Release the tokens! Public access to private securities is poised to surge

A nascent market is now, for the first time, capable of offering public investors direct access to trillions of dollars in private securities.

By Clarence Schwab and Josh Friedlander

Key Points

• Regulated platforms have emerged in recent years that allow continuous trading of private securities.

• Private securities accounted for $2.7 trillion of new capital raised in 2019, more than double the $1.2 trillion raised for all publicly traded securities that year.

• Private companies and funds of all sizes can now sell new and existing securities easily and more efficiently.

• These regulated platforms automate recordkeeping and allow issuers to tailor securities in unprecedented ways.

Favorable Market and Regulatory Landscape

Would it surprise you to know that many of the largest investable markets still trade over the phone and in private meetings? While the internet revolutionized the trading of public equities in the 1990s, it has barely made a dent in the trading of private securities.

That is changing, driven by the emergence of digital platforms that permit private investments to be resold to the public and traded as if they were public company stocks. We discuss why this change is happening now in the U.S. securities markets, with a focus on the regulatory landscape, the issuers and investors likely to benefit, and how we anticipate these markets evolving.

The value of private asset securities is a large part of the value of the entire securities market. Recent issuance of private (i.e., unregistered) securities is more than double that of public securities. “In 2019, registered offerings of equity and debt accounted for approximately $1.2 trillion of new capital, compared to more than $2.7 trillion reported raised through all unregistered offering channels,” according to the U.S. Securities and Exchange Commission.

However, average investors can only watch as wealthy individuals and asset management institutions — including private equity, private debt, real estate, venture capital and hedge funds — invest in these opportunities.

This is despite regulation that has existed for decades which permits the resale of stakes in private companies from accredited (wealthy) to unaccredited (average, public) investors. Under SEC Rule 144, accredited investors can sell their private placement stakes to average investors after a one-year lockup period.

In practice, such secondary trading has primarily taken place among accredited investors and remains illiquid, opaque and cumbersome. This is, in part, because a company or fund generally needs to agree to any resales. The minimum investment amount is also generally quite high, often in the hundreds of thousands of dollars. Even if an investor gets a company or fund to agree that she can sell her interest, she may still need to find a buyer, and often must pay high transaction costs for a broker to help do so. She can expect to pay about 3% to 7% in commissions, and to offer her stake at a material discount.

The SEC cites this very illiquidity as a key concern in explaining the restrictions on average investors purchasing unregistered offerings in the first place. “Keep in mind that private placements can be very risky and any investment may be difficult, if not virtually impossible to sell,” the SEC warns.

While the SEC is looking to achieve expanded access to investments, it balances that objective with protecting the public. This regulatory caution has been a significant factor in holding back continuous trading of unregistered securities — trading that could mitigate the SEC’s concerns about their illiquidity.

As a result, new digital platforms have had to make the SEC comfortable that the clearing, settlement, transfer and custody of such securities is accurate and secure.

Nonetheless we are confident that the public’s access to such investments will grow within the next few years. In part, this is because the SEC has already approved a few alternative trading systems that allow average investors to own and trade stakes in private securities. And the SEC has recently signaled their willingness to consider other changes that further expand retail access to private securities.

What also guides this confidence is the SECs implementation of provisions in the 2012 JumpStart Our Business Startups Act (“JOBS Act”) and its recent November 2020 pronouncement harmonizing rules and further increasing offering limits.

Specifically, as part of the JOBS Act rollout, the SEC implemented Regulation Crowdfunding (Reg CF). As originally drafted, Reg CF set a $1 million ceiling on capital that companies could raise online directly from the public through an SEC-registered intermediary. Retail investors for the first time could invest more easily in a primary issuance of, and secondary trading in, private securities. Reg CF encouraged the launch and growth of crowdfunding platforms including peer-to-peer lenders. In November 2020, the SEC raised the offering ceiling to $5 million.

