Xpert Financial new SEC regulated Exchange for Private Companies

Yesterday, the SEC approved the formation of a new exchange to handle privately held companies.  Xpert Financial. There are two other companies trying to penetrate this market as well, Second Market and SharesPost.  All will be private markets only open to accredited investors.  It’s not entirely clear how companies will be chosen for listing, or the fees associated with listing them.  But, this is a very interesting layer to angel and venture financing.  If it develops it will be good for the angel financing industry.

One of the reasons for starting an exchange is Sarbanes-Oxley.  The cost for a company to go public went up tremendously because of the extra accounting costs mandated in SOX law.  These costs are a compelling consideration for a company like Facebook or Twitter to remain private, rather than tap the public markets for cash. In start up companies, cash flow is king.  SOX saps cash flow that could be put into other resources. Not to mention the changes that have to be made in internal operations to go public.  The entire accounting/reporting system needs to be overhauled and retooled.  SOX has put a damper on the IPO market ever since it’s inception.

Employees of many of these start ups might have the most demand for an exchange.  They are investing their human capital into the company, and many of them earn very little actual salary to do so.  They are paid in equity.  In the start up world, many times equity is cheaper than actual cash. If the firm remains private, how do the workers monetize their investment?  For a company like Groupon, they really don’t have much of a choice.  They can go to a bank and get a loan on their shares or wait for a bigger investor to inject cash into the company.  In each case, they take a pretty big haircut between the actual market value and realized value of the shares.  The reason for that is they are transferring quite a bit of risk from themselves to the new investor. There is a slight chance an exchange traded secondary market could help manage some of that risk.  It will just depend on liquidity.

Many times, a new investor will balk at the deal if original stakeholders are getting out.  The “greater fool” theory is always at play in investing!  In more developed start ups, this is less of a problem.  But, if you are getting in while others are getting out you better have a really good understanding of the forces at work in the industry to make sure you aren’t getting snookered.

It is also important to note that 99% of angel investments don’t do an IPO.  Successful angel investments generally are sold off to another business.  For example, in the health care industry, it can be far cheaper for a large firm to continually buy up smaller start ups instead of taking the risk on research and development themselves.  The high tech industry is continually evolving, so companies like Cisco become big M+A houses, internalizing new technology and putting it to work rather than engineering it in house.  For the entrepreneur, the transaction costs of simply selling to another company are lower than listing the stock publicly.  In addition, IPO’s can be a royal pain in the ass and really disruptive to the day to day operations of a company.  They sound more glamourous than they really are.

The angel investment space is largely unorganized.  In 1996, there were only 10 registered groups.  Today there are around 300.  You can find the top ones on the Angel Capital Association website.  In addition, in recent years there has been a development of super angels.  These are successful entrepreneurs that form a fund of one to invest in start up companies.

Can these exchanges make money?  That’s a great question.  Exchanges generally have pretty high fixed costs, and make money off of transaction volume.  In the short run, none of these markets will make money. The transaction volume is just too small.  The other impediment is since the companies are private, it’s much more difficult to engage in the same level of due diligence to ascertain whether an investment is a good gamble or not.  In the long run, if the entire market gets comfortable with the structure, they might be able to gain some traction.  But I think that the big VC’s and angels will have to participate with known companies for these exchanges to become wildly popular.

Currently, there are lots of great little companies out there.  But getting publicity on them can be extremely tough.  For example, I didn’t find out about a great little finance firm, Mint.com, until I went to the Hyde Park Angels sponsored Excelerate Labs Angel bootcamp last summer. Dave McClure was speaking and had a “mint.com” shirt on. After looking it up on a computer I became a customer.

It is highly doubtful that these new exchanges will bring order to the angel space.  It is just too amoeba like.  But, if the heavy hand of regulation continues to make the cost of going public high, more and more companies will try to keep their shares on the secondary private market exchanges.

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