Secondary Markets Find Way To Buy and Sell Shares of Privately Held Companies

The boom in trading at private marketplaces like SharesPost and SecondMarket are catching the attention of investors — and regulators.


David Weir was using the Internet to act as a go-between for nonpublic companies and investors as far back as 2000. That was the year that the former JPMorgan & Co. technology banker joined OffRoad Capital, a small West Coast start-up trying to help private companies raise money online from individual investors.

At a time when interest in investing in Internet outfits was at a peak, OffRoad was highly successful. During its first year alone, the firm raised more than $50 million for a dozen-odd companies, says Weir, who was co-president and co-CEO. But when the Internet bubble burst in 2000, OffRoad — which in 1999 had raised $6 million in venture capital to get going — found itself in trouble. In May 2001, Weir left OffRoad, which was later sold in a fire sale to a New York private equity firm.

Now Weir is back on his quest. In November he was appointed CEO of SharesPost, a San Bruno, California–based marketplace for privately held securities. This time Weir is not alone. SharesPost is competing with a host of private marketplaces such as SecondMarket and exchanges like Xpert Financial and Gate Technologies to provide a place where investors can buy and sell shares in the current generation of hot Internet enterprises — Facebook, Groupon, Twitter and Zynga. These nonpublic social media companies currently have an aggregate valuation in excess of $100 billion, led by Facebook’s $50 billion valuation based on its most recent private financing.

The buyers and sellers on these private networks and exchanges are a varied lot. They include mysterious foreign investors such as Digital Sky Technologies, founded by Russian software entrepreneur Yuri Milner, and venture capital firm Kleiner Perkins Caufield & Byers, one of the high priests of Silicon Valley, as well as a slew of individuals and institutions that simply want in on the action. Even banking giants Goldman Sachs Group and JPMorgan Chase & Co. are using secondary markets to try to meet their own clients’ needs for private shares.

The frenzied activity in the private marketplace is drawing scrutiny from regulators — in particular, the Securities and Exchange Commission, which has been tasked with trying to apply securities laws that were written nearly 80 years ago. The SEC is being asked to act — to design a set of rules more appropriate to 2011, protect investors who are increasingly distanced from knowledge about what they are buying and make sure that companies themselves are not gaming their investors and regulators.

“I recommend that the SEC halt all trading in Facebook, Twitter, LinkedIn and Zynga stock since it invites speculation and further abuse, and that these companies must disclose their financial information to all holders of Facebook shares effective the end of year 2010,” a blogger wrote late last year on, an online network for entrepreneurs founded four years ago by journalist Bambi Francisco Roizen.


“Even if the SEC finds no wrongdoing or foul play in its investigations, the fact remains that many people could be taking unwise risks by investing money in companies without the proper knowledge about those companies’ financials,” wrote another blogger. “In proper investment rounds, VC firms and angels know all about the state of the new addition to their portfolio. Investing without knowing a company’s potential as a business is ludicrous.”

Despite the fearmongering, secondary marketplaces are creating a much needed alternative for firms looking to raise capital. The IPO market for venture-backed companies is in shambles. From 2004 through 2010 fewer than 400 venture-backed companies went public — an average of 57 companies a year — raising less than $40 billion, according to the National Venture Capital Association. Last year was a slight improvement, as 72 venture-backed companies went public, raising a total of $7 billion. And if the IPO market continues to languish, experts predict, the trades in privately held stocks could well exceed the $7 billion or so projected for 2011 by NYPPEX, a New York–based private market advisory, trading and research firm.

“You wouldn’t need a secondary market if you had a vibrant IPO market,” says NVCA president Mark Heesen. “These secondary markets are helping. You don’t want to starve your entrepreneurs. You just want them to be hungry.”

Companies like Facebook and Twitter don’t have to do IPOs; they can raise the large chunks of the capital they need outside the public markets. Smaller start-ups, not comfortable with prices in the current IPO market, are going back to their own investors for additional rounds of capital, waiting for public market conditions to improve. Still, the fact is that all these companies need capital — to make acquisitions, fund expansion, attract employees and allow investors to cash out.

