This article, originally titled “The 180 Degree Turnaround in the U.S. Equity Markets: The Dividing Line Between Public and Private Has Been Breached” first appeared in the “Jumpstart our Business Startups Act (JOBS ACT) Guide compiled by VC Experts
Public and Private Market Divisions Blurring
For 75 years, the rules in this country governing capital formation for high growth enterprises have not changed. There are two categories … (i) public companies which float equity securities e.g., common stock in public offerings with shares publicly traded on various exchanges; and (ii) private companies financed by placements to a limited group of investors pursuant to exemptions from federal and state registration requirements, the shares changing hands infrequently until and unless the company goes public.
The division between public companies and private companies is no longer a bright line. A new entrant … HPPOs (hybrid public private companies)… has approved HPPO shares are not listed on the NYSE or NASDAQ but are traded on secondary exchanges. Companies, holding shareholders “of record” to under 2000 (up from 500), can remain HPPOs.
Per JOBS Act, Title II, private companies can go “public” online without filing any paperwork other than their pitch materials and, if an Advance Form D 15 days before the PPO (my word for a “private public offering”) launches on the web. The distinction between public and private is fuzzed over in the case of both the HPPOs and the investment process … PPOs vs. IPOs, the enabling Rule for PPOs being 506(c). In fact when and as the Reg A+ regulations are finalized, there will be three ways to go public and only one of the same, the conventional IPO model, involves filing Form S-1, etc.
The census of U.S. start-ups setting sail (nicknamed Gazelles) could triple in my view if each and all could access early stage capital, empowering them to make it to the next stage of the Conveyor Belt and then beyond, meaning into those precincts to which institutional investors have retreated.
The Internet is Redefining Private Opportunities
As a force of nature, the Internet is like the Mississippi River which finds its own way to the Gulf regardless of the Corps of Engineers’ attempts to influence the river bed with dikes, dams, channels, etc. Post a business plan and pitch book online and the Gazelles are immediately in front of millions of pocketbooks.
Can it be imagined that sophisticated investors would find it “dignified” to patrol the Internet for deal flow? Why not, given that VCs with access to the largest deal flow are the most successful? But, would anyone with connections in the innovation space waste time looking at deals on the Internet, where anyone can present? “Undignified” is too mild an epithet, as I pointed out to an asset manager who laughed: “Joe! 20 years ago, looking for a romantic partner on the Internet was undignified. Now everyone over 30 goes to online dating services to find a soul mate.” His response was prescient; platforms are lining up to chaperone Internet-enabled deal flow, functioning like dating services … like-to-like. [For the latest on online platforms see this webinar discussion].
The web will (presumably) be cluttered with deal flow but the smart guys will look for dating services focused on aggregating and packaging quality deal flow into buckets and arranging like-to-like exposure … the buy and sell side. Industry sector buckets will be comprised of, e.g., medical devices; solar and wind; digital media; foreign high tech companies moving to the United States; spin outs from academic labs; the back ends of syndicated angel deals.
Where do the skeptics come from?
Skeptics fall into two categories. The first, conventional scandal starved media forecasting that Rule 506(c) will become an avenue for fraudsters… the Nigerian Royal Family. Every time a deal craters, as many if not most do even in the best managed portfolios, that will be evidence that the retirement savings of Grandma and Grandpa have been wiped out. That forecast of doom will, however, be counteracted by news of a 10x return … evidence that investing in deals chaperoned and curated by platforms staffed with experienced personnel is significantly better than playing the lottery.
And secondly, the nay-sayers are also forecasting strangulation by regulation. They are particularly focused on the statutory requirement that issuers online take “reasonable steps to verify” that each investor in fact qualifies as accredited. Self-certification by investors no longer qualifies of and by itself as “reasonable.” Each investor will fill out a questionnaire but the parties undertaking a PPO need to undertake “steps” in one of two categories … three SEC-blessed safe harbors which call for proof of financial status … e.g., federal income tax returns from the investor or verification from their tax preparers, accountants, brokers and investment managers. There are also “principles based” steps and those are not outlined specifically. To many this barnacle may drive issuers away from 506(c) because it is too onerous and/or risky. Review my tax returns? Fuhgeddaboudit! There are also extensive complaints about the requirement (if it becomes a requirement) that Advance Form D be filed and that pitch material be contemporaneously sent to the SEC. Further, there are administrative issues … custody of cash and securities, for example; insuring that filings are timely made; specified legends applied to the pitch materials as they are circulated. And negligent violations threaten to put the issuer in the penalty box, unable to raise money per Reg D for 12 months.
Change is Still A-Coming
The fact, however, is that nature abhors a vacuum. To meet 506(c) challenges service providers are coming to the web and managing the processes on behalf of customers at prices which appear realistic and reasonable. Such resources, e.g. CrowdClear http://www.crowdclear.com, deploy computer aided tools which verify accredited status; take custody of securities; manage back office procedures such as filing forms on time, attaching required legends and so forth. They are equipped with complementary tools, VC Experts’ deal terms and valuation https://vcexperts.com/intelligence, which can lift the Gazelle above the crowd; empowering investors to find the Gazelles which fit their preferences, and vice versa. Moreover, both the U.S. and international stock exchanges are welcoming customers, both public companies and HPPOs, each operating the third leg of the stool … secondary trading exchanges for private companies. The NASDAQ acquired SharesPost and the NYSE is partnered with ACE Portal.
My forecast. A huge economic impact once the beta test, now underway, winds up positive. Assuming it is, who can afford to hold out? For a related video interview see ‘The Role of the Internet in Capital Markets’