CREATING LIQUIDITY FOR EMERGING COMPANY EQUITY BY IMPLEMENTING A NEW MARKET STRUCTURE Can Berk Şen ANR: 877803 Supervisor: Patricia Gil Lemstra 2018 Table of Contents 1. Introduction ............................................................................................. 2 2. Paths for Emerging Growth Companies .................................................. 5 a. Emerging Growth Companies and Their Importance ........................... 5 b. Achieving Liquidity by Going Public ..................................................... 8 3. Secondary Markets for Private Shares in the Shadow of Major Public Markets .............................................................................................................. 11 a. Evolution of the Secondary Markets .................................................. 11 b. Current Regulatory Environment ....................................................... 14 i. Registration Requirement .................................................................. 14 ii. The Section 4 (1½) Phenomenon ....................................................... 15 iii. Rule 144 ......................................................................................... 17 c. The Functionality of Nasdaq Private Market (former SecondMarket) and SharesPost ..................................................................................................... 19 d. Rule 144A and Equity Markets Under This Exemption ...................... 23 4. A New Structure of Regulations for Secondary Markets ....................... 25 a. The Market for Emerging Companies ................................................ 27 i. Reduced Compliance Obligations...................................................... 28 ii. Reducing Litigation Expenses ........................................................... 31 iii. Listing Requirements ...................................................................... 34 b. Mature Company Market ................................................................... 37 c. Market for Delisted Companies.......................................................... 40 d. Private Securities Transactions ......................................................... 42 5. Conclusion ............................................................................................ 43 BIBLIOGRAPHY ............................................................................................ 45 1 1. Introduction Many growing small businesses depend on equity capital to finance their businesses1. These emerging companies can raise equity capital through four significant sources: angel investors, venture capital funds, private placement of securities, and public offerings of securities. Among these options, the amount of private equity funds raised in Europe has been increasing since 2012, reaching about 51 billion euros in 2016. Traditionally, private companies which use raised funds to develop their business and commercialize a business concept successfully, go public through an initial public offering (IPO). By going public, companies raise a significant amount of equity capital to boost their business, as well as provide its investors and employees with liquidity, since public markets offer a highly liquid market for those who want to sell their shares. However, the traditional route of going public through an IPO has become less attractive for the companies in the recent years, mainly because of the tight regulatory environment that makes it costly. Compared to the 1980s and the 1990s far fewer companies have gone public in the recent years. The IPO exits have been extremely rare for firms first financed after 1999 in the U.S., and as a consequence, there was an increase in the percentage of firms that remain private2. Meanwhile, in Europe, the value of IPOs in 2016 decreased drastically by 51% if compared to 20153. Public equity markets rely on young companies replacing the ones in decline, and investors and early-stage employees of emerging companies depend on the existence of a liquid secondary market to resell their equity4. In this context decline in 1 U.S. Gen. Accounting Office, ‘Small Business: Efforts To Facilitate Equity Capital Formation 1’ (2000). 2 Michael Ewens and Joan Farre-Mensa, ‘The Deregulation of the Private Equity Markets and the Decline in IPOs’ [2012], available at https://ssrn.com/abstract=3017610 3 IPO Watch Europe Annual Review 2016 (2017). PricewaterhouseCoopers LLC. Available at: https://www.pwc.co.uk/audit-assurance/assets/pdf/ipo-watch-europe-annual-review-2016.pdf 4 Victor Fleischer, ‘The Rational Exuberance of Structuring Venture Capital Start-ups’, UCLA School of Law, Law & Econ Research Paper No. 03-20 (2003). available at: https://ssrn.com/abstract=432840 2 IPOs is concerning, the alternatives to a public listing are not sufficient to provide liquidity. While the securities laws comprehensively regulate the way to go public and what is required from the firms to do so, regulations regarding secondary markets for securities in private companies are problematic and undeveloped. Shareholders of private companies can sell their shares under exemptions deriving from the securities laws, but these exemptions cannot provide sellers with sufficient liquidity, and contain investor protection loopholes. In the recent years, new platforms have surfaced for the sale of private shares, such as NLX or SecondMarket, but the regulations and the exemptions upon which these markets are founded are unsuitable to provide healthy liquidity alternatives. Companies that want to avoid the traditional IPO have other ways of accessing public markets without going through the IPO process, and without complying with the regulatory requirements needed for the IPO. For example, reverse mergers provide a backdoor for private companies to become a public one by merging with a public entity. However, taking an alternative route into the public markets has a set of drawbacks. There is a distinction between being just a public firm and being a public firm that trades on one of the premier exchanges.5 When a company fails to qualify for elite trading platforms, its shares are often relegated to be traded on the over the counter (OTC) markets. Even though recent innovations improved the quality of the OTC platforms, such platforms are still of low quality compared to established trading venues and remain as a poor alternative. They offer little liquidity and lack investor protection. Therefore, the alternative ways of going public are not a sufficient substitute for the firms. Regulation of the secondary market securities is clear regarding companies trading on the premier exchanges such as NASDAQ or NYSE, although, outside of that area, the regulations consist of a series of disconnected exemptions and rules that make little sense individually or together.6 As regulations are making traditional stock markets an unattractive listing venue, a suitable alternative has yet to arise. 5 Jeff Schwartz, 'The Twilight of Equity Liquidity' [2012] 34(2) Cardozo Law Review. 6 Campbell Rutheford B., 'Resales of Securities: The New Rules and the New Approach of the SEC' [2009] 37(4)Securities Regulation Law Journal 317-343. 3 The needs of investors and entrepreneurs on the topic of liquidity demand a broad rethinking of secondary-market regulations. To what extent can regulation help improve liquidity through equity for emerging companies? Liquidity problem of emerging companies is addressed in this paper by analyzing the existing exit strategies and regulations in the U.S., since the U.S. is the pioneer when it comes to equity markets and their regulations. A new structure for regulations which is responsive to the emerging companies’ development and evolution is proposed in order to provide investors of emerging companies with liquidity. Since my goal is to provide liquidity by regulating equity markets, crowdfunding is not included in this paper. In Chapter 2 of this paper, emerging companies would be discussed and the relationship between public equity markets and young firms would be analyzed in order to understand what made IPOs unattractive. Chapter 3 focuses on assessing existing secondary markets for private shares as a substitute for public equity markets. In this chapter I discuss the regulations regarding secondary markets for private shares, and make an in depth analysis of why they cannot provide a healthy liquidity platform for investors. In the light of these chapters, in Chapter 4, a new structure for regulations is proposed in order to provide liquidity for early-stage investors and shareholders of emerging companies. 4 2. Emerging Growth Companies and Liquidity In the recent years many startups and innovative companies have emerged by taking advantage of innovative and advanced technologies, and these companies play a significant role in the economy by creating more jobs. Considering that these companies are growing fastest during their early years, financing is vital during these early years. However, conducting an IPO to raise capital is hard to afford for these young companies because of its exorbitant costs. The Jumpstart Our Business Startups Act, or the JOBS Act is a law that aims to improve funding of young companies by easing many of the U.S. securities regulations. Emerging growth company is a new category of issuers created by the JOBS Act. In order to qualify as an emerging growth company, the company must have “total annual gross revenues of less than $1,000,000,000 … during its most