Published on March 30, 2016
By David M. Freedman and Matthew R. Nutting
Crowdfunded equity investments are generally illiquid for two reasons: (a) the one-year holding period and (b) the lack of organized secondary markets for Title III shares.
Restrictions on Transfers of Title III Securities
The JOBS Act imposes a one-year holding period (with exceptions) on securities issued via crowdfunding sites under Title III. During that first year, you may transfer (sell or donate) stock or LLC membership shares only (1) back to the issuer, (2) as part of an offering registered with the SEC, such as an IPO, (3) to an accredited investor, or (4) to a member of your immediate family upon divorce or death.
The one-year holding period (with the same exceptions) applies not only to original crowdfunding investors, but to secondary investors as well. In other words, the restriction follows the security.
The main purpose of a holding period is to ensure that the first-level investors are not acting as “underwriters” who buy large blocks of securities solely to resell them in smaller portions at a markup.
Further, any resale of securities must be made in compliance with state and federal law. While federal securities law “preempts” state law requirements for initial offerings made under Title II or Title III (that is, state laws may not impose registration or qualification requirements on them), there is no preemption for subsequent transactions.
State laws are a patchwork of conflicting requirements. Some states do not regulate secondary sales; others permit them to be made freely if they are “isolated.” Some permit resales freely to institutions. Until state laws are coordinated, the ability to create organized markets for secondary sales of Title III securities will be limited.
In addition to Title III’s first-year restrictions on transfers of equity crowdfunding shares, as well as state law restrictions, the terms of your deal might contain further restrictions and/or obligations regarding transfers of those shares even after the one-year holding period. For example, you will be obligated to notify the issuer of your intention to transfer shares, including the name of the transferee (you are the transferor), the price per share (or other valuable consideration) if you are selling the shares, and the date of transfer. The company needs to know who its shareholders are. If the deal terms include a right of first refusal, you must give the issuer an opportunity to purchase the shares at the same price and on substantially the same terms by which you intend to sell them to a third party. Some deals (such as Series Seed) include terms that give other Series Seed investors the same right of first refusal, so the notification process can be more complicated.
It is also possible that a company would simply prohibit any private sale of shares for a specified period. For example, a company could include a provision in the organizational documents stating that no investor can sell his or her shares for 36 months after the offering date. These customized elements of offerings remind us of the importance of reviewing deal terms before you invest.
Secondary Markets for Crowdfunded Securities
Even after the one-year holding period, it will be difficult to sell most Title III securities because no organized secondary market exists, at least not yet.
A good definition of “secondary market” is provided by New York corporate and securities lawyer Mitchell Littman:
A secondary market transaction is “a negotiated private sale of securities of an issuer whose securities are not publicly traded. Some transactions are effected directly from seller to buyer, and in some instances one or both parties may be represented by a broker-dealer who earns commissions on the sale or purchase. Buyers and sellers may find one another through networking, their individual brokers, or intermediaries.”
Bloomberg reported that transactions involving sales of private securities by employees and angel investors reached a record $12 billion in 2013 and are expected to rise to $19 billion in 2014.
Secondary markets for Title III securities will emerge as securities crowdfunding grows and evolves. It is possible that some equity crowdfunding portals and broker-dealer platforms themselves will have built-in peer-to-peer secondary markets that let their registered investors trade the shares that they purchased on-platform. The Netherlands-based equity crowdfunding platform Symbid already does this. Founded in 2011, Symbid allows non-accredited investors to participate with a minimum investment of €20 (and is the world’s first publicly listed crowdfunding platform).
Regulation D equity crowdfunding, which is open to accredited investors only, has existed in the USA since 2011, and just this year—in January 2016—the first secondary market for Reg D crowdfunding shares launched: CFX Markets, based in Chicago.
CFX “provides an open and secure network to facilitate secondary market transfers of private securities in alternative asset classes,” strictly for accredited investors. It is owned by PeerRealty, a real estate securities crowdfunding platform based in Chicago, but it will list crowdfunded shares originating on dozens of other platforms as well, including PropertyStake (real estate), CrowdFranchise (franchises), and EarlyShares (real estate).
Significantly, the issuer of securities will not have control over the terms of any transaction (such as minimum share price, maximum number of shares, or restrictions on who may buy, aside from basic SEC rules) on the CFX Markets platform, as issuers do on existing secondary markets like SharesPost and Nasdaq Private Market (a joint venture of SharesPost and Nasdaq OMX).
Proposed Venture Exchange Law
Congress and the SEC are exploring the idea of allowing “venture exchanges” to facilitate trading of securities issued by small companies. The proposed Main Street Growth Act, for example, would permit venture exchanges to connect buyers and sellers of small-company securities, but not to process transactions between those parties. The act defines small companies as those—both public and private—with assets under $2 billion. Here is a link to the Main Street Growth Act [PDF download], sponsored by Rep. Scott Garret of New Jersey.
Not that securities crowdfunding isn’t growing like a patch of weeds already, but it should get an even bigger boost from the emergence of venture exchanges and secondary markets for crowdfunded shares. Many investors who might be reluctant to plunge into CF securities today, because of illiquidity, will feel a bit more enthusiastic about it as secondary markets emerge.
About the authors David M. Freedman, based in Chicago, has worked as a financial and legal journalist since 1978. Matthew R. Nutting is a corporate lawyer with the firm Coleman & Horowitt in Fresno, CA. Freedman and Nutting are coauthors of Equity Crowdfunding for Investors: A Guide to Risks, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, June 2015).
 See SecondMarket’s “Blue Sky Report” updated January 31, 2013.
 Mitchell C. Littman and Lesley A. DeCasseres, “The Secondary Market for Private Shares,” Littman Krooks law firm, New York City, May 2012.