Secondary Markets an ‘abomination that should stop’?

What problems do secondary markets create for VC backed companies?

There is a very interesting article form Forbes from last week , about the ‘problem’ of secondary markets for private companies.

The main problems identified in the article, which quotes members of a panel at the Venture Forward Conference, is the lack of information about companies, the legal risk for companies that the murky rules of secondary market entail and the erratic overvaluation of shares which can negatively impact a companies perceived valuation to outsiders and complicates a future exit via a trade sale or IPO.

The solution, participants agreed, would be transactions ‘ orchestrated in house to vetted, knowledgeable, third parties’, which would ‘offer more safety for companies while still granting liquidity to employees and investors’.

the article goes on to mention potential existing solutions offered by brokers:

SecondMarket says that this is exactly the type of service they offer. Companies get full control of the sale of their stock, in addition to vetting rights over potential investors. Liquidnet, which secures private company stakes for large funds like Janus, BlackRock and T. Rowe Price, also works with companies to make targeted sales to secondary investors. Though SharesPost will cease trading a company’s stock at their request, they do offer the kind of over-the-counter investing that Hornik and Rice criticize.

I absolutely agree with the panel participants that a secondary model based on shareholders selling to ‘(company) vetted, knowledgeable third parties’ is the way to go forward. It is in fact exactly how things where done before secondary markets became a buzz word. As can be seen from the below quote:

When Richard Melmon, a co-founder of Electronic Arts (ERTS), left the video game pioneer shortly after it was founded in a dispute with his co-founder, he sold a portion of his holdings to a Valley financier named John Glynn, who recalls working hard to cultivate a relationship with EA before the deal. “These were very occasional transactions, and it was done the old-fashioned way,” Glynn says. “You earned the respect and trust of the company, and they ended up wanting you as a shareholder.”
(source)

I believe companies should go back to such a model. Brokers such as Secondmarket and Liquidnet have all moved towards offering companies controlled ‘liquidity programs’, which grant companies control over who is allowed to buy and sell and can provide information to the potential buyers. While this is a step in the right direction, it still does not allow companies and shareholders to build direct relationships with each other and with potential buyers of shares. It also creates a conflict of interest between companies and the brokers organizing the liquidity program: companies want occasional transactions only while brokers make money from commissions on transaction volume.

In fact, to achieve their goals, companies and shareholders don’t really need brokers. What they need is to build relationships with potential buyers of shares. Actual transactions can subsequently take place directly between those buyers and shareholders, something that is in fact favored by financial regulations (which are aimed at preventing parties with no pre-existing relationships from trading with each other). Simple communications with potential buyers and shareholders could help companies control their share price (by communicating a fair price to shareholders and potential buyers) and ensure all trading is done in compliance with corporate policies.

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