Opinion

Felix Salmon

Skype’s evil ways, cont.

Felix Salmon
Jun 27, 2011 04:46 UTC

The Skype/Silver Lake story is refusing to die, with Yee Lee’s revelations bringing out the same anonymous investor-group sources defending Skype’s actions. But if the defenders are comfortable in their anonymity, it seems only fair for me to share an anonymous email I got this morning from “Skype Insider”.

Remember the history of what happened here. First it was alleged that Skype was firing senior executives just before the Microsoft deal closed, thereby ensuring they don’t get their full payout. Then Lee came along and said that employees who left voluntarily were denied their vested equity in the company — which, as Graef Crystal has noted, does grievous harm to the plain-English meaning of the word “vested”. Dan Primack explains how Skype pulled this stunt by changing its options agreement after it was acquired by Silver Lake:

A source familiar with the situation says that many former eBay employees who remained with Skype have options that more resemble typical Silicon Valley (i.e., vested=yours). Moreover, the majority of Skype employees are in Europe, where the structure also is different.

But for U.S.-based employees who joined after Silver Lake and crew took over, you had to “be in it to win it.” In other words, these particular Skype employees wouldn’t get paid until the private equity firms also got paid.

We’ll get to the attempted defenses of Skype’s actions in a minute. But up until now we’ve been dealing with two classes of screwed-over employees: executives who got most but not all of their payout because they were fired just before the deal closed; and people who were hired after Silver Lake bought the company and who found that their vested options were worthless.

But according to my source, it’s actually worse than that. There’s a third class of employees, who were treated particularly badly: executives who were fired for cause, “based upon various trumped up justifications”, in the words of my tipster, thereby losing all their vested equity.

This is a particularly nasty move for Skype to pull, because such executives are naturally going to be reluctant to go public with their story. Any journalist would immediately ask Skype for comment, and the company would quickly start explaining, either on or off the record, just how bad the executive in question was. And no one wants to be the subject of that kind of public debate.

Importantly, if you were a Skype employee fired for cause, your options could be clawed back even if you had the old-school options contract. Former eBay employees who had had vested equity for years could suddenly find themselves with nothing.

Do I know for a fact that Skype did this? No — but I’d certainly be interested in hearing from anybody this happened to, in strictest confidence. And it’s consistent not only with the Skype-is-evil meme, but also with the message that Skype’s defenders are pushing. Here’s Henry Blodget:

Private equity firms have a different view of option compensation than VC firms, the Skype investor said. Specifically, private-equity firms recruit executives with a very specific mission: To fix the company and then sell it, a process that often takes several years. In private-equity’s view, executives only deserve a piece of the equity pie if they see that mission through.

Essentially, only one group of employees matters in PE-backed deals, and that’s the ones still standing when the exit arrives. You’ve “got to be in it to win it”, which means that anybody who’s not “in it” is, by definition, a loser, to whom the company owes nothing.

And the investors are quick to blame the losers here. See for instance Sarah Lacy:

As standard as getting to keep vested options if you quit before an investment is closed is in the venture capital world, it’s equally as common that you have to stay through the close of acquisition to keep them in the private equity world. Indeed, our source says the Skype contract is a boilerplate agreement for all the companies Silver Lake invests in. And all of this was in the paperwork the employee signed. He just didn’t read it carefully, at his own admission, because he assumed it was like other option contracts of venture-backed companies. That’s not really Silver Lake’s fault.

Actually, as Mike Arrington and Dan Primack and I have all tried our best to point out, the notorious clawback was not something which Yun Lee or anybody else could find by reading paperwork carefully: it’s impossible to read the clause in question and understand what it’s saying, since it references “the repurchase and other provisions in the Management Partnership agreement” — a completely separate document which Lee might not even have been given access to. (Arrington reckons he probably wasn’t.)

As for this suddenly-important distinction between venture capital and private equity, has Lacy forgotten that the public face of the Skype acquisition was not anybody from Silver Lake at all, but rather Marc Andreessen, a venture capitalist? Indeed, Arrington’s coverage of the deal had Andreesen Horowitz leading it, with Silver Lake a mere tagalong participant. And Silver Lake is hardly KKR or TPG: if you pop along to the CrunchBase profile page for the firm, you’ll see its headquarters are on Sand Hill Road, the boulevard synonymous with venture capital. Yes, Silver Lake is technically private equity rather than VC — but it does its best to hang out with VCs, co-invest with VCs, and generally inveigle itself into the VC world as much as it possibly can. Lacy’s sources might be very keen right now on the idea that they have “a different mentality and a different culture” to VCs. But the average Silicon Valley employee can easily be forgiven for failing to grok this distinction.