The lines between the public and private markets have blurred. Companies are recognizing that being public isn’t key to their business existence. In the 1980s and in the 1990s, start-ups, especially in information technology, needed the public markets, says veteran New York investment banker and asset manager Sorrell Mathes. Young entrepreneurial companies involved in new technologies depended on Wall Street bankers to mediate their deals and equity analysts to help understand the companies and explain them to investors, notes Mathes, who had been head of emerging growth companies and technology investment banking at Merrill Lynch and chairman of Merrill Lynch Venture Capital before starting New York–based investment management firm Mathes Co. in 1997. Going public wasn’t simply about raising capital, Mathes adds, it also was a way to establish market presence. But with the visibility that digital media companies such as Facebook, Twitter and Groupon already have, they don’t need the public markets the same way companies in the past did. “The private equity market is becoming the financing vehicle of choice until companies reach $1 billion to $2 billion in size,” Mathes says.

The SEC first took aim at the private equity market in December when Goldman revealed that it planned to do a $2 billion private placement for Facebook. In what would be a transaction governed by Regulation D of the Securities Act of 1933, Goldman said it would invest $500 million of the firm’s money in Facebook and raise another $1.5 billion from institutions and wealthy clients whose assets it managed. Almost everything about the transaction met the guidelines, but then regulators found an obscure provision that required a nonpublic issuer of primary securities to make sure it did not have more than 500 shareholders. If the offering created more than 500, the nonpublic company would have to be treated as a public company and subject to all public company regulations, including financial disclosure.

Could Facebook prove that on completion of the financing it wouldn’t have more than 500 investors? Was it prepared if it went over the 500-investor rule to make the necessary disclosures required of a public company?

Facebook didn’t want to take the chance. Meanwhile, in mid-January, Goldman decided to amend the offering, reducing the amount to be raised to $1 billion, and to use another provision of the Securities Act: Regulation S, a safe harbor provision that exempts securities from U.S. registration requirements if they are sold only to foreign investors and not offered within the U.S.

Facebook and Goldman dodged the SEC bullet. But concern that large companies and large banks are finding ways to circumvent regulation has only intensified. Regulators, rule makers and securities lawyers all argue that the absence of disclosure and transparency is harmful, to both institutional and individual investors.

Prior to Goldman’s Facebook flap, the SEC had already decided to move in on private marketplaces. In December it sent information requests to several participants, including SecondMarket and SharesPost. It also is said to have requested information from investor groups such as GreenCrest Capital Management and Felix Investments that had formed funds specifically to buy private shares in Facebook and resell them. SEC spokesman John Nester wouldn’t elaborate on what the requests contained. The companies would only say they had responded to the questions and that the matter was settled.

Securities lawyers familiar with the SEC say that the commission bungled the investigation. The issue isn’t whether there are 500 investors — that question does need clarification — but whether existing regulations are too burdensome and costly for many companies wanting to go public. “There are too many unknowns,” one lawyer says. “What do we know about the investors? How reliable is the information? And what happens if there is a glitch? Where does the investor go for redress?”

Lawyers point to the fact that the private market exchanges have no incentives to curb excesses. Since their fees are based entirely on the value of the transactions, the more a company gains in valuation, the more the exchanges stand to gain. All these private market exchanges need to do is make sure that the investors are accredited, in the event that something goes wrong. And even then the SEC isn’t really vigilant, lawyers contend.

“There is the erroneous assumption that if an investor is accredited, he must be sophisticated,” says Steven Caruso, a securities attorney with Maddox Hargett & Caruso in New York. What the financial markets have learned in the last few years is that wealth doesn’t equate to market sophistication, says Caruso, who is chairman of the Financial Industry Regulatory Authority’s National Arbitration and Mediation Committee. There is nothing in the financial regulations that says that if you are rich, “you waive the rights to full disclosure,” he adds. Brokerage firms have a dual responsibility — to those who they raise money for and to those they sell the shares to, says Caruso: “The two obligations go side by side.”

The overriding concern, of course, is that this is another bubble, and that regulators’ failure to address the issues will reprise the market crash that followed the bursting of the Internet bubble. The private markets still are not fully equipped to handle questions about accreditation and legitimate investors. “They are not asking questions about where the money is coming from or who is behind the money,” Caruso says.

