Sunday, December 14, 2014

Can Crowdfunding Revive Local Stocks Markets?

Back in October, I wrote an op-ed that appeared in the New York Times about local stock markets. Specifically, it was about the passage of Michigan's Investment Markets bill, a novel new law that allows the creation of intrastate stock markets that would let Michigan-based residents buy and sell shares of Michigan-based securities. The idea of a Michigan-only stock market harkens back to the local stock markets that once thrived across the country, and helped their regional economies thrive as well. The Detroit Stock Exchange (pictured left) raised money for fledgling automakers, for example, while the The Honolulu Stock Exchange capitalized Hawaii's banking, communications and power infrastructure in the early 1900s.

In a strange coincidence, just days before my op-ed ran, a Pennsylvania paper ran a story about LanX, a proposed local stock market for an eight-country region in western Pennsylvania. I wrote about LanX and its creator, Trexler Proffitt, then an assistant professor of business at Franklin & Marshall College, in my book (as well as well as in the New York Times Magazine in the weeks after the financial meltdown of 2008).

At Franklin & Marshall, Proffitt had done some of the only real research examining the role of local exchanges in American economic development. He and a fellow researcher counted 28 regional exchanges created between 1830 and 1930, from Richmond to Milwaukee to Los Angeles. The number of exchanges rose in lockstep with U.S. industrial production. But their research showed that regions with newly established exchanges had a 175% increase in manufacturing jobs—the dominant employer category at the time and a proxy for economic growth, That compared to 76% growth for the nation as a whole. So the local markets clearly helped their local economies.

Most of those markets have since merged or closed. Today, many promising regional growth companies can no longer access the public markets, which cater to very large corporations (the average IPO size is around $140 million, up from $10 million or so twenty years ago).

Proffitt believed that a Lancaster area stock market could help provide capital to small but growing companies in the Lancaster area and add as much as $10 annually to the local economy. It was also a way to forge connections. As he explained it: "The idea was to let investors see the social impact of the company they were supporting, a sort of “Buy Local” approach to investing."

The news out of Lancaster, however, was that Proffitt, now a professor at Emory University, was throwing in the towel on LanX. The reason? Crowdfunding had made the idea moot.

“Since the energy went in that direction, I thought this is too much of an uphill battle,” Proffitt told the paper.

The purpose of a stock market is twofold: to help companies to raise money through initial public offerings, and then to provide liquidity to share owners by providing a place to trade those shares.

As Proffitt notes, companies can now raise money through crowdfunding as well as other alternative capital-raising methods, such as direct public offerings. Today crowdfunding is limited to offering non-financial rewards to contributors, as Kickstarter does, or "equity" (including stock, debt or revenue-sharing) to wealthy individual investors. While we wait (and wait) for federal regulators to finalize the rules that will open up crowdfunding to the general public, more than a dozen states have adopted their own state crowdfunding rules.

Michigan is one of those states. It's Michigan Invests Locally Exemption, or MILE, allows Michigan-based ventures to raise money by selling securities to residents of the state through crowdfunding. Michigan lawmakers see it as a way to rev up their state economy and encourage a new generation of homegrown companies.

But for investors to really warm up to crowdfunding, they need to feel comfortable that they'll be able to sell their shares should they need to cash out. As Proffitt told me in an email recently, "All those equity shares have to go someplace and if there is no way to do that, investors are stuck. They may not care, because the limits keep their amounts small, but sometimes we all need our money back."
That's why Michigan followed up its crowfunding law with the Michigan Investment Markets law: to give Michigan investors the comfort of knowing they have liquidity. 

It will be interesting to see where this leads. Could crowdfunding platforms, in addition to raising money, also be a mechanism for secondary trading? If so, crowdfunding platforms could turn into a sort of stock market for local, small and mid-sized companies that don't have the wherewithal—or maybe the desire—to go public on the New York Stock Exchange or NASDAQ. The hope is that these new age stock markets, at least at the local level, might provide a platform for long term investment and a sense of place, rather than flipping shares to make a quick buck.