Lots of Obstacles Remain For Secondary Market

Listening to last weeks webinar by SecondMarket.com really highlighted all the obstacles that remain to the emergence of a vibrant  secondary market for private shares.  A market exists, and it’s growing nicely, as evidenced by the 20%+ monthly growth in transactions on the SecondMarket.com platform this year:

However, to put SecondMarket’s monthly volume in perspective, Google trades$70mm worth of shares  every 15 minutes of every trading day.  While the growth is impressive, it’s off a miniscule base.

SecondMarket set up the call to dispel myths that surround the secondary market.  To address the issues in as unbiased a fashion as possible, the webinar consisted of a panel of “experts” including Keith Rabois from Slide, who has traded shares on the SecondMarket platform; Sujay Jaswa from the VC firm NEA, and Chip Lion from the law firm Morrison & Forester.  The panelists were joined by SecondMarket CEO Barry Silbert.

The first issue addressed by the panel was why the markets exists to begin with.  The most basic answer was to give liquidity to founders, investors an employees who are involved with companies that are experiencing elongated exit periods.  The accompanying chart provided by SecondMarket shows that the average IPO now takes 10 years compared to just five years five years ago.  In that environment, the secondary market solves the liquidity issue faced by all the players in the ecosystem.

The secondary market decreases pressure on companies to exit as it enables the companies to address the liquidity issues that exist.  Yelp was cited as an example fo a company that had partaken in the secondary market to “stay private a little longer”.    In addition, staying private is becoming a more attractive options than going public given the financial and management burdens associated with Sarbanes-Oxley.

Understanding why the market exists is easy.  Understanding why the market is still so small starts to address some complicated issues.  The lawyer on the panel, Chip Lion, made a valiant effort to address the legal issues, but the complexity is daunting.

Under Section 5 of securities act of 1933, in order to be traded, securities need to be registered, UNLESS there is an exemption.  There are two common exemptions in the secondary market, Rule 144 (and 144A), and Rule 4- 1 1/2.  Both rules address a long list of issues including how long the securities need to be held before being re-traded, exclusions for “insiders”, the sophistication of the investors, and the information required of the company to provide upon request.  If you click on any of the links above, you’ll get a sense for the complexities.

In addition to the regulatory legal issues, there are legal issues as a result of the terms set forth in the companies financing documents.  Most VC backed companies terms include a “Right of First Refusal” or “ROFR” that needs to be waived or given the time to expire.  There are also often co-sale agreements giving the other shareholders the right to sell shares to the acquirer.  As time is the enemy of any deal, these terms cause friction in the market.

Silbert highlighted how SecondMarket has a 15 person department to comply with all the rules.

The daunting legal issues are coupled with a current marketplace where companies look wearily on private market transactions.  Company fears highlighted by the panel included:

  1. Employee De-Motivation – If employees monetize their wealth, there is a fear they will be less motivated to drive the company’s performance.  .
  2. Spread between options value and preferred shares – If a secondary market transaction place a fair market value that is higher than the Board has set, it could increase the price at which new options can be granted and deter an company’s ability to raw top talent.
  3. Confidentiality – A new shareholder could demand to see financial information the company would prefer not to disclose.
  4. The Rule of 500 – If a company has over 500 shareholders, they are required to file information as if they were public.

Some companies, including Facebook, have reportedly already limited employees ability to sell shares unless “a window opens”.   Interestingly, restricting current employees’ ability to sell creates the incentive to leave a company, as ex-employees often have far greater flexibility.

SecondMarket believes that these issues can be addressed by having more of a “structured” marketplace, where companies identify one broker (e.g. SecondMarket), who can address all the legal issues and help structure liquidity programs that meet the needs of all the different parties (most notably the companies).  While that may address many of the companies concerns, it seems to us to put other constraints on the market.  Having a company force a broker on both a buyer and seller isn’t how the public market works, as parties want to choose their own brokers.  So by definition, a closed system will decrease the price received by the sellers at it decreases the pool of potential buyers.  Also, a closed market just doesn’t smell right.  But if it does address the concerns of the companies, and if the companies are the gating factor to growing the market, maybe it is the best path to grow the market?

At the end of the day, we believe the market is best served by being as open as possible.  For employees struggling to make ends meet, it’s a tough pill to swallow to be told by your company that you can’t sell share or you have to sell them in a window or in a closed system that will decrease the prices.  I think enlightened companies that give their employees the most freedom will emerge, all else being equal, as the preferred places to work.   In fact, companies should embrace the secondary market as a way to increase employee happiness and retention.   One company we’re familiar with is planning to let their employees sell their shares, but the proceeds will be put in escrow and be drawn on by the employees on a monthly basis over four years.  Guess what, the employees are going to be thrilled, as it will meaningfully increase their monthly take home.  Both retention and productivity are sure to increase.  Finally, the company will also ask the employees to defer raises for four years, as in effect, they will be receiving very meaningful pay increases through the stock sales.  Lower costs are great for all shareholders.  Sounds like a great win/win/win.

That genie is clearly out of the bottle, as employees are increasingly aware of the secondary markets available for selling their shares.  Companies should embrace the genie, not try to stuff it back in the bottle.   Interestingly, SecondMarket mentioned on the call that they will be leveraging the secondary market to provide liquidity for their employees.  Maybe they can be the poster child they’ve been searching for?

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