And this just doesn’t withstand scrutiny at all:

If the amount is so small, why not just give him the vested shares? Because this is their standard contract, Silver Lake can’t without opening themselves up to lawsuits from all the other buyout deals where employees have to live by the same agreed-upon contract.

Er, no. Silver Lake had no obligation, under the terms of the contract, to claw back Lee’s shares. Remember the letter sent to Lee? It’s very explicit on this front:

Pursuant to Section 8.01 of the Partnership Agreement, Skype has the right (the “Call Right”), which it intends to exercise, to repurchase up to all vested shares underlying your Options at a per share price equal to the exercise price applicable to the shares being repurchased.

Skype had a right to claw back the options. It made a positive decision to exercise that right. It had no obligation whatsoever to exercise its Call Right, and everybody’s actions would have been perfectly consistent with the signed documents if Lee had held on to his vested equity.

The fact is that there’s no good reason at all for Skype to be behaving this way — and there’s also every reason to believe that Skype’s decision to turn evil was entirely a function of Silver Lake’s corporate culture.

In any case, all of Silicon Valley is now to understand that the relationship between Silver Lake and the employees of its portfolio companies is a fundamentally adversarial one, where incentives are actually opposed rather than aligned, and everybody needs to lawyer up before doing anything. That kind of attitude goes down badly everywhere, but especially in Northern California. And that’s the fundamental reason why this story is refusing to die.

Oh, and one last thing, from my tipster:

Employees did not actually receive stock options at all, but rather shares in a Cayman Limited Partnership, Skype Management Partnership, LP. This complex partnership arrangement was concocted solely to avoid the possible application of employee-favorable laws in California and Luxembourg.

You fancy a lawsuit against Skype and/or Silver Lake? You’ll have to show that California courts have jurisdiction first. Since Skype isn’t even an American company, and the shares were in the Caymans, that’s not going to be easy.

COMMENT

FRAUD IS FRAUD. THE EXERCISE OF A CONDITIONAL RIGHT MUST BE PREDICATED UPON THE ACTUAL EXISTENCE OF THE PREDICATE CONDITION. THE TAKING OF THE SHARES FROM THE EMPLOYEES BASED UPON FABRICATED WRONGDOING IS THE ACT OF SCOUNDRELS AND SCALAWAGS. IT DOES NOT MATTER WHERE THE PERPETRATORS OF THE FRAUD RESIDE OR WHERE THE ACTUAL PERPETRATION OCCURRED. THE COMMERCE CLAUSE OF THE U.S. CONSTITUTION GIVES JURISDICTION TO THE GOVERNMENT AND CRIMINAL PROSECUTION IS NOT ONLY PROBABLE, BUT ALSO LIKELY. THE HIGH ARE NEVER SO LOW AS WHEN THEY VICTIMIZE THE DEFENSELESS. MICROSOFT HAS BOUGHT A SHIP OF FOOLS WHO STUMBLED UPON A GREAT PRODUCT. IT IS MICROSOFT WHO WILL SUFFER FINANCIALLY WHEN IT PAYS OFF THE WRONGED EMPLOYEES. THE FOUNDERS OF SKYPE WILL TAKE THEIR ILL-GOTTEN GAINS TO THEIR NATIVE INDIA AND BE ABOVE EXTRADITION. SHORTLY THEREAFTER, THEY WILL OBTAIN NEW PASSPORTS WITH NEW NAMES AND PREAPRE FOR THEIR NEXT CRIME.

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Upgrading Skype and Silver Lake to Evil

Felix Salmon
Jun 24, 2011 15:05 UTC

Last week, Bloomberg’s Joseph Galante published a story claiming that Skype investors in general, and Silver Lake in particular, were firing senior executives just before the company is sold to Microsoft, so that they don’t get their full share of the proceeds from the sale. This seemed pretty evil to me, but it wasn’t long before anonymous Skype investors started showing up on various blogs (SAI, TechCrunch, GigaOm) pouring cold water on the allegations, saying that the firings were all the doing of Skype’s CEO, Tony Bates, and had nothing to do with Silver Lake at all.

The stories were very consistent with each other, and all of them seemed to be based on anonymous sources (except for GigaOm’s, which was based on the word of an unnamed “company spokesman”). Because of this, it’s impossible to tell whether there are multiple investors all credibly saying the same thing, or just one investor doing the rounds of the blogs and trying to push back against Galante’s story.

But now Galante is back, with the story of Yee Lee, who left Skype after a significant chunk of his options had already vested — and still didn’t get any money from them.

