Congress passed the RAISE (Reforming Access for Investments in Startup Enterprises) Act last December.
And hardly anyone noticed.
It gives legal cover to the buying and selling of existing private shares of startups.
That doesn’t seem groundbreaking. Employees and founders of startups were already selling their shares to institutional investors.
Yet the RAISE Act could go down as part of a critical one-two punch in the evolving legal landscape of startup investing.
Along with Regulation A+ (passed earlier last year), it begins to fix the one thing about buying private shares that – rightly or wrongly – makes many investors most uncomfortable.
The Big Missing Piece
The public stock market isn’t missing this piece.
It gives investors a measure of freedom and flexibility that the private startup market lacks.
It allows investors to change their minds and act accordingly.
And this missing piece sits at the core of price discovery in the public markets.
If you haven’t guessed by now, the big missing piece is…
Liquidity. From voluminous buying and selling.
The public markets have it. The private markets don’t.
Once you buy your private shares, you pretty much have to keep them. It’s very hard to sell shares you own – for a profit or loss – before a liquidity event (IPO or buyout) takes place.
And to understand why, here’s a little background…
No Longer Stuck in a Gray Legal Area
The resale of privately held shares wasn’t exactly illegal before RAISE came along.
But it existed in a gray area.
The SEC not only knew about it, but also provided interpretive guidance.
Security lawyers called this activity involving the resale of privately held shares the 4(a)(1-1/2) exemption (from registering the securities).
So don’t get me wrong, it never came close to rising to the standard of criminal or illegal activity.
But the SEC wanted to remove what residual legal ambiguity existed.
So it took the case law and its own interpretive writings on guidance and created an explicit code.
The new code introduced nothing hugely different from what was being practiced before the RAISE Act.
Prior to last December, an exemption was granted if…
- The resale was to a limited number of purchasers
- It was completed without public advertising or general solicitation
- The seller provides the purchaser with certain information regarding the company whose stock is being sold (the issuer)
- The purchaser is acquiring the shares for investment and not for resale (the purchaser is sufficiently sophisticated to evaluate the risks of investment)
- The purchaser also can bear economic loss resulting from the investment.
The new RAISE Act did add a couple of wrinkles, however.
Instead of referring to a “sophisticated investor” (whatever that means), the new code says the purchaser must be an accredited investor.
It also says the seller can’t be a “bad actor” (guilty of flaunting security rules, among other things, according to the SEC).
Nor does the new code mention “limited number of purchasers.” A nice deviation. If the number of purchasers is unlimited, sellers won’t be forced to target deep-pocketed institutional investors.
Instead of selling 1,000 shares each of a 5,000-share stake, for example, a seller can sell his shares to dozens (if not hundreds) of investors and still comply with the new law.
Helping Build a Strong Secondary Market
And that is exactly what a strong functioning private secondary market needs: many buyers complementing many suppliers.
We’re not there yet. But the SEC is moving in the right direction.
Current regulations allow individuals like startup employees to sell shares. But they’re not eligible to buy those same shares or, let’s say, the shares of their fellow employees.
The one explanation to this oddity – that it takes more sophistication to know when and at what price to buy than when and at what price to sell – doesn’t hold up. In fact, investors screw up all the time by selling at the wrong time at the wrong price.
What kind of market allows you to participate on one side but not the other?
Can you imagine being allowed to sell shares of Apple but not buy them?
What Does the Government Really Want?
Last year the government issued Regulation A+. The shares issued under a Reg A+ raise are available to non-accredited investors. They’re also unrestricted and freely transferable. Any restrictions imposed – such as transfer restrictions for a certain limited period – would come from the startups issuing the shares and not from the SEC.
There’s no reason why a healthy secondary market for these “private IPO” shares can’t eventually take shape.
And the new codification passed in December suggests that the government is willing to loosen the shackles that prevented anything more than a weak secondary market in private common shares from developing.
But by limiting this market to accredited investors, the government is also telling us that it thinks that nonwealthy Americans should stick to the Powerball because the secondary market for common private shares is supposedly too risky.
So, the government remains extremely cautious, but at least it’s moving in the direction of increasing inclusiveness.
That should continue. I bet that in five years’ time, we’ll be looking back at these first tentative steps as a turning point in Uncle Sam’s regulatory approach.
If I’m right, it’s great news for you.
Admittedly, cashing in your private shares any time you want is still probably a ways off. As is unloading your unwanted shares whenever you want.
The level of liquidity needed to create a robust secondary market of startup shares isn’t here yet. But with the passage of the RAISE Act and Reg A+, I can see that day coming.
In the meantime, the trend is your friend.
Accredited investors are slowly but surely being granted more power to do different kinds of startup investing.
Non-accredited investors are lagging behind but have finally been given the green light to invest in startups.
A robust and liquid secondary market is likely five to seven years away, in my estimation.
That seems like a long time. Progress will seem torturously slow.
But it’ll be here before you know it. Hemingway put it best when asked, “How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
Invest early and well,
Founder, Early Investing