A guide to secondary market for startups in Malaysia

It was reported last year that they are two regulated equity crowdfunding (ECF) platforms, namely pitchIN, and MyStartr that have applied to offer the secondary market feature. It was reported that pitchIN has received their in-principle approval and may likely be just a few of the ECF platforms in Malaysia that would be launching their secondary market f feature in the next coming months.

So what is a secondary market, how does it work, what are the risks involved for an investor, and why it is such an important feature, especially for crowdfunding investors?

What is a secondary market for crowdfunding platforms?

A secondary market in the context of an ECF platform is a trading platform that allows a crowdfunding investor to buy or sell shares hosted on an ECF platform. Before any ECF platform can offer this feature, prior approval from the SC will be needed. Any ECF operator that gets approved by the SC to offer such a secondary market feature is a pretty big deal considering the extensive rules and conditions that need to be satisfied before a platform may be able to offer such a secondary market to the registered investors.  It’s like running a mini stock exchange.

Why the secondary market is important for investors?

They are usually two common exits for an investor in a startup. The first is through an initial public offering i.e an IPO where the startup’s shares are listed and traded on a stock exchange (i.e. Nasdaq) and offered to the public to purchase the shares. The second is more common in this part of Southeast Asia where the shares are sold to another party (i.e can be a larger investor like a private equity fund or a corporate via an M&A or a buyout). An angel investor usually exits during a pre-IPO stage or earlier when a larger VC may come in and buy out the earlier investors.

Investing in a startup i.e. an unlisted company is inherently risky and challenging due to the lack of exit options. It’s a common belief in SIlicon Valley that any angel investor that wants to invest in a startup should be willing to hold the investment for at least ten years. Considering the long term nature of the investment, a lot of things can happen and may go wrong as well. The founding team may get into a dispute or the business may shut down for many reasons. In other words, you may lose your entire investment. 

As an investor, even if your startup investment is doing well, as an investor, you need to be able to sell your shares so that you can realise your profits i.e. capital gains from the disposal of the shares. If you’ve invested in a high-growth startup as an investor, you won’t be able to sell your shares easily because of this thing known as the illiquidity risk. Unlike investing in a public listed company that allows you to sell your Apple’s or Tesla’s shares on the Nasdaq, it is a big challenge faced by angel investors that wants to exit their investment in an early-stage startup. 

So a secondary market will let any crowdfunding investor put up his or her invested shares in an issuer (i.e. a company that has raised funds on a crowdfunding campaign hosted on an ECF platform) to be sold through such a secondary market i.e. a trading platform hosted by the ECF platform. This also means that anyone that missed an investment deal may be able to purchase the shares in a previous campaign by buying the shares from an existing crowdfunding investor.

What do I need to know before buying or selling shares hosted in a secondary market?

According to the SC’s guidelines, they are two conditions that will need to be fulfilled before shares can be traded on the ECF platform. 

1. The crowdfunding shares offered in the secondary market must come from a previous crowdfunding campaign

Only crowdfunding investors that have invested in past successful companies can offer their shares on the secondary market. For example, if you purchased 1,000 units of shares from an issuer during a crowdfunding campaign, you can only sell up to 1,000 units of shares in the secondary market. In other words, a secondary market cannot be used as an exit strategy by the founders of a startup as the shares permitted to be traded are strictly limited to only crowdfunding shares that were offered during the campaign period.

2. Complete at least six months’ moratorium period

You can only put up your shares for sale on a secondary market after six months from the date of a successful campaign. When it comes to the founders of a startup, there will be an additional six months period that will need to be satisfied before any of the founders can sell their shares on the secondary market.  

To recap, a private company can only have up to 50 shareholders. To resolve this impasse, ECF platforms have either set up a nominee structure  (i.e. a special purpose company formed by the ECF operator to hold the shares on behalf of the investors) (like pitchIN and Leet Capital) or to set up a legal vehicle (i.e usually formed as a limited liability partnership where crowdfunding investors will be made as partners in such an entity) each time for every new campaign to hold all or most of the entire crowdfunding shares by the new entity. 

If the ECF platform is already using a nominee structure, we should expect little actual paperwork that would be needed to be done by the startup’s company secretary. The traded shares may just be reflected electronically using the online database or ledger at the end of the trading day. Technically, there would only be the transfer of beneficial ownership but the legal ownership will still be held via the nominee as the holder of the shares (on behalf of the existing crowdfunding investor and future purchaser of the startup’s shares).

Since not all ECF platform uses the nominee structure, it is unclear how selling and buyer shares hosted on a secondary market trading for the crowdfunding shares held via a legal vehicle for such ECF platform will look like (as there is another layer of indirect ownership that was set up to facilitate the shares ownership).

What are the potential issues involving the secondary market?

They could be two main potential risks that may be when it comes to the secondary market.

1. Liquidity issues

Liquidity is a key measure of how well financial markets i.e. stock exchanges are working. It refers to how easily or rapidly shares can be bought or sold without substantially impacting the share price. So, even if you can sell your shares in a secondary market, we may not know if they are enough potential buyers that may want to purchase your shares. If there is not enough interest by potential buyers to be attracted to buy your shares, you may have to wait until there is a willing buyer or reduce the share price so that perhaps a buyer would buy your shares for you to realise your investment. So may likely incur a bigger capital loss if you liquidate your investment early.

2. Market or systemic risks

Since the secondary market is a trading platform, we should expect the usual ‘day to day’ fluctuation in a stock price (i.e. volatility). Since we will only know what the secondary market will be like in practice once any of the existing ECF platforms operationalise this feature, we may also likely have to expect a few glitches or confusion here and there as investors get used to and familiarised with the trading rules.  

As a startup, allowing for a secondary market feature to your investors may be an attractive exit strategy and perhaps will encourage more investors to invest in your company. As an investor, and for companies to raise funds on an ECF platform.

Disclaimer: Investing in an equity crowdfunding campaign is a risky investment. A startup you decide to invest in may not do well or even fail. You can lose part or your entire investment. For further details, please read the risk statement and disclaimer set out in the equity crowdfunding campaign carefully before deciding to invest in any crowdfunding campaign.

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