After a month of back-and-forth with Skype’s human resources department, Lee learned that even his “vested” options were worthless. It turns out the investor group, led by private equity firm Silver Lake Partners that bought Skype from EBay (EBAY) in 2009, had secured a so-called repurchase right that gave them authority to buy back the shares at the grant price. “I’ve never heard of a company taking away vested options,” says compensation expert and Bloomberg News consultant Graef Crystal. “It invalidates the meaning of the word ‘vested.’ “

There are many more details in this blog post from Lee, which includes the letter he was sent by Ricardo Velez, Skype’s associate general counsel. I’m reasonably good at hacking my way through legalese, but this is downright incomprehensible — and clearly designed to be so.

bollocks.tiff

Lee provides a copy of his 11-page stock option grant agreement, which is equally opaque. Here’s the relevant bit, buried halfway down page 3, at the end of a long clause which seems mainly interested in what happens when there’s an IPO.

If, in connection with the termination of a Participant’s Employment, the Ordinary Shares issued to such Participant pursuant to the exercise of the Option or issuable to such Participant pursuant to any portion of the Option that is then vested are to be repurchased, the Participant shall be required to exercise his or her vested Option and any Ordinary Shares issued in connection with such exercise shall be subject to the repurchase and other provisions in the Management Partnership agreement.

That one sentence, which is borderline unreadable and which makes no sense outside a deep understanding of the Managing Partnership agreement, an entirely separate document, was enough to render Lee’s vested options worthless.

Why on earth would Skype behave in such an evil way? Back to Galante:

Silver Lake declined to comment. When asked about Lee’s situation, Skype spokesman Brian O’Shaughnessy said, “You’ve got to be in it to win it. The company chose to include that clause in the contract in order to retain the best and the brightest people to build great products. This individual chose to leave, therefore he doesn’t get that benefit.”

O’Shaughnessy seems to have been the source for the GigaOm blog post, and with this on-the-record quote he’s rendered himself utterly unreliable. Silicon Valley companies attract employees by giving them options which vest over time. Skype — uniquely, I think, although anybody else owned by Silver Lake should be taking a long cold look at their option grants right now — decided to more or less invalidate that vesting schedule with a highly opaque clause which was clearly designed to be incomprehensible to anybody without extremely good lawyers. The statement that the clause was designed “to retain the best and the brightest people” is clearly a lie, since Skype’s best and brightest had no idea it even existed, and Skype made no attempt to call their attention to it.

I no longer think that what Skype did here is pretty evil: I now think it’s downright evil, and destroys the balance of trust on which Silicon Valley has been built. What’s more, I simply don’t believe that Skype did all of this itself, without detailed input from Silver Lake. Here’s Lee again:

Working with Silver Lake was my first opportunity to witness up-close-and-personal how a PE firm does its business of restructuring a company that they’ve just taken over. And it was breath-taking. The firm inserted itself into every level of the company. At one point in my tenure at Skype, Silver Lake had representatives or consultants on the Board, in C-level executive roles, in technical leadership and operating roles, and all the way on thru the organization to the person actually running our software deployment schedule… So Silver Lake put its fingers really deeply into Skype’s pie and they started rearranging things.

You can agree or disagree with the practice of re-organization, but I personally had never been part of a restructuring that ran so deep in a company. During the year I was at Skype, the company:

lost a CEO

hired and fired a CTO

hired and fired a CFO

gained a CEO, CMO, CIO, and CDO

created an entirely new product development org structure

eliminated every Project Manager role

fired, re-interviewed, and re-hired Product Managers

created a two new business units

combined two business units into one

dissolved one business unit

opened a new office and hired several hundred people

the list goes on…

All of this makes any Skype investor saying “it’s not us, it’s the CEO” sound naive at best and, more likely, downright disingenuous. Unless and until such an investor wants to go on the record defending Silver Lake here, I’m going to believe Lee, and assume that it’s Silver Lake who’s largely to blame for the utter breakdown of employer-employee relations at Skype. I don’t know where they got these techniques from, but they’re very alien to Silicon Valley and indeed the rest of the business world. And they do no good at all for the reputation of private equity companies more generally.

COMMENT

BTW, if he didn’t have access to the partnership agreement, then he would have a much better case. It would be helpful to have facts

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Beware Silicon Valley financiers, Skype edition

Felix Salmon
Jun 20, 2011 05:38 UTC

Tensions between owners and managers are nothing new; you might remember, for instance, the way in which Sequoia Capital forced Zappos to sell itself to Amazon over its founders’ wishes. But at least when the sale took place the executives got their full share of the proceeds — in contrast to what seems to be going on at Skype.

Skype Technologies SA, the Internet- calling service being bought by Microsoft Corp, is firing senior executives before the deal closes, a move that reduces the value of their payout…

Silver Lake, based in Menlo Park, California, led a $2 billion buyout of a 70 percent stake in Skype from EBay Inc in 2009. The private equity firm and several Skype directors have actively voiced their opinions on who should be fired…

“As part of a recent internal shift, Skype has made some management changes,” said Brian O’Shaughnessy, a Skype spokesman.

