Are secondary markets the missing link in equity crowdfunding for startups?

Are secondary markets the missing link in equity crowdfunding for startups?

While the prevalence of equity crowdfunding has increased, investors have had very few opportunities to exit such investments. Thus, several equity crowdfunding platforms have started considering the development of secondary markets for buying and selling shares. Using detailed data from the world’s first secondary market for equity crowdfunding, we investigate whether plans to list on the secondary market increase investor participation and thus the amount of money entrepreneurs raise during their equity crowdfunding campaigns.

Most startups need money to grow. One way startups can access funding is by selling equity to the crowd through online platforms. For instance, the equity crowdfunding platform Seedrs has helped UK startups raise over two billion pounds since 2012.

While this is lucrative for the startups, the crowd –that is, the investors– are facing a problem. Since their money is tied in unlisted shares, investors are discovering that recovering their investments is not trivial. To sell their shares, investors need to wait for the startup to list on a public stock market or to get acquired by a competitor. This takes time.

To help investors “exit” their investments, some equity crowdfunding platforms are setting up secondary markets for buying and selling shares. But how do such secondary markets work? Would investors and startups welcome such markets?

Not a public stock exchange

A useful way to describe secondary markets for equity crowdfunding is to pinpoint their differences from the public stock markets. One key difference is how the market functions. While public stock exchanges allow automated trading, secondary markets for equity crowdfunding are often simpler bulletin boards –think eBay– where sellers post their interest to sell and buyers post their interest to buy. Another difference is the amount of publicly available information. While publicly listed companies must regularly disclose information to the public, unlisted companies face no such requirement. A third difference is liquidity. Unlike the public stock markets where trading is frequent, secondary markets for equity crowdfunding have generally little liquidity. Their small number of buyers and sellers means that opportunities to trade can be infrequent and ad hoc.

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While researchers know a lot about the public stock markets through decades of research, we know very little about secondary markets for equity crowdfunding. We took a first step to address this.

In an article recently published in Research Policy, we study a secondary market for equity crowdfunding that operated in Finland during 2014-2021. The secondary market was a collaboration between a local broker, Privanet, and an equity crowdfunding platform, Invesdor. Any company that had successfully raised equity on Invesdor’s platform had the option to become listed on the secondary market after the campaign. This setting gave rise to findings that surprised us.

More willing to invest and willing to invest more

First, confirming our intuition, we discovered that if entrepreneurs announce a plan to list on a secondary market, they are able to raise more money in their equity crowdfunding campaign. This finding supports the view that secondary market listings reduce risk for investors, since a listing renders investors’ shares more liquid. If investors believe they can sell their shares at will, they are more willing to invest – and willing to invest more.

Indeed, as we uncovered in additional analyses, liquidity seems key. When our focal secondary market matured, it turned out that the market was not working as expected: there was very little trading. Conjecturing that investors saw this and updated their beliefs about the liquidity of their shares, we compared the effect of a listing plan between the early and the later years of the secondary market. The difference in entrepreneurs’ fundraising gains is remarkable: when investors had reason to believe in the secondary market’s liquidity, entrepreneurs who announced a listing plan collected over 300% more funds. But later when illiquidity became apparent, the fundraising benefits of a listing plan disappeared.

Is listing your business risky business?

If investors value (liquid) secondary markets so highly, we would then expect most companies to list. But what seems to be happening is quite the contrary. Despite the potential fundraising gains, many entrepreneurs refrain from listing. We interpret this as a sign that a listing bears risks for the entrepreneurs. For instance, listing could backfire on the company’s capacity to raise more funds in the future. Especially if many shareholders are seen to be trying to sell on the secondary market, prospective future investors may interpret it as a bad signal about the value and quality of the startup. This turn may affect the startup’s reputation and thus its subsequent fundraising capacity.

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In sum, while secondary markets for equity crowdfunding may bring advantages to some investors and some entrepreneurs, they also entail challenges that make it difficult to generalize their development. One crucial problem is information asymmetry, a well-known problem in finance and one that is particularly severe in the context of unlisted startups. Information asymmetry makes trade difficult because it advantages the informed party over the other, which can lead to market failure. In the case of listed shares, regulators have solved this problem by ensuring that everyone has access to the same information. In equity crowdfunding, the only people to receive financial information about the startup are the shareholders, which currently leaves prospective buyers to make their investment decisions in the dark.

To conclude, when it comes to secondary markets for unlisted startups, the investor-platform-startup tripod faces a dilemma. Investors would welcome well-functioning secondary markets. But they currently lack the information to make informed investment decisions. Platforms are trying to fulfil their investors’ needs. But they are discovering the difficulty of implementing well-functioning secondary markets. Entrepreneurs enjoy the primary market benefits that secondary markets bring. But they face the risks associated with a listing. To address these tensions, regulators might need to step in.

Armin SchwienbacherProfessor of Finance, FAIRR Research Centre, SKEMA Business School - University Côte d'Azur, France

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Anna LukkarinenAs a Postdoctoral Scholar at Stanford University, Anna Lukkarinen is doing quantitative empirical research on entrepreneurial finance.

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