In that same regulatory update, the SEC increased the offering limit for Reg D 504 issuance from $5 million and $10 million. This exemption permits the direct sale of securities to unaccredited investors, and unlike most other private placement types requires no disclosures.

Importantly, the JOBS Act also legislated a significant increase in offering limits available to companies and existing shareholders under the existing Reg A exemption. The Reg A exemption permits the public to participate in primary issuances, and companies to issue new shares and permit existing shareholders to sell their shares, without the disclosure and cost burdens of being fully public.

As a result of the JOBS Act, in 2015 the SEC rolled out new Reg A limits, which allowed companies to raise up to $50 million (up from $5 million previously) and permitted existing investors to sell up to $15 million directly to the public. In November 2020, the SEC raised those ceilings again, from $50 million to $75 million, and from $15 million to $22.5 million, respectively.

From 2015 through the end of 2020, Reg A offerings have raised an estimated $3 billion. These offerings can list on regulated continuously traded platforms or on regulated national exchanges.

But the greatest opportunity to expand access to private assets involves larger and more established private companies and funds. These companies and funds typically issue securities under the Reg D exemption, which permits them to raise an unlimited amount of capital from accredited investors. In 2019, Reg D offerings raised approximately $1.6 trillion, $400 billion more than the combined public equity and debt issued the same year. After their one-year lockup, investors in such securities can sell them to the public under the SEC Rule 144 exemption.

Retail Trading Venues for Digital Assets

There are two regulated U.S. venues on which retail investors can continuously trade private securities. These are tZERO and OpenFinance, with tZERO being the larger platform by volume traded.

Both tZERO and OpenFinance operate approved broker-dealers with Alternative Trading Systems (ATSs) and are capable of acting as marketplaces for private securities. ATSs are defined by the SEC as “...trading systems for securities that meet the definition of ‘exchange’ under federal securities laws but are not required to register with the Commission as national securities exchanges if the ATSs comply with the conditions to an exemption provided under Regulation ATS.” To comply with the above conditions, ATSs must also be registered broker-dealers.

Two other trading platforms, Securitize and Figure Technologies, are planning to become active venues for continuous trading. In October 2020, Securitize completed the purchase of a broker-dealer and ATS, for which it received regulatory approval in November. Figure Securities, a subsidiary of Figure Technologies, announced this May 2021 that it had received SEC approval for an ATS and FINRA approval for a broker-dealer.

Some players in adjacent markets might become potential new entrants. These include INX Limited, which has signed a definitive agreement to acquire OpenFinance subject to regulatory approval. Large retail broker-dealers might also choose to enter the sector, as might secondary market platforms that now permit only accredited investors to trade private assets.

Examples of Securities Sold to Retail Investors  

There have been two significant examples of Reg D private placements resold to retail investors on a digital platform: tZERO Group and Aspen Digital.

tZERO Group originally offered accredited investors preferred shares in a private placement, and later permitted investors to sell their shares to the public. These shares now trade continuously on its tZERO marketplace.

Aspen Digital first offered accredited investors shares in a private placement that represent an indirect ownership in the St. Regis Aspen Resort, and later permitted investors to sell their shares to the public. These shares also trade continuously on the tZERO marketplace.

Separately, the first $75 million Reg A offering (for Exodus Movement) is set to provide its investors secondary liquidity on the tZERO marketplace, and possibly on Securitize, as early as July 2021.

We briefly examine below the problem tZERO Group, Exodus Movement, as well as Overstock.com, were each solving with their use of platforms that enable continuous secondary liquidity:

tZERO Group

Company: Management company overseeing digital asset brokerage and ATS facilitating issuance and trading of securities.

Security Type: Preferred stock (Ticker: TZROP)

Offering Type: Reg D private placement

Problem: Generate liquidity option for owners of TZROP shares.

Solution: Ultimately enable investors to list their non-public securities on a continuously traded marketplace on which all investors can trade.