When there’s a change of control, it’s standard for all options to vest in full. In this case Silver Lake is firing a slew of executives — at least eight, according to Bloomberg’s Joseph Galante — just before the change of control happens. Silver Lake’s partners and investors get to cash out at the $8.5 billion valuation; a large swathe of Skype’s own management, by contrast, does not.

This does seem pretty evil. I’m sure it makes financial sense for Silver Lake, which will be less diluted by the immediate vesting of lots of options. But when you’ve just scored one of the biggest home runs in the history of private-equity investing, it’s generally considered polite to share the spoils with the people who actually run the company. Rather than summarily firing them for no obvious reason but sheer greed.

COMMENT

TechCrunch is saying that they still got 75%, and it wasn’t pressure from Silver Lake but completely an internal decision.

http://techcrunch.com/2011/06/20/skype-i nvestor-amount-saved-on-firings-wouldnt- have-been-worth-the-phone-call/

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The difference between public and private stock markets

Felix Salmon
May 12, 2011 00:47 UTC

SecondMarket put on a conference in San Francisco this morning, where I got to talk to chief strategy officer (whatever that means) Jeremy Smith. I asked him about my theory that it’s easy to make big acquisitions if you’re public, using a hypothetical Facebook-Skype deal as my example.

Jeremy pushed back a bit: anything Facebook could do as a public company, he said, it could do as a private company too. Leverage? Banks would be lining up to lend money to Facebook right now. A big capital raise? Again, there’s no shortage of people wanting to invest in Facebook, or of banks willing to give Facebook a bridge to such a raise.

There is however a huge difference if Facebook wanted to pay in stock. For one thing, illiquid stock in a private company is much harder to sell than liquid stock in a public company. And while a VC fund might be willing to accept stock as payment on the understanding that it would sell that stock pretty quickly, it would be impossible to persuade any such fund to accept another form of illiquid equity. They’re meant to be making an exit here, not a new investment. If Facebook is buying a small company owned by its founders, they might be willing to take stock in payment. But exiting venture capitalists, not so much. (Unless the exiting fund could then sell that stock to a younger fund run by the same company; I’m not sure whether that would work.)

I learned quite a lot at the conference about the nuts and bolts of listing on what SecondMarket likes to call its “liquidity platform” — it’s not nearly as onerous as listing on the NYSE, but it’s still not easy, and it does require a fair amount of legal legwork. So far, the smallest company to use it had a valuation of about $150 million; it’s designed for companies worth $1 billion or so. That’s big money — but still small enough that we’re talking about a set of companies which are too small to go public, judging by the size of IPOs in recent years.

In any event, most of these companies won’t go public: they’re nearly all VC-backed, and 90% of VC exits are via M&A rather than via IPO. And this is where the real value of a SecondMarket listing becomes apparent: in an M&A transaction, the acquirer is always going to feel the need to offer some kind of premium over the latest value that the shares fetched on SecondMarket. Without that price being out there, negotiations can be harder, since the buyer wouldn’t be able to see the price that a significant number of buyers with ready cash are willing to pay for equity in their target.*

And one panelist, I forget who, pointed out another clever way that SecondMarket is changing the way that companies and investors interact: historically, secondary offerings, of stock held by existing shareholders, always took place after an IPO. Now, with SecondMarket, they’re taking place on a regular basis before an IPO. That removes an important incentive to go public, and will only serve to make the average age of companies at IPO even higher.

Meanwhile, all the signals on Capitol Hill seem to be pointing towards the SEC making life easier for companies like SecondMarket, and embracing the new halfway house between private and public. That would make the government far more responsive to this development than the law world, where Wilson Sonsini’s Yokum Taku said that he be “shocked” if the standard provisions in the structure of VC-backed companies, which haven’t really changed since about 1974, were changed at all in his lifetime.

The most interesting panel was moderated by Dan Primack, who asked a good question: what happens when the bubble bursts? Right now SecondMarket is riding high because pretty much all the companies using it to trade their stocks are seeing their valuations float effortlessly ever higher. But once those valuations crash, will people still be willing to sell? And who will want to buy? Will there be vulture secondary investors?

My worry is that these markets are a bit like the housing market, where people remember the valuations at the peak of the market, refuse to sell for substantially lower amounts, and the market stops clearing. After all, the primary market in private equity — the capital-raising rounds which are marked as Series A, Series B, and so on — is highly allergic to “down rounds” and does tend to seize up during market downturns. Why should the secondary market be any different?

The public markets, by contrast, go up and down all the time — they have no problems at all with stocks going down. So the open question is whether private secondary markets are more like public secondary markets, or more like private primary markets. We’ll find out, I guess, when the current dot-com bubble finally crashes.

