How SecondMarket works

April 12, 2011

I spent most of this morning at SecondMarket, having a long conversation with Adam Oliveri, the person in charge of their private company market. That’s the part of the company which gets the most attention: it’s where stock in companies like Twitter and Facebook change hands, for instance. I learned a huge amount while I was there, and have now changed my mind on whether Facebook is going to go public: I finally understand exactly why companies need to do an IPO once they have more than 500 shareholders.

Once the 500-shareholder limit is breached, companies have to start reporting detailed financial information to the SEC. Which isn’t in and of itself a compelling reason to go public — lots of private companies with public debt file that information, after all. But there’s something else which gets triggered when you have more than 500 shareholders: you have to register your equity securities with the SEC. And at that point, your shares can be traded by anybody at all in the public over-the-counter markets, even if you haven’t had an IPO.

It’s conceivable that companies could continue to encrust their shares with various contractual restrictions which prevented shareholders from trading their shares in the OTC markets, even after those shares were formally registered with the SEC. But in practice, it’s almost impossible for companies to prevent OTC trading in their publicly-registered securities. And when a stock trades in the OTC markets, that trade is registered and printed in public. At that point, with a company’s stock being traded by anyone at all, at any time, at a public price, on the basis of public information filed with the SEC, the company is to all intents and purposes public already. So it might as well just make it official by having an IPO.

Now that Facebook has said that it passed the 500-shareholder limit this year, then, it’s pretty certain to go public in 2012. (Kara Swisher thinks it might be even earlier than that: I have a bet with her that it won’t happen before September 21 of this year. If it does, I need to go to San Francsico and buy her dinner, but if it’s still private at this point she needs to come to New York and take me out.)

SecondMarket actually has two platforms for trading private-company stock. The main one is Adam’s private company market, which is about two years old at this point, and has seen equity in 50 different growth stocks change hands. It’s pretty much restricted to growth stocks: none of those 50 companies has ever paid a dividend, and they’re overwhelmingly in the technology space.

For other companies, SecondMarket has set up a much more nascent market, which kicked off in January with those trades in Pimco stock. It’s also designed to help trade stock in partnerships (like McKinsey, say), or maybe even large, established private companies like Mars or Cargill. But mostly it seems that SecondMarket has its eyes on companies like Pimco which are subsidiaries of larger companies but which still use their own equity as a recruitment and compensation tool. Reddit is one company which might try to price stock on SecondMarket, as a way of helping it attract talent and grow while still remaining a part of Conde Nast.

Adam also helped answer my question of why SecondMarket is taking off now. Look at the three companies which really got this market started: Facebook, LinkedIn, and eHarmony. They’re all highly visible companies, with metrics that can be measured externally with quite a lot of specificity by companies like ITG Investment Research. It’s also much easier these days to find such companies’ articles of incorporation and the like online — and of course huge amounts of information about these firms is published by the fast-growing blogosphere. So while the amount of information that would-be investors have is surely lower than if there was a formal SEC-registered prospectus, the rise of the internet has made it much easier to do reasonably good diligence on how much a company might be worth. And that’s especially true when the company is young enough that its revenues don’t matter very much.

On top of that, webby companies like these are generally pretty capital-efficient: there’s very little risk that existing shareholders will be unpleasantly diluted by some big upcoming capital-raising round. It’s no coincidence that SecondMarket hasn’t seen trading in green-tech or biotech startups, which are much more capital-intensive.

And then there’s the big picture, which is simply that we’re seeing fewer IPOs of small companies, and that most companies when they do IPO are more like 8-10 years old rather than 3-4 years old. At that point, you’re likely to have had a reasonable amount of turnover in terms of employees, and early employees who have long since left the company are reasonably going to want a way to cash in their equity stakes. That demand for liquidity — along with long-term employees who have a lot of paper wealth but still live relatively frugally and who would like to monetize some of their stake — is what helped get SecondMarket’s equity business started.

Letting employees sell some of their vested stock doesn’t disalign incentives — quite the opposite, in many cases. After all, venture-capital owners of fast-growing tech startups are looking for high-risk home-runs and have diversified portfolios. Employees, by contrast, are always going to be more risk-averse, and letting them cash out in the growth phase can give them enough money to be willing to take the kind of risks their VC paymasters want to see.

It’s also worth clearing up some of the misconceptions in Dennis Berman’s column today on SecondMarket and SharesPost. For instance:

Many in Silicon Valley and Washington regard SharesPost and rival SecondMarket as small saviors of American capitalism. These markets give young companies and their employees new ways to raise capital or sell private stock without the arduous financial and legal disclosure of fully public companies.

This is partly true, but I’m pretty sure that neither SharesPost nor SecondMarket has ever let a company raise capital using their platform. I asked SecondMarket about this today, and in principle they’re open to exploring the idea in future, but for the time being they’re concentrating on simple transfers of shares, rather than the capital-raising issuance of new equity.

Berman continues:

SEC boss Mary Schapiro seems conflicted about these new markets’ purpose. The agency is investigating potential abuses in these secondary markets, including conflicts of interest and insider trading.

There’s no hyperlink here, so I have no idea what Berman thinks he’s talking about. It’s conceivable, I suppose, that he has an SEC source feeding him secret information about an internal SEC investigation that nobody else knows about. But if he did, one imagines he’d write a news story about that, rather than mentioning it in passing in a column which leads with the death of his grandmother 20 years ago. Certainly I’ve seen nothing to indicate that the SEC is investigating SharesPost or SecondMarket for potential abuses including insider trading; this seems to me to be both inflammatory and false.

After quoting Ben Horowitz as someone who is skeptical about such markets (but not mentioning that Horowitz spent $80 million buying shares of Twitter on SecondMarket in the secondary market), Berman comes out with this:

For a market to work best, investors need to be comfortable that they can trade at will.

This manages to completely miss the point of SecondMarket and SharesPost. They’re emphatically not trading vehicles: they’re designed to facilitate one-off transactions. In the two-year history of SecondMarket’s private-companies market, the company has seen maybe half a dozen instances of what you might call tertiary trades: someone who bought at one point and then sold later, once the price had gone up. SecondMarket gives an opportunity to invest in private equity, and private equity by its nature is illiquid. In fact, that’s why many investors like it: they want to capture the illiquidity premium, happy holding on to their stake for many years and knowing that they have an asset which isn’t highly correlated with public markets.

Going forwards, of course, SecondMarket would love it if the 500-shareholder restriction was relaxed. When the rule was introduced in 1964 it was pretty arbitrary, but it was set at a level which wasn’t particularly onerous: the 500-shareholder limit was very rarely triggered before a company went public. After all, in those days you could go public when you were still small; today, that’s much harder. Today, the 500-shareholder limit is a real constraint on how companies do business, how they compensate their employees, and how they structure themselves internally. Is there any good fundamental reason to change the way you incentivize and compensate employees just because you’re hiring lots of people? Of course not — but that’s the effect the rule has.

So while I worry about the public-policy effects of having fewer public companies, I also see no reason for the SEC to keep this rule at its anachronistic 1964 level. On the other hand, I think it might make sense for the SEC to regulate SharesPost and SecondMarket more explicitly than it does at present, rather than having them operate in the shadow of exemptions which were written long before they were founded. If the SEC set clear rules for how private exchanges like this could operate, then that might open the way to bring the rules for companies listing on public exchanges into the 21st Century.

Update: SecondMarket’s Mark Murphy emails to say that Horowitz’s secondary-market acquisition of Twitter shares did not take place through SecondMarket.


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