The concept of the crowdinvesting secondary market picked up again this year as Seedrs and Crowdcube announced they would launch a secondary market for their funding. Since I am only active on Seedrs, I limit myself in my remarks to the Seedrs secondary market, which is officially still in beta.
The development of functioning secondary markets, where buying and selling are possible on a regular basis, I think is important for establishing crowdfunding as an industry in the long term. However, every platform that tackles this project faces major challenges: information asymmetry, resolution, pricing and liquidity.
Who can buy from whom? After all, the investor who already holds shares has an immense information advantage over every new investor. This information asymmetry could be exploited by an old investor to gain advantage in the sale. For example, he could sell his shares in a liquidity crisis of the start-up to the new investor, who knows nothing about this crisis.
Seedrs is currently solving this problem by allowing only existing investors to trade with one another. Consequently, the problem of information asymmetry has been circumvented, as all investors have access to the same information (should). At the same time, however, the circle of potential buyers was downsized and liquidity was withdrawn from the market.
A second way to address information asymmetry could be due diligence by the potential investor. However, this usually violates the contracts with the start-up, which commit the old investor to secrecy. On a large scale, the process of due diligence can only succeed if this process is controlled by the platform that operates the secondary market. However, I have not seen such a model yet, and probably will only be done with the approval of the financed start-up. So in this scenario, market breadth would probably suffer.
Pricing and liquidity
Should the price be set by a market maker or another third party or should the market functions determine the price?
When pricing through a market maker, the first problem is finding someone who wants to take on that burden at all. A market maker would have the problem that on the one hand, he has to set spreads that are attractive to investors, while at the same time holding a large default risk, as he has to hold a portfolio of shares, which also enables him to buy and sell shares at any time to be able to. The whole thing seems to me to be a small volume business with high operating costs, which seems very difficult to present. I do not want to talk about the potential risk.
If the price is determined by a third party that does not take the opposite side of the business, the question always arises of the ‘fair price’ and potential conflicts of interest. A third party, which is not the platform itself, should also, for political reasons, not follow a too different valuation approach than the platform. After all, investors would rush to the barricades if they were able to sell their shares in the secondary market, which had just been acquired on the platform through funding, for only half.
For the public market scenario, market depth may not be sufficient to create a liquid market that is similar to the public capital market. There would still be the variant of auctions where investors could bid on shares of other investors. This process could be similar to stock or bond issues with a fixed time and price window.
This is – I think – the current main problem on the investor side. Buying or selling non-publicly traded products always involves a lot of paperwork. In addition, for many investors, the legal complexity. In the worst case, the paper has to be sent several times by post, so that at the end of the transaction all the signatures are located where they should be. This creates on the one hand operational effort and also costs.
It would therefore be necessary to provide standardized processes and documents on the platform side, which would enable one-preferably completely digital-processing. Without these basic requirements, a halfway lower secondary market for the rather small-volume investments of the crowd investors should not be portrayed. The effort seems to most simply not justified.
Irrespective of the question of whether a crowdinvesting secondary market makes sense, it seems an extreme challenge to present it platform-wise in a way that satisfies all sides.
What is your opinion? What challenges are the platforms and / or investors still facing?