Market Structure Evolution, Increased Regulation and the Decline of US IPOs
 

Regulatory tweaks and technological innovations over the last several decades have transformed the way companies raise capital and extended the benefits of early-stage investing to more people. Whether it was the decline in the American IPO market or the rise of online fundraising led by SeedInvest, capital formation has always been in flux. And now capital formation is on the cusp of another transformation, this time in a way that will make it possible for more companies to raise more money for a more diverse set of assets from a more diverse investor base. At the heart of this democratization of capital formation are crypto and blockchain technologies.  This article, the first in a series, describes how these technologies may lead to an explosion of a little-understood process called “tokenization” and as a result will expand private markets.  We aim to demystify tokenization (and in the process crypto and blockchain) and provide a practical guide for operators and investors, with specific information on its risks and benefits at each stage of the capital formation process.

The JOBS Act and the rise of private markets

The JOBS Act, “Jumpstart Our Business Startups,” passed into law in 2012, designed to facilitate other ways for retail investors to participate in growing companies, and for those companies to access capital. By some measures, it has been a success: private fundraises reached $2.4 trillion in 2017, having surpassed the public markets some years earlier.

Market Structure Evolution, Increased Regulation and the Decline of US IPOs in the Lead up to Tokenization

However, the JOBS Act has not brought about the return of the IPO. The chart above shows how new stock issuance remains at historic lows. Today, the number of companies publicly traded on US markets is half what it was, 20 years ago. Companies stay private longer; more end up merging with or being acquired by other companies. The “microcap” IPO, in the mid-to-low double digits of millions, used to make up most of the share of initial offerings on US stock markets. Today it is a tiny percentage of primary issuance, and its fall corresponds with a broader reduction in the number of companies going public.

The JOBS Act offered new options for those companies that didn’t have access to public markets, as well as for their investors. By some measures, it has succeeded: private markets have grown. However, its most ambitious regulatory exemption, Regulation A+, still falls short of its potential impact. Tokenization may change that, by enabling not a revolution in those structures, but a step forward in efficiency and improved optionality to trade in the secondary market. With tokenization, Reg. A+ and other JOBS Act exemptions have the potential to bring about a similar change–but in the opposite direction.

However, the JOBS Act has not brought about the return of the IPO. The chart above shows how new stock issuance remains at historic lows. Today, the number of companies publicly traded on US markets is half what it was, 20 years ago. Companies stay private longer; more end up merging with or being acquired by other companies. The “microcap” IPO, in the mid-to-low double digits of millions, used to make up most of the share of initial offerings on US stock markets. Today it is a tiny percentage of primary issuance, and its fall corresponds with a broader reduction in the number of companies going public.

The JOBS Act offered new options for those companies that didn’t have access to public markets, as well as for their investors. By some measures, it has succeeded: private markets have grown. However, its most ambitious regulatory exemption, Regulation A+, still falls short of its potential impact. Tokenization may change that, by enabling not a revolution in those structures, but a step forward in efficiency and improved optionality to trade in the secondary market. With tokenization, Reg. A+ and other JOBS Act exemptions have the potential to bring about a similar change–but in the opposite direction.

What is tokenization?

We’ll begin with a brief definition of what we mean by “tokenization.” For those who feel comfortable with that term and with crypto-assets and trust-minimized systems, in general, you can skip ahead to the next section without losing any continuity.

Tokenization means using a “token” or a cryptographically secured unique digital record, to establish ownership, and transfer of ownership, over some other form of value. That other form of value is then said to be “tokenized.”

The idea is one of many innovations in the development of crypto assets since the launch of the bitcoin network in 2009. Bitcoin’s core innovation is provable, digital scarcity, without the involvement of a central authority. Much as you own a hundred-dollar bill, or a work of art, you can own bitcoin; your ownership of that bitcoin and the sanctity of the total supply are both secured by cryptography. This is unlike ownership of a publicly traded stock or a bond, which requires the DTCC as an intermediary. Bitcoin and other tokenized assets require no central intermediary. For this reason, they are sometimes said to be “decentralized,” though many people who don’t like buzzwords prefer the term “trust-minimized.”

What tokenization can do for securities

Why not set up a DTCC-like entity to control secondary market ownership and trades? This market is much more fragmented than the public markets. Its participants are smaller; the costs of managing such an ownership record centrally are too great.

In the 1960s, Wall Street suffered a “paper crisis.” Trading in securities, recorded on paper passed physically between brokerage houses, reached 12 million shares a day. To solve the problem, the financial industry digitalized stock ownership; the Depository Trust Corporation (DTC) was created. Today, shares traded on the NYSE measure in the billions per day.

There’s no crisis forcing a similar digitalization of private, or unregistered, securities. But digitizing this asset category through tokenization could provide similar benefits in efficiency. Much as digitization supported an order-of-magnitude increase in trading volume for the public bond and equity markets, tokenization can do the same at the dawn of the secondary markets for unregistered securities. Unregistered securities carry more risk to the investor. Today, each secondary trade in these assets often involves the approval of a trust company, the approval of the issuing company, and consultation with a lawyer–not to mention a steep discount to the nominal price. To activate these markets, it’s necessary to get past all that. Tokenization presents an opportunity to do so.

