Do we need a secondary market for unquoted shares?
Private limited company shares (or unquoted shares) can be bought and sold only in very limited circumstances. The government considers them too risky to be traded freely. Active investors historically preferred the more liquid quoted shares but IPOs have been off the boil for years. Is there a new alternative about to emerge?
A famous crowdfunding platform Seedrs is launching a secondary market making it easier for individual investors to buy and sell unquoted shares. But for the secondary market to work there has to be some stock, and for there to be stock, restrictions on share sales common in most private companies under their Articles have to be lifted. Is lifting restrictions on the transferability of unquoted shares the way forward?
We investigate what a secondary market would mean for the founders, angel investors and VC funds.
Unquoted shares cannot be freely sold without the positive step of setting out rights in the articles and or shareholders’ agreement. Private limited companies usually restrict transfer by imposing contractual restrictions on the shareholders. The idea is that the founders do not want to find themselves in business with someone they have not selected by approving the issue of shares.
This capital lockdown makes it unattractive for investors to put cash into the company if the prospect of exit is remote.
The debate is – would lifting the restrictions on the transfer of unquoted company shares make it easier for companies to access capital and for investors to expand their portfolios? Would it boost the economy?
What a secondary market could look like
Opening the market for shares would lessen the degree of control held by the founders. But there is the potential of opening up a pool of new shareholders bringing new ideas.
In an early start up environment any time not taking the offering to market is lost time. Modern investors usually demand regular financial and business updates which eat up precious time. High investor turnaround is likely to place a heightened admin burden on the already-stretched board making it less focused on the business.
The biggest benefit of opening the market for unquoted shares is that is removes the pressure to exit when the company is not ready to do so. Equally, a secondary market could deter new investors from participating in the future funding rounds if they can buy shares from existing shareholders. If an existing shareholder is desperate to realise his investment in an open market the value can be reduced and this can put the business into decline.
A share sale, unlike a share issue, does not generate cash for the company. As a result, the company may be left underfunded with a prospect of exit never coming true, to the detriment of the founders.
Implications for the angel investors
Lifting restrictions on the transferability of private company shares benefits the investors in many ways. Gone would be the days when exit, be it a trade sale, an asset sale, listing or even a buy back, would be the only way to realise value. Rebalancing a portfolio would become easier and a sinking ship faster to abandon. On the flipside, there is no way to force anyone, including the company, to buy the shares so if the demand isn’t there, there is no secondary market.
Increasing, the transferability of unquoted shares is dictated by the tax position of the seller. As a rule of thumb, a third party offer generates the best tax result for the seller which would be further facilitated if the shares were freely transferable. However, releasing shares to a secondary market also has implications for SEIS and EIS tax reliefs which will be lost if not held throughout a qualifying period. The tax legislation does not permit the roll over of SEIS or EIS tax relief. Is HMRC likely to relax the rules? The answer is unlikely unless the industry can point to demonstrable increased revenues for the Treasury which could be difficult.
Valuation of the shares would become an issue. Without a stock exchange to provide financial metrics, the shares would be traded at different prices. Would the potential buyers be entitled to confidential company information which the company’s directors would have to disclose? Given the individual bargaining power of different investors, a secondary market is likely to turn into wild west where the share price does not reflect the underlying performance of the company, therefore increasing transaction risks. There would need to be a system for moderation which immediately complicates the simplicity of a secondary market.
Half way house ideas can be made to work. For example, one idea is to create an informal market. A private company can regulate who and when shares can be sold and can regulate who buys the shares. A similar concept to good and bad leavers could be adopted. For example, investors who have special circumstances could sell shares to persons approved by the board. A few simple steps providing the sense of a safety blanket for investors could prove attractive. Of course, what would constitute special circumstances could take some debating. As would who the shares can be sold to.
Implications for venture capital
The introduction of a secondary market is unlikely have an impact on VC investment. VCs typically assume significant control over the companies they invest in and have the bargaining power to demand rights to sell shares. It is possible that VC managers would use the secondary market to bag a bargain.
Silver lining – SEIS, EIS and Investors’ Relief
In the absence of a trading platform for unquoted shares start ups and growth companies need an attraction. The government actively encourages investment into private companies through a range of tax reliefs, particularly Seed Enterprise Investment Scheme, Enterprise Investment Scheme and Investors’ Relief. The perks can be significant – up to 50% income tax relief on shares subscribed via SEIS and no capital gains tax on exit. But HMRC do impose holding periods for full tax relief. HMRC expect investors to be in for the long run.
Start ups and growth companies are a motor of the British economy. Investment contributes to new job creation and the knowledge economy. Unlocking the capital and encouraging a wider range of business investors is a goal to pursue. But care is required. The operators of a secondary market will have made their commissions before any business collapse.