*Update: In a classic example of the way that public shareholders get less information than anyone else looking to buy a stake in the company, it’s worth noting that this information does not make its way into the IPO prospectus. LinkedIn’s S1, for example, says that its shares have been trading on SecondMarket. But it doesn’t say for how much.

COMMENT

Interesting article. Because the stocks that “trade” in the secondary markets are trading in a much more controlled environment and are being purchased for 100% cash (not margin) by investors with long term investment goals, we are not going to see a big bubble burst like we have experienced in the past. For the first time in history we are witnessing a dynamic combination of technology advancing communications at lightening speeds, companies generating actual revenue at unprecedented rates and an untarnished long-only marketplace that does not facilitate shorting, margin, derivatives and small retail investors. Getting to bubble bursting territory would require the involvement of small retail investors buying in on margin. This new flock of investors will drive prices higher and higher until there is no more support and the marging calls begin. We are still a long way away. Check out http://nextstreetjournal.com for additional insight.

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How being public eases acquisitions

Felix Salmon
May 10, 2011 06:00 UTC

The acquisition of Skype by Microsoft comes just in time for the Capitalyze conference in San Francisco, which I’m sure will be talking about this:

The biggest winner of this deal could actually be Facebook. The Palo Alto-based social networking giant had little or no chance of buying Skype. Had it been public, it would have been a different story. With Microsoft, it gets the best of both worlds — it gets access to Skype assets (Microsoft is an investor in Facebook) and it gets to keep Skype away from Google.

If Om’s right about this, then Facebook is just plain lucky that deep-pocketed Microsoft came along to keep Skype out of Google’s hands. If Facebook were public, on the other hand, then it could have just snapped Skype up itself.

I’ve already said that Facebook will go public — but for boring technical reasons, rather than for big strategic reasons like this. And so the question arises: is Om right? Does being public give companies the ability to make large strategic acquisitions, which are impossible so long as they’re private?

This particular case, like so many other cases where Facebook is involved, is exceptional. Skype’s owners, including Silver Lake Partners and Andreessen Horowitz, might well have been quite well disposed towards a deal where they sold Skype to Facebook and got a large yet illiquid chunk of Facebook in exchange. But I’m not sure if that’s even possible, the way that those funds are set up in Silicon Valley: while Silver Lake and Andreessen Horowitz are indeed investing in the likes of Facebook, they’re investing their new funds in those companies, rather than the old funds which invested in companies like Skype and are now reaching maturity.

In any event Om’s point is a good one: if a private company wants to make a big acquisition, that’s a lot easier if your stock is public than if it’s private.

Staying private, then is something which companies might like to do for much longer than they did in the past. But if you’re extremely ambitious and want to grow through the acquisition of large companies, then you pretty much need to be public. Look at Glencore: it desperately wants to buy Xstrata, and the only way it can see of doing that is by going public first.

I’m not entirely clear on why this should be. After all, private-equity companies make enormous acquisitions all the time, and they’re not public. (At least the funds making the acquisitions aren’t public.) It makes for an interesting intellectual exercise to wonder whether Facebook could borrow $7 billion or so to buy Skype, if it were so inclined. But of course it isn’t so inclined: that kind of leveraged buyout makes no sense in Silicon Valley, and Skype would be crushed under such a debt burden. The only remotely sensible way to borrow the money would be if it were a bridge to an IPO, and then at that point you might as well just IPO first.

But the lesson of Skype is that you never know when a big strategic opportunity might arise. And when it does, there will be some part of you wishing that you were public, if only for the option value it confers.

COMMENT

Having a currency to use in acquisitions is a rationale often used by investment bankers when discussing IPOs with private companies. As you’ve pointed out, it’s not just a sales line.

As for why this deal might make sense for MSFT, check out this blog: http://bit.ly/mluvHm

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How Congress works for you, private-equity edition

Felix Salmon
May 8, 2011 06:04 UTC

I had a long discussion at lunch today talking about my theory that it’s just as well the Basel III process was ill-publicized and depoliticized. Because when issues get onto Congress’s radar, the quality of debate can be low indeed. Take this debate between two Democrats on the question of whether private-equity funds should register themselves with the SEC:

Rep. Jim Himes, D-Conn., said that private equity funds act a lot like venture capital funds, which are exempt from SEC registration under Dodd-Frank.

“Private equity entities do not employ leverage any more than venture capitalists do,” he said.

Mr. Himes praised private equity funds for staying in falling markets when others are fleeing.

“They are countercyclical investors,” he said.

Despite Mr. Himes’ support, the ranking Democrat on the subcommittee opposes Mr. Hurt’s bill. Rep. Maxine Waters, D-Calif., said that putting private equity under the SEC’s aegis would better protect public pensions in part because it would subject private equity advisers to a fiduciary duty.

