Public markets have inadvertently benefited from a long-standing rule against advertising private offerings. That rule is poised to change, and public market investors should be aware of how the change will impact them.
Most Angel and Venture Capital raises are completed under the safe harbor exemption of Rule 506 of Regulation D of the Exchange Act, which permits companies to sell securities to accredited investors without having to go through the expensive and onerous process of SEC registration. However, one downside to raising capital in this manner is that companies cannot partake in "general solicitation or advertising", which not only prohibits issuers from advertising securities offerings, but has led to private companies restricting almost all public communications when contemplating an offering, making the fundraising process incredibly inefficient.
Enter the JOBS Act, which was signed into law by President Obama in early April to significantly lessen regulatory hurdles small companies need to jump over to raise capital. As part of the JOBS Act, the SEC is required to amend Rule 506 to exempt companies raising money under 506 from the general solicitation ban. Although the removal of the general solicitation ban has been delayed (the SEC was supposed to lift the ban by July 4th, 2012), that change is now likely to happen in the upcoming weeks. Below are three important reasons why you, the public market investor, will be affected by the removal of the general solicitation ban.
1. Increased transaction volume going to the private market. Private capital markets have been growing rapidly in recent years, buoyed by the (private market) success of companies like Zynga (ZNGA), Twitter, Groupon (GRPN) and LinkedIn (LNKD). SecondMarket, one of the leading private exchanges, saw its transaction volume grow from $100 million in 2009 to $625 million in 2011, the lion's share of which were transactions with billion dollar tech companies. With the removal of the general solicitation ban, the volume of transactions facilitated on private exchanges will grow rapidly as awareness among the pool of potential investors will greatly expand. This expansion will become a virtuous cycle: As more issuers can advertise offerings on private exchanges, more investors will become aware of these offerings and commit more capital, which will result in more companies seeking these investors. As investors shift assets into private markets, the outflows are likely to come from public market equities, reducing aggregate demand for public shares.
2. Increased liquidity for private shareholders. When Groupon, Zynga and others made the decision to go public, liquidity for investors was an important consideration (among many other reasons). While a handful of private exchanges provided some liquidity for investors and other shareholders, the lack of scale in these communities limited the volume of transactions. However, with the lifting of the general solicitation ban, companies who go public to provide investor liquidity will soon be able to further delay the decision to go public, as private exchanges provide increased liquidity. This may result in adverse selection of public companies, as the best companies who can access sufficient liquidity in private markets will likely prefer to stay private and avoid the onerous disclosure requirements of being public. While this trend started in the technology sector, as more investors and more companies migrate to private markets, other industries like healthcare or consumer will likely follow.
3. Change in investor preferences. While the general solicitation ban will grease the wheels of change to private markets, the seed of public market discontent has been germinating for some time. PIMCO's Bill Gross and investor Nassim Taleb of "The Black Swan" fame have both recently come out expressing pessimism over the ability of any investor to generate alpha in public equities. In addition, incidents like the flash crash and the trading glitch from Knight Capital Group have further eroded confidence in public markets. While certainly not all investor concerns can be mitigated in the private markets, and other new concerns will arise, the private markets are better suited to the long-term buy and hold strategies that may no longer produce alpha in the public markets.
As an investor, it is critical to understand the shift to the private markets that the lifting of the general solicitation ban will facilitate. As private markets amass liquidity, the search for growth and alpha will increasingly come from private market exchanges, not public markets. Understanding how to play this increasing trend, whether through the public or private markets, is critical.
Additional disclosure: I am the founder and CEO of CircleUp, the largest equity-based crowdfunding site in the U.S.