The specter of insider trading conspiracies also hangs over this community. It’s no secret that the IPO market has traditionally been an insider’s market. Underwriters — in spite of elaborate road shows — have placed many IPOs directly with “family and friends,” relying on them to publicize the offering and create the aftermarket buzz. During the Internet bubble it wasn’t unusual for venture capitalists and senior executives at many established IT companies to have routine distributions of initial public offerings, solicited or unsolicited. And now, more than ever, IPOs are distributed to an even more select group of buyers.

Veteran venture capitalist Alan Patricof believes that the entire system is broken. “Small companies simply can’t go public,” says Patricof, the founder and managing partner of New York–based Greycroft Partners. “The economics are not there.”

With the zealous prosecution of insider trading in the U.S. courts — although most currently involve hedge funds traders — many senior executives at these social media companies worry about transparency and rules about disclosure and insider trading. They are also concerned that full disclosure puts them at a competitive disadvantage with their rivals, many of which are still private, and with recruiting key employees.

Given the environment, very few entrepreneurs have the incentive to go public, says Patricof. In the business plans that he has seen since he launched Greycroft in 2006, “95 percent say they expect liquidity through acquisitions,” he says. “We need a new approach. Maybe we should go back to manual markets.”

SecondMarket Holdings is the brainchild of Barry Silbert, a former New York–based investment banker for Houlihan Lokey Howard & Zukin, a specialist in financial restructurings and bankruptcies. It was there, in 2002, while Houlihan Lokey was selling off pieces of then bankrupt Enron Corp., that Silbert came up with the idea to create an automated trading platform for private or restricted securities. He recognized that these instruments were hard to sell in person, not only because it is difficult to identify buyers but because the buyers — and the sellers — often prefer anonymity.

To develop the technology, which took almost a year to build, Silbert and partner Bradford Monks, a lawyer, raised $350,000 from friends and angel investors. In early 2004 they launched Restricted Stock Partners, an electronic trading platform that would allow buyers and sellers to conduct transactions with total anonymity. Silbert was quick to recognize the need to create a market for restricted securities in nonpublic companies, which were sitting with tens of billions of dollars in private investments. In previous decades companies such as these would gain liquidity through IPOs and acquisitions. But in the mid-2000s the IPO window was shut tight and the rate of small company acquisitions had slowed. Moreover, many employees in these companies were desperate to sell shares as well.

In 2007, Restricted Stock Partners raised $3.8 million in venture capital from New York’s FirstMark Capital to fund its expansion. (That year also marked the passing of Monks, who died of cancer.) In 2008 the company changed its name to SecondMarket and was operating multiple illiquid asset platforms, including the private market exchange. As the market in restricted shares boomed, SecondMarket added investors in Southeast Asia. In February 2010 it raised another $15 million — at a postfinancing valuation of $150 million.

Being the first private equity marketplace has been good for SecondMarket. Last year it did more than $500 million in trades in private companies, led by activity in Facebook. In the fourth quarter it reported total trades of $178 million, with Facebook accounting for 39 percent of the completed trades. “Venture funds represented a plurality of the buyers (more than 40 percent of completed trades), but hedge funds, mutual funds, asset managers and secondary direct funds continued to be active buyers,” SecondMarket reported. “High-net-worth individuals were very active purchasers as well, with nearly 20 percent of the completed transactions.”

In 2009, Thomas Foley, a sometimes entrepreneur and investment banker, met with venture capitalist Tim Draper, one of Silicon Valley’s most prolific early-stage investors, to tackle what he saw as the growing problem that companies were having raising capital. With Draper and several angel investors, Foley put together a $3 million financing to create Xpert Financial, a new enterprise to provide liquidity to privately held venture-backed companies and their shareholders. Draper’s brother, Adam, is a co-founder of Xpert Financial and runs its business development.

“I was worried about what was happening to entrepreneurial companies,” says Foley, who is CEO of Xpert Financial. In the 1980s companies that went public were on average six years old and had revenue of $20 million, he explains. In the 1990s the numbers had changed to ten years and $60 million. By the time the 2000s came around, they had increased to 12 years and $200 million.

