Secondary Markets: Much Needed Liquidity For Silicon Valley Startups Or A Private Stock Market For The Rich?
Tuesday afternoon I was in the "Gulag," the warren of Venture Capital firms along Sand Hill Road, to attend SharePost's conference on "Market Issues & Opportunities for Private Companies."
The conference room was packed and for good reason. The lack of IPOs over the past ten years has created a liquidity crisis: how do investors and entrepreneurs get some of their money out of their companies, many of whom are profitable enterprises?
SharesPost, which was founded by Greg Brogger in early 2009, offers a solution: a private stock market for privately held shares where wealthy, accredited individuals can buy and trade shares held by Angels, VCs, and employees of startups.
This secondary market has become controversial in several respects:
-It is a private stock market that the public cannot participate in but it's the only way to buy stock in hot companies such as Facebook or Zynga.
- There are grey areas where the Securities Exchange Commission has no clear regulatory powers but which might result in new rules.
- There are many potentially serious issues around insider trading, accounting, and tax and legal liabilities that have no clear precedents.
- It has created a divide in the VC community where investors are concerned that their startup entrepreneurs will cash out too much of their holdings, and that their motivation will become "misaligned" with the interests of the investors.
Joseph Grundfest, a former SEC Commissioner, and current W.A. Franke Professor of Law and Business at Stanford Law School, presented the keynote. He made a strong case for bridging the "chasm" between growing a startup and preparing it for an IPO.
He said that current laws and regulations governing private secondary markets are aimed at protecting the public from being duped and defrauded. But if the investors are wealthy, they are considered "well informed" about the risks and therefore no additional regulations protecting the unwary, should be required.
A healthy secondary market might also lead to companies remaining private and avoiding all the expense of going public, such as Sarbanes Oxley and other regulatory compliance costs. These can be a big burden for young companies.
There were several panels on the various issues surrounding these types of deals. Here are some of my notes:
- Steven Bochner, the CEO of Wilson Sonsini Goodrich & Rosati - Silicon Valley's top law firm, talked about the need for some clarity from the SEC on key legal points. He said that the current rules state that buyers of private shares have hold them for at least one year, while SharesPost would clearly like to have a more liquid marketplace. This should be changed.
He also warned of insider trading lawsuits. He cautioned VCs that sit on boards, not to attend board meetings, hear something material, and then trade shares afterwards. He said that there will be insider trading prosecutions in secondary markets, and that plenty of smart people get caught all the time in publicly traded companies. Private companies must adopt insider trading policies now.
Dixon Doll - a former chairman of the National Venture Capital Association and a leading VC, said that secondary markets had brought some relief to the VC community. He said that two years ago, there were many complaints about the lack of liquidity. It can take as long as nine to 10 years for a company to IPO or be acquired when it used to take three to five years.
He said that ten years without any liquidity puts an incredible strain on a company's management and investors.
Ian Sobieski, managing director of Band of Angels, the leading Angel investor group, and an advisor to SharesPost, said that secondary markets had opened up new investment opportunities for Angels. He said he was now able to invest in Facebook, when two years ago his choices were limited to early startups, or public companies.
But he said that it was unlikely that Angel funding for startups would be affected. This is good news because Angels have taken over the early stage investment rounds and have been playing an important role in keeping innovation going in Silicon Valley, making sure that there is a crop of investment opportunities for the larger, later stage VC funds.
- Greg Brogger, chairman and president of SharesPost, said that the trading platform was designed from the start, to avoid any potential issues with regulators, and that lawyers from Wilson Sonsini had looked at every detail.
He added that SharesPost is being proactive and had asked the SEC for clarity on some key issues.
- Scott Painter, CEO of TrueCar, said that he had chosen a lifestyle as a startup CEO and that he was always sacrificing salary for equity. Over the long run, secondary markets save money for startups because they can't afford to pay him what he would earn at a public company.
He made an excellent point in noting that a startup needed different types of investors at different stages of its growth. If a board has investors that want earlier liquidity, that can result in misaligned interests.
Lise Buyer, principal at Class V Group, is a real firecracker. She disagreed with the oft repeated woe at the conference, that we used to have so many more IPOs compared with acquisitions, and now IPOs are just 10 percent compared with 90 percent acquisitions.
She pointed out that more than 40 percent of tech IPOs during the bubble period "blew up," the companies quickly lost value and never regained their IPO price. They weren't ready for an IPO.
Mary Miller, Assistant Secretary at the Dept. of the Treasury, said that the government is interested in secondary markets. She said that there has been a recovery in financial markets but not in the economy, and that's a key concern.
She said that the Treasury Dept. is keen on investigating what's going on in secondary markets and to see how that can help boost the economy. She disagreed with a comment that her department moves slowly, saying that it was moving very quickly in key areas.
Karey Barker, Managing Director at Wasatch Cross Creek Capital, said that allowing institutional investors to buy private shares can help a company IPO, because it can remove the large overhang of stock and its effect on price that's always present with founder's stock.
There's a lockup period where company founders have to wait six months after an IPO. With a big chunk of stock waiting to hit the market, it can depress the share price, and discourage public investors until the overhang is cleared.
Here are some other points that were discussed over the course of the afternoon:
- The 500 shareholder limit in private companies should be changed. Under current rules a company with 500 or more shareholders must publicly report its financial statements. Mr Bochner from Wilson Sonsini, said that founders and employees shouldn't be counted in the 500 shareholder rule.
- There was discussion about valuation and tax and accounting issues. Does the valuation of a company through trading activity on SharesPost affect the official valuation by the accountants, which is used to price stock options and is supposed to be good for one year?
- Just because an individual investor is rich and accredited, doesn't mean that they are savvy. There are many different classes of private shares, with different rights and restrictions, yet some investors don't understand the difference and are just keen to own a hot stock.
- Discounts to valuation. Secondary markets provide liquidity, but they aren't very liquid compared with public stock markets. Sellers have fewer buyers and that means they often sell at a discount, which can range from 15 percent to 40 percent or more. There is not yet enough history on transactions to determine appropriate discount rates.
- So far, the valuation of private companies has been going up, there's been about $50 billion increase in the combined value of the hottest private companies over the past year: Facebook, Zynga, Twitter, LinkedIn.
- What will happen when traders in private shares start to lose money? That could attract new regulations and possibly restrict the access to liquidity that SharesPost, and other secondary private markets provide.
- The secondary market is putting money back to work and that's helping innovation in Silicon Valley.
It's a fascinating topic and we will certainly hear more about the many issues involved. And there will be lots of money made in these private stock exchanges. The best example is Yuri Milner, the Russian investor who has been buying large amounts of shares in Facebook and other hot companies, over the past two years.
Mr Milner was privately derided as being a naive, "hick" investor on Sand Hill Road, because he was prepared to pay large premiums for Facebook shares. However, he has proved himself to be extremely savvy. He's made more than $4 billion from his deals and recently bought Silicon Valley's most expensive home for $100 million. And with no set plans to live there.
That's a middle finger salute to Silicon Valley's "smart money" VC community.