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Sunday, 16 March 2014 22:00

Taking Stock: Intrastate stock exchanges could offer chance for liquidity for equity investors, but ‘huge barriers’ remain

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In the span of 32 days recently, the Michigan legislature took two pioneering steps, legalizing intrastate equity crowdfunding and proposing to set up stock exchanges where investors can trade their shares in Michigan-based companies.

But in becoming one of the first states to tackle crowdfunding, lawmakers’ bold steps forward have many in the business community taking two steps back to assess the many unknowns that exist. Experts don’t doubt the system will eventually work for some companies, but today, they see many practical challenges for firms that want to sell and list crowdfunded shares.

“There are a lot of people, including legislators, who are being told we need to do something about capital formation in the U.S. and let’s start here in Michigan,” said Jeff Van Winkle, an attorney with the Grand Rapids office of Clark Hill PLC. “Muddling through is what we’re doing.”

The federal JOBS Act of 2012 opened crowdfunding to equity investing by lifting a long-held prohibition on publicly promoting a capital solicitation. As federal regulators dragged out drafting rules for equity-based crowdfunding, Gov. Rick Snyder signed legislation in late 2013 that allows Michigan-based investors to make equity investments in Michigan-based small companies via crowdfunding. Michigan became just the fourth state in the nation to enact such legislation.

Under Michigan’s crowdfunding law, unaccredited investors can put up to $10,000 into a single issuer, while accredited investors can make unlimited investments. Issuers can raise up to $2 million if they make their financial statements available to investors and state regulators, and up to $1 million if they don’t.

While many heralded the new law as a unique opportunity for Michigan companies to raise capital, most agreed it represented only half of the equation.

“That’s sort of the front end, but what you really need (now) is a back end, and that is the liquidity that would help a small shareholder to be able to get their money out of the business by selling (their shares) to somebody else,” said attorney Shane Hansen, a partner and co-chair of the funds and investment services practice at Warner Norcross & Judd LLP in Grand Rapids.

In January, Rep. Nancy Jenkins, R-Clayton, introduced a bill that she says will complete the loop and provide a vehicle for those investors to sell their equity stakes. The bill would set up the legal and regulatory framework for intrastate stock exchanges to be regulated by the Michigan Department of Licensing and Regulatory Affairs.

Currently, the bill is pending in the House Commerce Committee. Among its early backers were the Michigan Chamber of Commerce, the Michigan Bankers Association and Michigan Municipal League, according to committee minutes.

Experts say the introduction of the bill — believed to be one of the first of its kind in the U.S. — reflects how lawmakers are seeking to modernize decades-old regulations for the digital age and the new way that crowdfunding enables small businesses to raise capital.

Without an exchange, investors could have a hard time finding a buyer for their shares. Even so, the stock exchange concept comes with “huge barriers,” Van Winkle said. While he likes the concept behind the legislation, he said the idea of an intrastate stock exchange has plenty of challenges.

Stock exchanges would differ from crowdfunding portals, which are only for small businesses to promote a solicitation, connect with prospective investors and raise capital. An exchange would enable those companies — after a successful capital raise — to apply for listing so shareholders could trade their shares.

Federal law requires stock exchanges to register with the U.S. Securities and Exchange Commission. An intrastate exchange could, however, seek an exemption from the SEC based on its low volume and, in so doing, alleviate the potentially burdensome registration and ongoing compliance costs, Hansen said.

Without the exemption, the cost of complying with federal securities regulations could potentially make an intrastate stock exchange financially unsustainable, experts said.

“But times have changed and so technology might be a way of doing this on a low-cost basis,” Hansen added.

The stock exchange could also look to partner with neighboring states on a regional exchange, a move that could create more trading volume and attract investors, but it would incur the cost of registering with the SEC and compliance costs, Hansen said.

Even then, an intrastate stock exchange may still struggle to sustain itself and attract brokers, Van Winkle said.

“It’s a small market. How are you going to make a living doing that?” he said.

The state must also commit resources to make the exchange work. In particular, operators would have to register with state regulators, who could void transactions conducted by investors who are later shown as residents of another state.

“It does represent a significant investment of state resources to try to make this happen for probably not more than one exchange,” Hansen said.

Then there are the practical concerns for both investors and small business owners who opt to join an intrastate stock exchange. An intrastate exchange likely would not attract institutional investors such as venture capital firms to acquire existing shares. Venture fund managers have generally viewed small businesses supported by crowdfunding as being too small for their liking, said Gregg Dimkoff, a finance professor at Grand Valley State University’s Seidman College of Business.

Equity-based crowdfunding is primarily suitable for entrepreneurs opening or expanding a business such as a bakery, restaurant, a specialty retail store or a small manufacturer such as a tool and die shop — concepts that don’t fit with angel or venture funding, Dimkoff said.

“The operative word is small, where $50,000 to $100,000 will really make or break them,” he said.

Allowing an intrastate stock exchange in Michigan is “one more piece of the pie” in altering capital formation, for better or worse, Dimkoff said.

Dimkoff also doubts a business seeking to raise capital through crowdfunding would attract more than a few dozen investors. That low trading volume complicates setting the price for shares traded on an exchange, he said.

“It’s supply and demand, but you’re relying on supply and demand when there’s not enough trading going on,” Dimkoff said.

Entrepreneurs will also need to learn to deal with a few realities of having a publicly traded stock, said Jeff Lambert, president and managing partner of a Grand Rapids-based public and investor relations firm that bears his name. His firm, Lambert Edwards & Associates Inc., helps 20 publicly traded companies communicate with investors on the New York Stock Exchange and Nasdaq markets.

Under Michigan’s new crowdfunding laws, companies will need to disclose information to shareholders and be prepared to handle the time and cost required to respond to shareholder inquiries, he said.

One of the biggest challenges for entrepreneurs will be communicating effectively with investors because that can have an impact on the value of company shares, he said. That’s not always easy for executives who like to operate in stealth mode.

“You’re talking about an entrepreneur basically opening their kimono every quarter or every month to say, ‘Here’s the profit, here’s all of the financials of our business.’ That’s a big thing to ask of a private company, particularly when the nature of [entrepreneurial companies] is often peaks and valleys,” Lambert said. “That’s a lot of scrutiny that people aren’t going like.”

However, an exchange could provide a way for investors to exit their investments prior to having their shares significantly diluted should the growing small business ever seek a subsequent, much larger capital infusion from new investors, attorney Hansen said.

“When more money comes to the table … the next round of financing is the White Knight that brings it and brings more, and that usually comes at a price,” Hansen said. “It’s just providing liquidity for small investors to be able to take their marbles and go home.”

Clark Hill attorney Van Winkle said he likes the concept of intrastate stock exchanges and considers the bill “a step in the right direction,” but he thinks the many unknowns will need to be answered as the bill goes through the legislative review process. He also questions how much backing the legislation will garner in Lansing. The bill for intrastate stock exchanges lacks the kind of momentum behind it that the crowdfunding bill had last year — in part because “the issues are more complex.”

The upside to setting up the exchange is that it offers investors a way to get liquidity that they could reinvest in other small businesses through crowdfunding, GVSU’s Dimkoff said. The downside: Michigan is on the forefront of the concept and “we’re kind of feeling our way through this” and navigating through unknown territory, he said.

“I do think 10 years from now, this will be an interesting capital markets experiment,” investor relations consultant Lambert said. “I think the stock market [will be] less of an end game and crowdfunding itself will be a source of capital, but it’s got a lot of bugs to work out at this point.”

Brian Edwards and Joe Boomgaard contributed to this report.


Read 6105 times Last modified on Sunday, 16 March 2014 23:34

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