President Obama signed the Jumpstart Our Business Startups Act in 2012 to “help entrepreneurs raise the capital they need to put Americans back to work and create an economy that’s built to last.” The goal was to democratize startups – making capital available to diverse entrepreneurs in new geographies, including women and minorities outside Silicon Valley, for new business projects beyond high technology.

It has not worked. Capital has consolidated, not dispersed. And in Democratizing Startups, published in the Rutgers University Law Review, I explain why the problem runs deeper than anyone in Congress anticipated.

The consolidation problem

The net effect of securities regulations and market conditions is the opposite of democratization. Startup companies are encouraged to stay private, and staying private means capital consolidates in a few large, mature firms instead of recycling into new startups.

The evidence is striking. Once-rare “Unicorns” – billion-dollar startups – now number in the hundreds. More money flows into huge private companies, yet total venture capital investment remains flat. That means less capital goes to new startups. The innovation economy is being starved at the roots while its canopy grows ever thicker.

Startup companies are encouraged to stay private so capital is consolidating in large, mature firms instead of recycling into new startups. Evidence of consolidation is that once-rare “Unicorns” (billion-dollar startups) now number at least 170. More money is going into huge private companies, yet total venture capital investment is flat, so less is going to new startups.

The JOBS Act was supposed to fix this by making it easier to sell stock. But selling stock is only half the equation. Investors also need to be able to resell it.

The illiquidity trap

This is the core of my argument: the JOBS Act addressed issuance but ignored resale. It allowed startups to sell stock through crowdfunding and mini-IPOs, but securities regulations still do not permit the easy resale of that stock on exchanges.

Without secondary markets, private-company stock is “illiquid” – hard or impossible to sell after you buy it. This creates a cascade of problems.

First, the new small investors that the JOBS Act hopes to attract are discouraged by the inability to resell their stock. Established, larger investors have better access to off-exchange resale markets. Crowdfunding investors are stuck.

Second, staying private means capital is locked up in mature companies instead of being recycled into young ones. Mainly young companies create jobs. When capital cannot exit a company through a stock sale, it cannot flow to the next generation of startups.

Third, startup employees paid in stock options face a de facto non-compete. Their options are worthless until the company goes public, which means they cannot leave for a competitor or start their own venture without forfeiting their compensation. This distorts labor markets in ways no one intended.

Dark pools and offshore markets

Without legal secondary markets, trading moves to the shadows. Wealthy and influential investors who need to resell large blocks of private stock do so in “dark pools” – secret trading environments known to very few investors. These dark pools promote opportunism and fraud while providing none of the virtues of public exchanges, like price discovery and transparency.

The alternative is even worse: offshore stock markets. Some private company stock is traded on exchanges in foreign jurisdictions with minimal regulatory oversight. This exposes American investors to the exact risks that American securities law was designed to prevent.

I note that firms like SharesPost, FundersClub, and AngelList have attempted to create private stock trading platforms, but all operate under severe restrictions imposed by SEC no-action letters. SecondMarket shut out retail investors completely. The market is telling us that demand for secondary trading exists, but regulation prevents it from being satisfied legally.

The Rule 144B proposal

My solution is a new “Rule 144B” safe harbor – a regulatory provision that could be enacted by the SEC without an act of Congress. The proposal would permit transparent, web-based venture stock exchanges with two critical safeguards.

First, exchanges would employ fraud-prevention intermediaries that I term “independent analysts.” These are a hybrid of public stock analyst and venture capital manager – professionals who evaluate private companies and provide the independent assessment that retail investors need but cannot obtain on their own.

Second, the exchanges would operate publicly and transparently, eliminating the dark-pool problem. Price discovery would occur in the open, and all investors – not just institutional players – would have access.

Democratizing startups requires safe-harbor exemptions from securities regulations for both original issuance and resale of stock, but securities regulations do not permit resale on exchanges.

The 144B exchange provides both liquidity and investor protections. It answers SEC Commissioner Luis Aguilar’s call for “any and all viable suggestions as to how to improve the secondary trading environment for shares of small business securities.”

Why this matters beyond Silicon Valley

The illiquidity problem is not just a technical issue for securities lawyers. It is the mechanism through which the startup economy remains geographically and demographically concentrated.

If you are an entrepreneur in Pittsburgh or Atlanta or rural Iowa, your potential investors face a stark reality: any money they put into your company is locked up indefinitely. There is no exchange where they can sell their shares if they need liquidity, no market price to tell them what their investment is worth, and no analyst coverage to help them evaluate the company’s progress. Under those conditions, rational investors concentrate their bets on Silicon Valley companies with the highest probability of an IPO or acquisition – the only realistic exit.

Democratizing startups requires making startup stock liquid. And making it liquid requires building the infrastructure for legal, transparent, regulated secondary markets. The JOBS Act built half the bridge. The other half – the resale side – remains unbuilt.

If you care about broadening access to the startup economy, the fight is not over crowdfunding limits. It is over secondary markets.

Read the full article: Seth C. Oranburg, Democratizing Startups, 68 Rutgers U. L. Rev. 101313 (2016).