“The nature of the liquidity event changed drastically,” Foley says. In the 1980s, IPOs accounted for almost half the exits. By the 2000s, IPOs accounted for only 10 percent of all exits. And although mergers are just as effective in creating liquidity, they also tend to alter the business and its management. Says Foley, “We needed to transform the landscape and come up with a way that companies could get liquidity without disrupting their businesses.”

The falloff in IPOs wasn’t just a problem for companies; it was also a problem for shareholders. Foley says he talked to entrepreneurs, venture capitalists, hedge fund managers and institutional investors, and they all were loaded down with shares of companies waiting to go public that they couldn’t sell. Foley’s solution: an automated trading exchange to trade private shares of prepublic companies.

It took more than a year and a half for Xpert Financial to satisfy regulators’ concerns that its alternative trading system would be in compliance with the rules governing trades in shares of nonpublic companies. Finally, in January of this year, the SEC approved Xpert ATS, an online trading exchange that resembles Nasdaq but deals only in restricted shares and accredited investors.

That month a fourth player said it was joining the fray. Gate Technologies announced that it had received $3.6 million in funding from a group of private investors. Gate plans to use the capital to expand its market infrastructure for providing an end-to-end solution buying and selling illiquid and alternative assets. “This additional capital is also a validation of interest in the electronic trading of illiquid and alternative assets,” Gate co-founder and CEO Vincent Molinari said at the time. “This successful raise provides us with the tools to respond to a high level of demand from the market.”

These are not the only players buying and selling restricted private equities. Small and relatively unknown groups such as San Francisco–based EB Exchange Funds, New York’s Felix Investments, J.P. Turner & Co. in Atlanta and New York–based GreenCrest Capital are among those buying shares of Facebook on these private market platforms and repackaging them as funds. EB, for example, requires investors to pony up a minimum of $100,000 to join its fund. In return, it charges a 5 percent participation fee and another 5 percent when the shares are liquid and distributed. (The SEC is reportedly investigating these specialized funds as well.)

SecondMarket and SharesPost have like-minded business models. They offer similar platforms and almost identical trading formats. And because they trade in restricted stock — shares that cannot be sold without cooperation from the issuing company — they have to work closely with the companies themselves. Both marketplaces say their strongest pitch is to CFOs. They are not only providing liquidity to these companies, their shareholders and employees but also giving them a means to decide who can own their shares.

To trade shares on SharesPost and SecondMarket, buyers have to meet accreditation requirements as laid down by the SEC: $200,000 a year in reported income or $1 million or more in investable assets. (For institutional investors, which now are an increasing presence on these platforms, meeting the accreditation criteria is a cinch.) Sellers don’t have to meet the financial accreditation requirements but still have to register and have the suitability of the shares they plan to sell vetted.

At SharesPost, once potential sellers register and indicate what they want to sell, they are contacted by a general license broker who makes sure that the post is accurate. Only then is the seller’s intent to sell posted. When buyers and sellers agree on terms, they sign a stock-purchase agreement and a third-party escrow agent — in SharesPost’s case U.S. Bank & Trust — informs the issuer of the shares. The company, under the right of first refusal, can buy back the shares or agree to the transaction.

The process of buying and selling shares on SharesPost and SecondMarket isn’t like a regular public stock transaction — it’s time-consuming and bureaucratic. Nonetheless, it served the needs of Greg Parsons, a former software engineer at Kayak, a travel search web site that has been toying with the idea of going public. Parsons had signed a standard four-year option agreement in 2004 when he began to work at Kayak. Parsons left in 2009 but kept his options. All that time Kayak was in play – a possible IPO, a potential acquisition target. But when Google announced last summer that it was acquiring Cambridge, Massachusetts–based ITA Software, which has built a rival shopping and pricing engine for the travel industry, Parsons was convinced he should sell. The process took several months, he says, but eventually he was able to sell his shares at a price that valued Kayak at $700 million.

In addition to helping engineers such as Parsons sell their private shares, SharesPost also has begun to create online sealed-bid auctions for Facebook, Twitter and LinkedIn. In December, for example, it offered 165,000 shares of Facebook to its members with a reserve price of $23 a share. If the bids fell below $23, the seller could withdraw its shares. The auction, which took place over a week, was oversubscribed, says Weir. Ultimately, the shares were sold at $25 each, raising more than $4 million for the seller and putting a value of nearly $57 billion on Facebook.