Even by Congressional standards, “private equity entities do not employ leverage any more than venture capitalists do” is pretty spectacularly wrong. “Private equity” is, after all, the polite way of saying “leveraged buy-out”, while venture capitalists don’t use debt at all.

As for the idea that PE shops are “countercyclical investors,” wouldn’t that mean that they did more deals when markets plunged during the crisis? As opposed to, say, this?

LBO-volume-over-time-Citi-300x194.jpg

On the other hand, it’s a rare argument where you end up siding with Maxine Waters, and I’m underwhelmed with her idea that the purpose of the bill is to protect GPs by ensuring that LPs have a fiduciary responsibility.

The main reason for PE shops to be regulated, of course, has very little to do with fiduciary responsibility, and everything to do with the fact that leverage is a systemically-dangerous thing, and regulators need to know where it is and how it’s being put to use. But it can be hard to explain systemic tail risk to the kind of people who only really understand the meaning of a pie chart when they bake an actual pie.

And remember — this is the Democrats, who tend to be slightly — slightly — more sophisticated about such matters than the Republicans. People like Brad Miller and Barney Frank really do know what they’re talking about. But it’s hard for them to compete with armies of lobbyists intent on dumbing everything down to the point of utter nonsense.

COMMENT

I believe you are misinterpreting Rep. Himes’ comments. When Rep. Himes indicates that PE firms do not employ leverage, he means that, like VC funds, PE funds themselves are not leveraged. The underlying portfolio companies may have debt in their capital structures (similar to a large proportion of non-PE owned companies). The distinction is highly relevant in the regulatory context if the presupposition is that leverage creates systemic risk. Since neither fund structure employs leverage within the fund, there is no more systemic risk to failure of the underlying investments in a PE fund vs. a VC fund. Many start ups fail, costing their investors some or all of their investments. Portfolio companies in either case can and will go bankrupt. The issue is the impact of that failure on the system. In either case, since an equity investment would be lost, there is no leverage creating systemic risk.

With regard to Rep. Waters’ comments, SEC regulation has no impact on fiduciary duty. GPs in PE funds are currently fiduciaries to their investors and no SEC regulation would alter that duty.

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Dennis Berman’s ethics

Felix Salmon
Apr 18, 2011 21:10 UTC

Last week, Ira Stoll took issue with Dennis Berman’s column on SharesPost and SecondMarket, on the grounds that Berman lied about his own identity: he pretended to be his late grandmother. Stoll likened Berman’s behavior to Project Veritas’s entrapment of NPR — something the WSJ itself said failed to “meet the ethical standards of elite journalistic institutions, including of course The Wall Street Journal”.

Now SharesPost CEO Dave Weir has written his own take on the Berman column, and it goes much further than attacking Berman for lying about his identity. He also accused Berman of misrepresenting SharesPost’s policies, “leaving readers largely misinformed and our company unfairly maligned”.

I asked Berman if he had any response to Weir, and he replied by sending me a copy of his response to Stoll:

As you can appreciate, the integrity of these markets is based in part on honest disclosures by both buyers and sellers. My intent was to probe the strengths and weaknesses of a system that relies almost exclusively on buyers’ own disclosures for establishing whether they are “accredited.” That self-reporting standard enabled my grandmother to slip through. So might other people with intent to dodge the rules.

My approach and objectives were discussed in detail with the companies prior to publication. As you can see, the story also praises SharesPost for cutting off my access.

We take ethics and fairness very seriously at the Journal. We are in the business of truth-telling, not deception. In this case, applying a simple test to an entire way of doing business helped shed light on an important topic for investors and markets that ultimately serves the public good.

Weir was well aware of this response when he wrote his email, and aware too that it doesn’t come close to answering his substantive criticisms. In fact, Berman’s response to Stoll only serves to exacerbate the misinformation in his original column, since he says that the SharesPost system “relies almost exclusively on buyers’ own disclosures”. This simply isn’t true, as Weir explains:

-Mr. Berman failed to mention that his fraud only enabled him to view information on our site. Had he attempted to transact, he would have been required to undergo a second level of compliance review and direct dialogue with one of SharesPost’s FINRA registered brokers;

-Had he actually entered into agreements with a seller, those agreements would have required him to make multiple contractual representations to the seller, the company and SharesPost that he had provided accurate information and was in fact an Accredited Investor;

-Had he actually entered into a contract to purchase shares, the transaction would have been processed by U.S. Bank, a third party escrow agent, which first verifies buyers’ and sellers’ identities by collecting all the documents required under the Patriot Act and Anti-Money Laundering regulations.