Programmable ownership

Bitcoin’s ledger is mainly used to record ownership of bitcoin. But cryptographically secured ownership ledgers can record much more. Because it is digital ownership, it is also programmable ownership. In the case of tokenized securities, compliance–the terms of ownership and trading–can be encoded in the security itself, so that unauthorized or non-compliant transactions are blocked before they happen. Reducing the role of intermediaries lowers the cost per transaction to a point where it can be accessible to smaller issuers.

This efficiency also may allow complexity that otherwise would be cost-prohibitive. This includes secondary market trading in relatively small issuances of unregistered securities, in addition to transactions across borders. Investors from multiple jurisdictions across the globe can participate in primary issuance and secondary markets, buying, holding and trading under the rules that govern participation in their jurisdiction. In today’s world, that requires a lawyer for each jurisdiction. Tokenized securities could be traded in this way, with compliance in all jurisdictions governed by instructions encoded in the securities themselves.

How various stages of JOBS Act exemptions may be applied

The JOBS Act did not introduce a silver bullet for everyday investors, or for companies raising capital. But it did add a few new tools to the toolbox. Below, we list what some of those are and spell out the innovations introduced by tokenization. To be sure, some deals will be transacted as they always have: buy-and-hold sales of securities that are not intended for, and are often restricted from, secondary trading. However, tokenization introduces new choices into those deals, which investors and issuers alike will begin to rely on. As described in in the bullet points below, growing companies now have new options to add to those already supported by changes in legislation.

  • Regulation D: Privately held companies have been raising capital under the Regulation D exemption for a long time. It’s widely used in US venture capital, for example. The JOBS Act lifted two important restrictions:
    • D issuers may now market their fundraise publicly, without violating the terms of the exemption. This allows issuers to raise money over the internet, though only from accredited investors
    • D issuers may now sell securities to as many as 2,000 investors. That also opens the door to wider, less exclusive fundraising efforts

The key limitation of Reg D is that issuers must sell only to accredited investors–those with annual income over $200,000, or assets worth at least 1 million dollars, excluding the value of their primary residence. That limitation holds for a lock-up of one year after the securities are issued, after which time the securities can be sold to any buyer.

Innovation: With tokenization, Reg D shares can trade on a secondary market, without needing an intermediary to verify the accreditation status of each new buyer, time the lockup period, or ensure that the number of shareholders doesn’t exceed the cap of 2,000. That means there is potential for shares to trade across borders, with traders in multiple markets exchanging shares under the rules of their local jurisdictions, without the cost of an intermediary to approve those transactions, which would be cost-prohibitive for most companies.

  • Regulation CF: These small offerings are appropriate at the early stages of a company’s life, or the early stages of a new product. Like crowdfunding on non-equity platforms like Kickstarter and Indiegogo, they often come alongside other forms of private capital, like a Reg D round with angel investors or venture capital investors. Unlike Reg D, they are open to non-accredited investors. However, they are limited to a $1 million raise–a significant amount for a crowdfunding campaign, and a possible proxy for widespread interest, but not a meaningful amount of funding for many companies.

Innovation: Reg CF primary issuances operate much as it has previously under the JOBS Act before tokenization. Even now, there are multiple Reg CF exempt offerings under way on SeedInvest’s platform, offering individuals access to securities issued by companies, without accreditation or public company filing burdens. Tokenization will allow these investors to more easily trade on future secondary markets, allowing an early-stage investor to potentially reap the rewards of a prescient pick at the point of future rounds under Regulation D and Regulation A+, without having to wait for a company to go public.

  • Regulation A+: This is the closest thing to a silver bullet that the JOBS Act has to offer. It allows an issuer to raise up to $50 million each year, an unlimited number of investors and allows the participation of non-accredited investors. Recent changes, which SeedInvest was among those pushing for, allow US issuers to comply with national securities regulations, rather than a patchwork of state blue-sky laws. The Reg A+ filing requirements are less than those of an IPO, but are still a fairly high and expensive bar to clear. A Reg A+ offering can cost an issuer up to half a million dollars in fees, exclusive of the commissions and percentages of equity that the brokers of such offerings typically charge. That is why Reg A+ has not been widely used and its success record is spotty.

Innovation: Tokenization can lower the cost of running a compliant securities offering under the Reg A+ exemption. More importantly, it allows the benefits of a Reg A+ “IPO” without the pitfall. The chief benefit of Reg A+ is reaching a broad base of investors at a stage before a company is ready to go public. The pitfall is, the securities offered in such a way tend to do poorly on public markets. SeedInvest has seen success with projects that don’t go straight to list on a securities exchange, following their offering. Now, projects like these can offer their investors the option to trade, without the daily pressure of a market listing. Reduction in cost will mean Reg A+ is accessible for a broader range of issuers. They’ll be able to offer their investors improved optionality to trade in the secondary market, without “going public” too early.

Conclusion

In securities markets, tokenization represents an incremental change: modest gains in efficiency and interoperability that will improve markets, not revolutionize them. But in securities markets, these kinds of small changes can have a powerful impact. We saw that with the implementation of decimalization and stricter accounting rules, in the early aughts–and, some might argue, with the advent of digitalization itself, in the 1960s. Looking at the dramatic effect these modest changes had on the US IPO market, all but wiping out micro-cap issuance in a matter of years, it’s easy to see how tokenization could have the reverse effect: opening new capital raising options for companies at various stages of growth, and allowing a much broader global set of investors to participate.

 

This post was written by SeedInvest on December 12, 2019

Crypto, “Tokenization,” and the Future of Raising Capital


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