One of the myriad tasks that modern finance accomplishes is to conceive of ways to make illiquid assets into something that is liquid.
For instance, 100 years ago a mortgage was an incredibly illiquid asset: A bank had little choice after issuing a mortgage other than collecting its monthly payments until the homeowner sold the house, defaulted, or paid it off. A bank that made its bread and butter financing houses in its community exposed it to an immense amount of risk if the community’s economy were to suffer a downturn or see a collapse in home prices. As a result, down payments were large and banks limited loans to relatively well off households.
Eventually, banks began to securitize home loans and sell the monthly flow of mortgage payments to investors, which made their business much safer and—not coincidentally—made it much easier for homeowners to obtain a mortgage.
A modern version of this phenomenon is evidenced in the secondaries market, which have become common in Silicon Valley. Here is how they work: An investor who puts money directly into a startup receives a share of the company negotiated at the time of his investment, with the understanding that there won’t be a formal market for his share until the company does its IPO.
There’s a good reason for this insistence of a long-term attachment; for starters, it insulates the founders of the company from short-term pressures to compromise their business plan for a quick buck and reduce potential long-term returns.
Just as importantly, the long-term investment encourages investors to have a more hands-on approach to such investments; if the startup falters, the investors are more likely to roll up their sleeves and offer advice and counsel if they can’t easily cut their losses and leave.
The fact that venture capital investors tend to be more hands on than the typical stock market investor is beneficial to everyone: the investor offers his skills and experiences and not only stands to help the company—and his investment—but he also learns more about the company as well, and is in a better position to make a sensible decision with regard to his investment.
While there are good reasons to encourage long-term investing, we don’t necessarily want such investors to feel that their wealth is stranded indefinitely.
It’s also worth noting (as I recently did) that a succession of laws has made IPOs costlier and more difficult to do, so startups have been taking longer to advance their company to an IPO. Some have startups have postponed that stage indefinitely, choosing to avoid the increased regulatory and reporting strictures that the SEC imposes for as long as possible.
This can create a problem for some investors, who may need to diversify their wealth or put a greater portion of their assets into something more liquid—even if (or especially if) the company is doing well: investors don’t want to have the majority of their holdings in one company,…