For the moment, both SharesPost and SecondMarket are trading platforms. They do not buy or sell the shares; they simply offer them for sale. In return, they receive a fee of 5 to 7 percent of the value of the transaction.

Everyone wants to get in on the private market action — even legendary venture capital firm Kleiner Perkins. In 2003 the firm invested in Friendster, a social network business that went nowhere. Subsequently, it refused to invest in Facebook. So, when in recent years it found its image as Silicon Valley’s investment trendsetter eclipsed by the likes of newcomer Andreessen Horowitz, it decided to crash the party. Beginning in 2008, Kleiner Perkins started investing in the later rounds of Groupon and Twitter even at their lofty multibillion-dollar valuations. In February it finally invested in Facebook— buying shares on the secondary market at a post-money valuation of $52 billion.

In January, Russia’s Digital Sky Technologies, together with Goldman Sachs, invested in Facebook at a $50 billion valuation. DST already had led a $135 million funding round of Groupon in April 2010, giving the two-year-old digital-coupon company an estimated valuation of $1.35 billion. DST owns 5.1 percent of Groupon, as well as 1.5 percent of Zynga, the San Francisco–based social gaming company. As of March 15, DST’s combined stake in Facebook, Groupon and Zynga had an imputed value of more than $1.7 billion.

The secondary market also has its day traders — those who want to own a piece of private companies before they go public or to simply profit from the ride. A JPMorgan private wealth manager says she bought shares in Facebook at a valuation of about $4 billion or so — because her clients wanted in — and then quickly sold at approximately a 60 percent gain. Another investor says he went to a Chicago broker to buy shares in Pandora, a digital-music provider, because he heard it would go public and wanted to get in before the IPO. “I’m just taking a flier,” the New York investor says. “But I know it will be a hot offering.”

When it comes to public market offerings, the SEC has focused on issues of disclosure and transparency. In the past, companies have had to postpone their offerings because regulators felt that too much information was public — and that they were unfairly promoting the issuances. Hence the quiet period, during which companies are required not to disclose their financials or their business prospects. Keeping quiet is a dilemma that the SEC now faces with social media companies — businesses that are interacting with their customers, investors and competitors on a daily basis.

“What you are seeing is a new reality,” says Morris Simkin, an attorney with Snow Becker Krauss in New York who has been involved in securities laws since the mid-1950s. “People want liquidity.”

But Simkin also believes that private market exchanges are helping to delay the public offerings of companies that are worried about the cost of doing an IPO — which is estimated at $5 million for smaller companies — as well as the cost of staying public. In particular, companies grouse about having to follow the arcane rules of Sarbanes-Oxley and deal with zealous prosecutors who are forever on the prowl for securities violations.

“Private market exchanges are a short-term fix, not a long-term investment solution,” says Joseph Cohen, the former head of investment bank Cowen & Co. Even if investors provide short-term liquidity to these companies, they still need to be public, Cohen argues, adding that the infrastructure to sustain a broad public market for emerging growth companies simply doesn’t exist.

But investors are believers in the longer term. The venture capitalists and angels that have stepped up to finance the development of private market exchanges say that the firms they are bankrolling are just the first step in changing the capital-raising process. Barring major structural and regulatory changes, they predict that the new multitiered marketplace — with both public and private trading venues — will provide the necessary liquidity for shareholders and use different regulatory provisions for different sets of players with different sets of needs.

SharesPost’s Weir believes that creating liquidity for start-ups is only part of his firm’s mission. Its real business is in helping later-stage venture-backed companies raise capital. Over the past five years or so, an average of $21 billion has been raised annually by venture-backed companies. Organizing this activity is both necessary and profitable, Weir contends. Selling secondary shares together with raising capital can be a sizable business, he explains, especially in an environment in which there are no specialized bankers and the population of public buyers of small technology companies is sparse.

Indeed, with tens of billions of dollars in venture capital being invested by institutional investors and angels, companies are not worried about capital. “Shareholders want reliable liquidity,” Weir says. “They just want to know that there is a window in which they can periodically sell their shares.”