American small businesses don’t have access to primary and secondary equity markets. In fact, it was only 2012 that the SEC allowed this type of trading.

What are primary and secondary exchanges? Think a stock market for local economies.

Imagine an owner who started and worked on their business for four years. Early stage owners, founders, and operators have an impossible dilemma: invest revenue back into business growth or pay themselves.

Many entrepreneurs of the older generation will say: “any business takes two to three years minimum before an owner gets paid.”

In other words, an owner/operator puts goodwill into their small business. For many small businesses that goodwill never materials as a return on investment if they don’t achieve a certain size or scale of customers.

Further, when an owner wants to exit their firm, there is not an open market to sell their company. Without an open market, the owner loses significant value.

The owner/operator, they never recoup the years of sweat equity they put into the company. Small businesses are not entirely “illiquid,” they often do find buyers or investors. However, the lack of liquidity for small businesses is well studied in academia. The loss in value of small businesses is called the Illiquidity Discount.

The Illiquidity Discount

Noted Finance Researcher Dr. Aswath Damodaran from NYU’s Stern Business School published a survey of research into the impact of illiquidity on firms. Liquidity ultimately comes from an exchange or a capital market. Investors trade equity into the firm. Trading equities require that information about the firm distributed to investors. Exchanging information creates value for the investor, firm, and market.

For privately held firms the illiquidity discount is 20-30%! Further, within the range of privately held firms, firms that are larger and who have a possibility of going public in the future have a lower illiquidity discount. Smaller businesses suffer from the highest range of that discount.

Other factors that influence the illiquidity discount is whether a purchaser has controlling interest of the company and/or how much of the assets owned by the firm are liquid.

Large Firm Value and Venture Finance

A recent article from the Wall Street Journal casts more skepticism about WeWork, a New York-based coworking operator that recently branched into different product offerings such as a Code School and online Meetup Portal.

Like much of the recent writing about WeWork, the article notes the firm’s recent loss of nearly 2 Billion USD.

The company has raised Billions from investors such as Softbank’s Vision Fund. WeWork states that their business model is front-loaded with expenses that requires them to burn cash in the short-term but operate profitably in the medium to long-term.

WeWork posts impressive metrics such as being the largest commercial real estate provider in New York City and physical presence in major metros across the world.

However, WeWork is a company that could likely go public. Their illiquidity discount is lower.

Many smaller entrepreneurs look at the financial model of WeWork with skepticism and a sense of unfairness. Why can WeWork command a higher value simply because of its size? Younger entrepreneurs worry that these types of finance-centric business models can lead to too much growth too fast that ultimately erodes social value and could put the company at risk of collapse.

Addressing American Small Business’ Illiquidity Discount

Empowering small businesses with secondary markets offers three immediate benefits. First, and above all else, it allows American small businesses to utilize finance in the same way that large and scaling companies utilize finance.

Venture finance is approaching a crisis of confidence as early tech firms scaled in ways that externalized costs to society. Secondary markets remove the pressure of scale from aspirational firms.

Second, small business owners can recoup the goodwill they put into their firms. Small business owner/operators are largely building businesses with social or community impact. They are employers. Owner/operator should recoup their investment of time at the early stages of their business.

Third, secondary markets remove the discount for small businesses. Small businesses are no longer at a disadvantage compared to larger firms. A lot of speculation explores the recent decline of rates of entrepreneurship. Quite literally, starting a small business is a bad deal in the new economy.

A small business owner’s work is immediately devalued by 20-30% without a secondary market to trade ownership of the company.

Above all else, American small businesses can grow in value, quite literally overnight, by removing the illiquidity discount with secondary markets. Imagine the economic growth caused by a 20-30% rise in the value of small businesses!