy.  That helps employees and early investors get out.

I think it’s important to note that seed stage investors all have different preferences.  Some are satisfied with a 3x return.  Some want a blowout 100x return and are willing to swing for the fences on every single investment.  Within angel groups or investment syndicates, it is often hard to accommodate those preferences.

If you are a startup that has been around a while and has proven the business but has early-stage investors who might like to get out there is a conundrum.  The business isn’t at a lofty valuation, but it’s clear you are growing and there is a need and there isn’t a clear reason why you’d want to raise more VC money.

  • How do you disclose sensitive financial and strategic information to a potential new investor without it being public potentially informing competitors or acquirers?
  • How do you even find these kinds of investors?
  • How do you stay private and not run afoul of SEC rules on investor number?
  • How do you make it so the entrepreneur keeps control and doesn’t have an adverse investor joining the pool?
  • How do you do the transaction so that the company’s business isn’t disrupted?
  • What sorts of fees are going to be tacked on, legal and transaction, which take a bite out of returns?
  • Are we comfortable with exposing the public to the risks of these sorts of firms?
  • How many investors are willing to buy the equity in a company knowing that the cash won’t go to growth?
  • How do you show the numbers in a standardized format?
  • What should the minimum enterprise value threshold be to even entertain these kinds of things?

You can set up a two-sided marketplace open only to accredited investors, but the above questions still remain.

At a bare minimum, a few things need to happen.  First, there needs to be movement on the policy side to make it cheaper to go public.  Second, private companies need to figure out a standard way to inform the market without disclosing information they don’t want out in the open for strategic reasons.

I think this is an issue we need to figure out.  A lot of public/private pension money is tied up in the startup world via fund of funds.  It would be nice for that money to flow back to the pension holders. For employees, it’s nice to get liquid. They can diversify their human capital risk and perhaps buy a home, pay off some debt, or invest somewhere else.  For angels/investors, it’s always nice to ring the cash register.  Figuring it out will be good for the startup community and more importantly, good for society.