Secondmarket and the way forward for private secondary markets

SecondMarket recently came out with info on their 1H 2012 activities, which I think are telling about the state of the private secondary markets.

“We’ve never had so many companies engaging with us,” Barry Silbert, SecondMarket’s CEO, told CNBC Monday. “They’re looking at what’s happening in the public market with the way stocks [from recent IPOs] are getting pummeled, [and] the way that the management teams getting destroyed in the press,” and want nothing to do with it, he said. CNBC further adds that ‘Silbert wants SecondMarket to be the solution for small companies wary of those IPO pitfalls to get liquidity’.

This is a very interesting view from someone on the inside of the private secondary markets. In the case of Facebook, it is probably correct to say that the stock is getting  pummeled in the public stock market, and Zynga is certainly facing <a href=’http://www.bloomberg.com/news/2012-08-22/zynga-spurning-sale-strands-owners-at-worst-web-value.html&#8217; target=’blank’>several difficulties</a> in the public markets. But can we really say this amounts to an ‘IPO pitfall’ for private companies going public?

The public markets seem to be treating the average tech IPOs well. Witness the recent IPO of Kayak and Palo Alto Networks. Both companies had great public debuts. The WSJ quoted Palo Alto Chief Executive Mark McLaughlin that Investors appear eager to buy IPOs “if you have a strong company”, who further said that “Not surprisingly, a lot of institutional buyers will take a long view on a good company. They’re not worried about what the market was doing yesterday or how it performed today”.

The FT recently stated that ‘Facebook shares have fallen despite the success of other technology public offerings this year. The other 22 IPOs from the sector in 2012 have an average gain of 25 per cent through to the end of last week, according to S&P Capital IQ, a research firm.’

Perhaps Facebook getting pummeled in the public stock market is a reflection of a disappointing current monetization strategy from the company. The price of a stock should reflects the expected future earnings. Public investors are disappointed by the current revenues of the company and therefore expect future earnings to be disappointing as well. If you disagree and think Facebook is being undervalued by the market, you can buy the stock. At least you can do so now with full knowledge of the company’s financial position.

Facebook enjoyed very high valuation on private secondary platform such as Secondmarket, and perhaps the fact that it didn’t report its results to buyers in those markets played a role. As the NYT noted as early as 2010:

“Investors are taking on substantial risk when buying shares in these private companies. Despite Facebook’s ubiquity it does not disclose its financial results.”

One such pre-IPO buyer candidly admitted to the WSJ that he thought it was a “bragging right” when he landed the opportunity to buy (Facebook) shares last fall at $31. “I accepted the fact that this was a speculative play,” he said. “But I thought the pre-IPO price was just bound to be lower than what it would be on the public market.”

Felix Salmon provides on his blog an interesting view into the 2011 frenzy to acquire private shares of Facebook: ‘it’s increasingly looking as though shares in private tech-companies are a bit like fine art prices: a place for the rich to spend lots of money and feel great about owning something very few other people can have. The minute they become public and democratic, they lose their cachet. And a lot of their value.’

So what can we deduct from all this? What is the difference between the private and public secondary markets?

The main difference between the private and public stock markets is that public companies are subject to disclosure requirements while private companies are not, and that trading in the public market is cheap and liquidity is usually plentiful, while it is lacking and expensive to access in the private markets.

If you buy stock of Facebook today, you can do so for  $10 or less in transaction cost, and you can sell it back to the market any time. If you bought shares of Facebook in the private markets, you paid 2 to 5% in commission, and you can sell your shares at the earliest on August 16 2012, when the first batch of insider lock-ups expire. Reselling private shares within the private markets themselves is almost no-go, because of legal restrictions

Before the 2011 ‘private market frenzy’, savvy professional participants in the private markets would usually build a relationship with the company before buying shares, and get access to company information. John Glynn of Glynn Capital Management, recalled in a Business Week article that “These were very occasional transactions, and it was done the old-fashioned way. You earned the respect and trust of the company, and they ended up wanting you as a shareholder.”

The key lesson would be that you should only buy private shares from a company with whom you have an established relationships and who grants you access to corporate information. VCs have access to such information via privately negotiated information rights. Professionbal secondary buyers such as DST or Millenium probably have access to company information, as they bought shares from employees with the full cooperation of the company.

The way forward

Interestingly enough, this is also the path that activity on Secondmarket  seeems to be taking. In 1H 2012, the number of ‘accredited investor’ buyers dropped by 5x to 6% of the volume, compared with 27% in 2011 FY. Also, the share of ex-employees as seller dropped by 3x. Ex-employees represented 80% of the transactions in 2011, compared with only 24% so far this year. Remember that Facebook implemented an insider trading policy preventing current employees from selling shares in 2011. Also notable is that almost 60% of shares sold in 1H 2012 were preferred shares, which means that sellers were likely institutional shareholders as opposed to employees.

These 2012 numbers point towards a more muted private market based on activity from professional participants(institutional vs merely ‘accredited’ individuals) with an established relationship with the company, and who transact with the full collaboration of the company.

This is not surprising as Secondmarket recently switched it’s model from one were participants could trade shares of any company, to one where companies control the trading of their shares on the platform, pre-select buyer and sellers and have to provide the market with a modicum of financial disclosure. Such company sponsored transaction are I think the way to go forward for the private markets, or perhaps a return to how to market operated pre-Facebook buying frenzy.

More disclosure by private companies and a direct relationship with potential buyers of their shares are the way to go forward, it could however turn out to be less lucrative for Secondmarket than the 2011 trading of Facebook shares. The WSJ pointed out :

“(…) a month before the social network’s shares jumped to the public market, SecondMarket laid off about 10% of its staff. And while it continues to trade shares of hot private companies, these deals can offer limited rewards. A majority of such companies pay SecondMarket a flat rate to manage a transaction in which the company itself has already selected those that will buy its stock.”

The WSJ goes on: “SecondMarket’s primary asset is the collection of well-heeled, accredited investors on its platform. Fund managers that specialize in oddball investments are anxious to tap into that money pool and will pay SecondMarket a percentage of the cash they can raise.”

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