Market(s) where traded: tZERO ATS

Significance: Validation that privately owned securities can be traded on a continuously traded secondary marketplace also open to retail investors.

Exodus Movement

Company: A software storage solution for cryptocurrencies and digital assets.

Security Type: Class A Common Stock (Ticker: EXIT)

Offering Type: Reg A

Problem: Raise capital.

Solution: Offer common stock using a Reg A exemption, which permits private placement directly to retail investors.

Market(s) where traded: Expected to begin trading on tZERO ATS and Securitize (provisionally) as early as July 2021.

Significance: Completion of this large Reg A validates raising capital from both accredited and retail investors at an accelerated pace as compared with an IPO process, and with a reduced regulatory burden. Exodus filed its offering circular on February 26 and closed its offering on May 5, a total of 69 days.

Overstock.com

Company: Publicly traded, tech-driven online retailer, which owns a majority interest in a portfolio of startups focused on distributed ledger technology.

Security Type: Preferred stock (Ticker: OSTKO)

Offering Type: Issuance of dividend shares to existing shareholders.

Problem: Increase participation and long-term liquidity on the tZERO ATS platform.

Solution: Overstock issued preferred stock as a dividend to existing Overstock common stockholders. For every 10 shares of common stock (“OSTK”) owned, Overstock issued one share of OSTKO as a dividend. These securities can only be traded on the tZERO ATS.

Market(s) where traded: tZERO ATS

Significance: Validates a method for distributing a customizable security. Also promoted the tZERO ATS platform to shareholders of the company’s publicly traded shares. To trade securities, investors originally needed to open a brokerage account with a broker-dealer that subscribed to tZERO’s ATS, but now can also open a brokerage account directly with tZERO.  

Issuers

Companies and funds of all types can benefit from issuing securities on the growing number of digital platforms. These range from privately held companies that have never issued a private placement of securities to private asset management funds and public companies.

Companies with poorly traded public securities may find advantages to listing on such continuously traded markets — whether illiquid preferred securities, illiquid debt securities, or common stock with very low average volumes. These poorly traded securities include those of companies that trade over the counter. And even the preferred and debt securities of some large companies that have high average common stock volumes could benefit from being relisted on digital platforms.

In addition, some asset management firms will find these platforms compelling. These secondary trading venues can provide the limited partners invested in their funds with the ability to easily sell their stakes, an offer of enhanced liquidity which might assist in fundraising. As with companies, digital marketplaces also permit funds to engage with entirely new retail and accredited investor bases.

For both companies and funds, securities issued on digital platforms can also lower compliance costs related to the shareholder register. In addition, continuous secondary trading can save managers time in not having to handle shareholder or limited partner liquidity on a one-off basis.

Customization and Branding

It should be emphasized that once the terms of private securities are digitally coded (making them “digitally enhanced securities,” as they are sometimes called), all changes in beneficial ownership and specific transaction terms will be automatically recorded. This automated process enables fast and accurate recordkeeping. It is superior to the non-automated process that now often accompanies private transactions. It also means that custom rules can be automatically applied and enforced to, for instance, limit shareholder concentration and limit trading to investors only in approved jurisdictions.

This customization can also be used to encourage customers to become investors, and vice versa. Research shows that customer-investors are even more supportive of brands.

A survey conducted online in 2020 by The Harris Poll found that among 2000 respondents, all of whom were individual investors, 80% agreed that “being a shareholder in a retailer, consumer product company or brand would make them more likely to be a customer of that company or buy their products.” In addition, “77% of individual investors would be more likely to buy shares of a publicly traded company if they were offered a shareholder perk, reward or product discount.”

In theory, it will be possible for companies and funds to curate the type of investors they might want to have trading their securities — offering “preferred securities for preferred customers,” so to speak. A company or fund could limit the initial sale of the security to its elite customers, or even create a security that might only be transacted among those customers, keeping that equity in the hands of a select group. The ticker and price of such an offering could be restricted and only seen by permitted buyers.