Berman’s response is barely adequate as a reply to Stoll. There are many legitimate concerns about SharesPost, but the fear that people are lying about their identity to trade shares on the system is not one of them. Berman gives no reason to believe that has ever happened, or that anybody is silly enough to even attempt it: after all, no one wants to end up running the risk of having valuable shares taken away from them on the grounds that they were acquired under false pretenses.

The rest of Berman’s response is even weirder. Whether Berman subsequently talked to the companies under his own name is beside the point — and if the WSJ is “in the business of truth-telling, not deception”, why did Berman lie and deceive? His only defense is that doing so “ultimately serves the public good”. And that defense, as we’ll see, doesn’t stand up.

If Berman’s statement is weak as a response to Stoll, it’s clearly inadequate as a reply to Weir. If Berman’s intent was “to probe the strengths and weaknesses” of the SharesPost system, as he says, then why didn’t he mention any of the strengths of the system, which would clearly have prevented his late grandmother from buying shares?

And more generally, if Berman’s “in the business of truth-telling”, then why did he end up publishing a column which, as Weir says, “ignored and embellished the facts to suit his story line”?

There are lots of errors in Berman’s column, starting with its headline: “Meet My Departed Grandma, Fledgling Facebook Investor”. This is false: Berman’s grandmother failed utterly to invest in Facebook.

Berman goes on to say that his grandmother was “cleared” to buy Facebook shares, and that SharesPost certified her as an accredited investor. But as Berman himself admits later on in the column, in the first instance buyers certify their own credentials; the minute that the process reached the point at which SharesPost had to do any clearing or certifying, the company suspended the account.

Berman then says that trading on SharesPost is “especially prone to insiders’ whims”. It’s unclear what the literal meaning of that phrase is meant to be, but the message is crystal-clear: SharesPost is a Wild West haven for insider trading.

In case you missed the message the first time, Berman goes on to add that the SEC “is investigating potential abuses in these secondary markets, including conflicts of interest and insider trading” — a statement which as far as I can tell simply isn’t true. There was a story back in February about the SEC looking at “potential conflicts of interest” at SharesPost and SecondMarket, but there was nothing in it about insider trading. Berman’s assertion, which comes without any sourcing, is dangerous precisely because it’s unfalsifiable. But if he did have good sources, you’d think that he’d lead with the SEC’s insider-trading investigation, rather than with his dead grandmother.

In between musings about insider trading, Berman declares that on SharesPost, “prices can swing on just a few trades” — but again it’s unclear what he means exactly. Does he mean that SharesPost has seen wild price swings? I doubt it, since he doesn’t give a single example. He probably just means that in theory there can be big price swings — but that’s true of any market. Again, the real meaning is clear, even if the literal meaning isn’t. Berman’s saying that prices on SharesPost are particularly volatile. Is that true? Again, he doesn’t give us any reason to believe that it is. Instead, he looks at a wide bid-offer spread for eHarmony shares, which just says that the market in eHarmony shares isn’t clearing — and you can’t have price volatility in a non-clearing market.

What else? For one thing, Berman says that SharesPost and SecondMarket “give young companies and their employees new ways to raise capital” — simply not true. No company has raised capital on either platform.

He also says that “players in these companies’ shares couldn’t care less about the intricacies of market regulation”. Which is self-evidently not true: if you’re buying shares in these companies, you care deeply about who you’re going to be allowed to sell the shares to, and how, and when.

And he massively misrepresents how close he and his dead grandma managed to get to actually playing in this market:

A few have made small fortunes, cleverly snapping up shares of companies like Facebook and Groupon and riding into the sunset. Last week Grandma and I joined their ranks, spending a few days loitering, testing and playing in these private markets.

If I were to test a market, I’d test it by making some small trades to see how they went. That’s obviously not what Berman did, though: he never got anywhere near being allowed to make trades. So what he means by “testing” the markets is far from clear. As is what he means by “these private markets” plural, when in fact he only signed up for one market — SharesPost.

Berman even contrives to quote Ben Horowitz saying that he “expects these marketplaces to founder”, without mentioning Horowitz’s massive conflicts: Horowitz’s fund is a high-profile alternative option for investors wanting to get access to private equity, and indeed Horowitz bought a significant $80 million stake in Twitter on the secondary markets himself.

And as I said when Berman’s piece came out, his claim that “investors need to be comfortable that they can trade at will” manages to completely miss the point of these markets.

Most amazingly of all, Berman manages to miss all the good, real reasons to mistrust these markets while he’s busy spinning his silly yarn about the connection between his dead grandmother and insider traders. Quoting Ben Horowitz but not Tim Geithner — that’s just plain weird.

