ICOs, Tiny IPOs, & OTC Securities, Oh My …

Perusing the press, one might think that the investment universe is fraught with the perils of the Wizard of Oz forest, where Dorothy once famously declaimed: “Lions and tigers and bears, oh my!” My inspiration for this comment was a couple of articles published by Bloomberg on the topic of investing in small and emerging growth companies.

The first article, titled “Inside the Dangerous World of Tiny IPOs,” misses THE key point about Initial PUBLIC Offerings, whether the “listing” is on a National Market System exchange, on an OTC market, or leverages a more exotic mechanism such as an Initial Coin Offering: Early stage investing is risky. Many ventures fail, but the risk means that the returns from investing in the companies that thrive are markedly higher than later-stage investing. The second article, titled a more hopeful “Murky Corner of U.S. Stock Market Takes Step to Clean Up Fraud,” explains how OTC Markets and the SEC are (correctly) focused on ensuring that investors are aware of stock promotion schemes and that such promotion is truthful.

The point is that ALL early stage investing should be viewed through the same lens. Small IPOs, Initial OTC listings, private equity/venture capital investments, crowdfunding, and even Initial Coin Offerings (ICOs) are ALL ways for early stage companies to raise capital. In each case, there is a large risk of failure, that (theoretically) also carries with that large return potential. NONE of these methods should tolerate FRAUD, however; so whatever is disclosed to investors needs to be truthful, include obvious “red flags,” and not omit key information.

Some regulators, however, developed a habit of intervening using the “rear-view mirror” of asset performance to determine when to step in. This is problematic since all asset markets have had (and still have) their share of pure “story” stocks whose valuations can only be justified by the charisma of their founder or some variation on the “next big thing” story. If we learned ANYTHING in the dot-com crash, it should be that stock price appreciation is NOT conclusive proof of business viability, even when it continues for years. (And, conversely, a declining asset value is not proof of business failure is also true. There are many examples of long-term focused companies whose stock prices suffered while carrying out their strategies.)

The reason for this column, however, isn’t to criticize Bloomberg’s coverage, but rather to point out that there are some serious issues facing both issuers and investors in the emerging growth arena. Increased regulatory burdens and cost of litigation for listed public companies, coupled with the growth in power of venture capital and private equity funds as gatekeepers, with huge pools of investment dollars at their disposal, has led to both the rise of “unicorns” (private companies valued in multiple $billions) and a reduction in the number of listed companies overall. The result is a two-tiered market, where the elites with access to private equity funds can grow their wealth at a markedly superior rate to the general public, which lacks access to such investments.

To his credit, the goal of the new SEC commissioner, Jay Clayton, is to “enhance the ability of every American to participate in investment opportunities, including through the public markets” (“Remarks at the Economic Club of New York,” July 12, 2017), which should translate into an environment where regulators establish clear disclosure standards, but encourage all types of markets. As a result, “alternative” markets that the investing public have access to should also be encouraged, with clear regulation.

One example is the OTC equity market, as represented by OTC Markets, Arca, and emerging players such as the Delaware Board of Trade. Those markets can, in many cases, provide access to lower cost capital, with less dilution, than private equity or venture capital. This is why efforts by the SEC and OTC Markets as described by Bloomberg are welcome.

It is also worth a quick discussion of the evolving market for Initial Coin Offerings (ICOs). That market holds promise for the public to invest in both equity-like securities as well as in new, network value chains. ICO markets, however, are in their infancy and have been rife with tales of malfeasance and stories of deception. It is important to not “throw the baby out with the bathwater,” however, as there is value to the concept. ICOs provide an ability to firms to pre-sell their services as a way of funding development or to gain access to funding for the creation of distributed networks. This is a valuable concept, with the added benefit of providing opportunities to the public. The best way forward, therefore, is not to encourage “heavy handed” regulatory action, but focus on policing fraud while developing standards that match the rapidly evolving marketplace.

I want to make clear that the current SEC seems to be following this approach already. According to the DAO Token investigative report press release:

“The SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us,” said SEC Chairman Jay Clayton. “We seek to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.”

This is an approach worth applauding, and I hope it continues.