A security’s terms can also be customized to offer access to revenue, gross profit or income streams linked to specific products or projects customers engage with most.

Investor Engagement

It is logical to anticipate a surge in demand for private assets that can trade continuously. A proxy for this is the recent surge in retail investment in securities of individual public companies.

Retail investors opened 10 million new security brokerage accounts in 2020, according to an estimate by JMP Securities. In the first quarter of 2021, Fidelity Investments alone added 4.1 million new securities accounts (up 156.3% from Q1 2020), and Charles Schwab added 3.2 million new securities accounts.

These retail investors are choosing to trade in individual stocks and options, highlighting a big shift away from passive investing in stock indexes and exchange traded funds. In its latest quarterly review, the Bank for International Settlements examined the growing influence of retail investors, noting that “share turnover for exchange-traded funds (ETFs) tracking the S&P 500 has flattened over the past four years, while that for the S&P 500’s individual constituents has been on an upward trend during the same period, pointing to 2017 as the possible start year of retail investors’ rising influence.”

This dramatic move in retail investor behavior indicates their likely interest in tradeable private securities.

We also anticipate that accredited investors, hedge funds, venture capital firms and real estate funds might find these markets of interest, as they can participate as minority investors, seizing opportunities to allocate to continuously traded securities of private companies.

As previously discussed, some of these same asset management firms may also permit sales of limited partner interests in their own portfolios. There is already a robust institutional market for the purchase of investor stakes in the portfolios of private equity firms. According to McKinsey’s Private Markets Annual Review, these so-called secondaries funds more than tripled their 2019 fundraising to $87 billion in 2020. “Secondaries funds have now achieved something more like mainstream status in the eyes of many,” according to the report, demonstrating the attractiveness of secondary liquidity for buyers and sellers. In permitting their accredited investors to sell stakes to the greater public, asset management firms could engage with a much broader investor base, especially if they significantly reduce the minimum commitment required to become an investor.

What’s Next

Early adopters are likely to continue to be companies and funds like Exodus Movement and tZERO Group that already operate in digital markets. Companies and funds focused in all other sectors will follow as they become more comfortable with the listing process and depth of liquidity.

We also expect that new types of securities linked to non-fungible tokens and crypto assets will be approved, issued and traded on regulated platforms. 

As far as a large step, the SEC is seriously considering approving a new, fully digital exchange on which every existing publicly traded security could be listed. At this time, the SEC does not permit securities to trade using blockchain or distributed ledger technology.

At tZERO, for instance, securities, which they refer to as “digitally enhanced,” do not trade on chain and the shareholder register appears as a ”courtesy carbon copy” on a blockchain while clearing, transfer and custody are handled off-chain.

Nor do national securities exchanges (e.g., Nasdaq, NYSE) list or enable the trading of securities issued or transferred using blockchain or any distributed ledger technology.

In mid-2018, tZERO and Box Digital Markets entered a joint venture to launch a regulated security token exchange, BSTX. The SEC considered and denied the application in 2020. In April 2021, BSTX refiled an updated application that addresses the SEC’s comments.

Such an approval would permit a new blockchain-enabled exchange for publicly traded securities of all types. The benefits could include lower administrative costs, faster settlement, improved accuracy, increased transparency and 24/7 trading in all asset classes.

While such distributed ledger technology that is fully integrated with an exchange would be welcome, it is not necessary for retail investors to invest in private assets.

The new and growing market we have explored here offers private companies the potential to meaningfully expand their investor base, and provides existing investors significant liquidity they can use to finance other innovations.

This paper will be updated periodically to account for significant new developments. As of May 2021, this document refers only to developments in the U.S. market.

Clarence Schwab is founder and managing partner of Kronor Capital, which advises private companies and individuals on capital formation, investments, mergers and acquisitions.

Josh Friedlander is the former editor of Absolute Return magazine and former deputy editor of Euromoney Magazine.

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