All of which makes me very sympathetic to Weir, who says reasonably enough that “the Wall Street Journal can and should do better”. Is what Berman did unethical? Yes — if you’re going to lie in the service of reporting a story, you need to be able to get information that way which you couldn’t get through normal reporting channels. It’s no great secret or revelation that people can put whatever information they like into a web form, and then start lurking in SharesPost forums, calculating bid-offer spreads and reading investors’ whines about not being able to buy into Groupon.

If Berman’s late grandmother had actually been allowed to buy shares, that would have been a serious security breach. But she wasn’t. So the ends don’t remotely justify the means here.

And this wasn’t some kind of deep investigation on the part of Berman: rather, it was a cheap stunt, designed to confirm Berman’s pre-existing prejudices. Something which can be justified in the former case can still be a very bad idea in the latter.

To make matters worse still, Berman isn’t some kind of overenthusiastic kid reporter who stepped a bit too far. He’s the deputy bureau chief for Money & Investing, helping to shape large chunks of the WSJ’s finance coverage. What he does is a clear signal to everybody who works for him about what is and isn’t acceptable in WSJ reporting. Unless, of course, he makes it clear that he has lower standards for his own work than he does for the work which he edits.

COMMENT

Dennis Berman hit the nail on the head. These secondary markets are relatively unregulated yet currently have disproportionate influence on potential primary market offerings. Without transparency there is the opportunity for manipulation and for investors to be hurt. Kudos Berman!

Posted by ExtraCare | Report as abusive

How SecondMarket works

Felix Salmon
Apr 12, 2011 20:23 UTC

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.

COMMENT

Maybe inflammatory, but no longer false. http://www.sec.gov/news/press/2012/2012- 43.htm

Posted by Setty | Report as abusive

Should the SEC try to boost the IPO market?

Felix Salmon
Apr 11, 2011 21:04 UTC

Clare Baldwin and Sarah Lynch are unambiguous: “As US regulators review rules on shares issued by private companies,” they write, “they must not make it too easy for hot Internet companies such as Facebook or Twitter to avoid the scrutiny that goes along with an initial public offering.”

They’re talking, of course, about the letter which SEC chairman Mary Schapiro sent to Darrell Issa on Wednesday. It’s a long and pretty boring document, and it’s certainly not as revolutionary as some of the press coverage would make you think. Jean Eaglesham, who broke the news without printing the letter, set the tone of the subsequent discussion by saying that the SEC review “could remake the way American start-ups raise capital,” “would upend the normal path for fledgling companies to raise funds,” and “could shut out many ordinary investors from one of the fastest-growing market sectors.”

But it’s hard to see anything in the letter which really supports Eaglesham’s reading. Mostly the letter is dry and legalistic, and in fact it takes pains to say that “the Commission seeks to minimize the costs of being a public company in the United States and provide a regulatory environment that encourages companies considering going public.” The part of the letter which talks about revisiting the 500-shareholder rule makes it clear that any change is overdue in any case, given how the rule isn’t having its intended effect:

500.jpg

All of this seems much more like a common-sense view of a rule which hasn’t really been updated since it was enacted in 1964, and much less like a revolutionary attempt to kill the IPO market by making it particularly attractive to stay private. Certainly there doesn’t seem to be any point in forcing companies to give out options, or phantom stock, or stock appreciation rights, or other such weird and wonderful inventions, just as a means of getting around a rule which has been around for half a century and is showing its age.

And it’s easy to overstate what exactly goes on in places like SecondMarket:

The SEC is wrestling with the needs of private companies to raise capital against the investing public’s need to make informed decisions.

The issue has jumped into the spotlight as Wall Street banks and electronic markets offer investors a chance to buy and actively trade stakes in hot Internet companies such as Facebook, Twitter, Groupon and Zynga before they go public.

Investors are indeed being offered the chance to buy stakes in companies like Facebook — although Facebook is sui generis and is much more of an outlier than it is typical. But as far as I know, no one is actively trading any of these properties. The auctions come up irregularly, they often require shareholders to hold on to their stock for a period of years, and the trading costs are very high — on the order of 5% per trade. Meanwhile, Goldman’s attempt to come up with a private exchange where shares could be actively traded has fizzled embarrassingly, and never attracted any hot internet companies.

As Jason Zweig says, there’s a good reason retail investors are barred from investing in private placements: they are very risky and dangerous things. But global high net worth individuals are increasingly interested in buying in to such placements, and the SEC has no real reason to stop them from doing so. I’m not a fan of this development. But that doesn’t mean I think the SEC should keep its rulebook in 1964, just because doing so might allow companies to prosper in private hands a bit longer.

COMMENT

Between frank-Dodd and Sarbanes, companies have figured out that it isn’t worth the effort to be traded on US exchanges. the next step is for Facebook to list somewhere else. Maybe a place with good regulations and a strong currency.. Switzerland comes to mind

Posted by wsd | Report as abusive
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