What is secondary market? Navigating liquidity in crowdfunding

A couple of years ago, reselling private equity investments was impossible because there was no secondary market to do so. Now though, it is becoming increasingly common for equity crowdfunding platforms to offer this option to their investors. Let’s explore or refresh the basics as to what this phenomenon entails.

How does the secondary market work

The secondary market definition is straightforward: it is a marketplace that enables investors to resell previously purchased assets.

The main idea of a secondary market is to enable investors to buy and sell stocks among themselves without involving the issuer in these procedures. The most popular secondary markets, such as the New York Stock Exchange, operate for the stock market, but in recent years, such markets were also created for the crowdfunding sector. 

Primary vs. secondary market 

The primary market involves the issuing of stocks. After that, the company issuer starts selling the stocks to investors.

Earlier, you could exit such an investment only in the following cases:

• if the company issuer gets bankrupt;
• if the company issuer goes public;
• when the company issuer is acquired by another business.

It may take years before any of these events happen. This is why such investments have always been considered highly illiquid. Also, according to the JOBS Act Title III, they could not be resold or otherwise transferred to anybody other than to the issuer, an accredited investor, or an investor’s family member for one year.

With the introduction of the secondary market, the approach to this investment type changed. The secondary market enables investors to exit their investments in stock earlier by selling them to other investors, which is seen as one of the main benefits of the secondary market.

Another benefit is connected with stock pricing formation. If the stock issuer sets the stock value in a primary market, it doesn’t work this way in a secondary market where the prices are impacted by supply and demand. If a company performs well and the market is dominated by positive sentiment, there are more investors willing to buy the stock, and this pushes the stock price upward. And on the contrary, if the company doesn’t perform as expected or the market is stagnating, investors aren’t willing to buy the stock, and its value starts declining.

How the secondary market works for crowdfunding investments

The secondary market for crowdfunding works based on the same principles, with the only difference being that investors sell and buy pre-IPO stocks and loans in the repayment stage. While things are clear with stocks, one may be wondering how someone may want to buy late or defaulted loans.

In crowdfunding, loans come secured with a mortgage on the property. With the majority of mortgages being first-rank, the maximum loan to value ratio that enables a platform to recover investments and investors – to still earn, even if the loans are defaulted.

When it comes to stocks, the seller and buyer share the returns in the event of an exit. The seller will get his return share based on the number of days the investment was held, and the buyer will get his share based on the same principle.

If a buyer purchases a loan with claims, all the claims are transferred to the buyer. Once a seller sells a loan with claims, he doesn’t have any right to any of the future payments.

The secondary market in equity crowdfunding and in P2P lending 

An opportunity to trade on secondary markets is regarded as beneficial by many investors and platforms. While earlier, equity crowdfunding was accessible to venture capitalists only, now, equity crowdfunding is changing it by offering options to invest in equity to a wider range of investors.

However, equity investments are illiquid, and this is one of the main concerns of those who cannot lock their funds in a project for years. The same applies to loans. Even if loans are secured by mortgages on top-tier property, one cannot exit such an investment asap, even in the case of an emergency.

Still, there are some cases when secondary markets become useful.

Pros and cons of the secondary market for investors and borrowers

While many platforms offer investors a secondary market option, it is still not as common because secondary markets have their benefits and limitations.

Benefits and limitations

Secondary markets offer investors exit opportunities for otherwise illiquid investments. By offering early exit opportunities, they facilitate the recirculation of funds by allowing investors to retrieve their funds and reinvest them.

If a secondary market operates efficiently, it can provide valuable information on the actual price of an asset which is highly beneficial for both investors and borrowers and help investors to make decisions on further financing. Secondary markets enable investors to buy a larger share in a promising company which helps to eliminate such an issue of most crowdfunded businesses as excessive ownership dispersion.

The main drawback of secondary markets is that they aren’t regulated as traditional stock markets are. In most cases, they match those willing to sell shares or loans with those willing to purchase them, and that’s it. Disclosure requirements to companies whose shares are sold are also absent in crowdfunding secondary markets, this is why buyers need to find out on their own all possible data about a company whose shares they intend to buy.

Finally, if when launching a crowdfunding campaign, a project owner declares his intention to list the stock on a secondary market, it may distract investors from the crowdfunding campaign. Also, if early investors start selling the stock on secondary markets, it may affect the project’s reputation negatively. Both factors may impact the project’s ability to raise the target funding, and its crowdfunding campaign will end up in failure.

What’s next for the secondary market? 

Having a secondary market with high liquidity is beneficial to crowdfunding platforms. It turns illiquid online investing options into liquid, facilitates the funds’ recirculation, and allows them to buy stock and loans at a discounted price.

However, the secondary market sector is still in its infancy stage and is not available on many crowdfunding platforms. With its development, equity and P2P lending crowdfunding may move to a qualitatively higher stage, so, hopefully, more developments in this sector are underway.