The WSJ had a very interesting article last May which told the stories of various people and their intention to buy shares of Facebook either in the IPO or before it in the secondary market. One of those stories is about someone who tried to buy shares via Sharespost. it gives some insight about how potential buyers were bidding on shares in a private company, without having access to any company information and without having a pre-existing relationship with the company. It also suggests that Sharespost was not very strict about enforcing the ‘accredited investor’ requirement for buyers on their site. This potential buyer is quoted saying that ‘between his 401K and an IRA fund and the college savings, (he found a way) to squeeze together the $100,000 minimum (transaction size) recommended by SharesPost’. That doesn’t sound like someone with at least $1M in assets or $200k in income…  While Sharespost did seem to have a close relationship with him: “Jim, I’m gonna be honest with you, you’re not gonna get it, very rarely does it sell for the minimum,” Mr. Supple says he was told by his SharesPost broker.

Here is the full excerpt:

Rockville Centre, N.Y.—Jim Supple was driving with his daughter Jade last autumn, when she turned to him and said, “Daddy, can I buy some of the Facebook company?”

Mr. Supple, 47, had been teaching Jade about investing in the stock market for years. He started putting money for her in stocks like eBay and Disney when she was a baby. But the request still took him aback. “How do you know about buying Facebook?” he asked.

“I saw in the news that they were going to be selling parts of the company,” she responded. “Can we buy some?”

Since then, Mr. Supple has been trying to find a way to take $25,000 he has saved for her college fund and purchase Facebook stock. “She doesn’t need this money for another eight years,” says Mr. Supple. “If it goes the Google route, I’ll be in good shape.”

Although he thought Facebook was a strong investment, Mr. Supple had been burned before, having lost some money in a Ponzi scheme, he says. He wanted to be sure that he was being more careful this time before betting so much on one company.

On Jan. 17, Mr. Supple tried to dive in. Two former Facebook employees were selling 70,000 shares in an auction on SharesPost Inc., one of the secondary markets for Facebook shares. The bidding started at $31 a share. He bid $32.01. “Jim, I’m gonna be honest with you, you’re not gonna get it, very rarely does it sell for the minimum,” Mr. Supple says he was told by his SharesPost broker.

Mr. Supple works for a Manhattan-based company called SNAP Interactive that creates a software application that allows singles to go on Facebook and find dates. Over a Jan. 18 dinner of burgers and beer at the New York steakhouse Del Frisco’s, Mr. Supple asked his boss, Cliff Lerner, what he thought about buying up Facebook in the secondary market.

“You know, there is a very high minimum to get into the secondary market,” Mr. Lerner cautioned Mr. Supple. Mr. Supple said he could figure out a way, between his 401K and an IRA fund and the college savings, to squeeze together the $100,000 minimum recommended by SharesPost. “Am I out of my mind?” Mr. Supple asked Mr. Lerner. “No, I think you’re gonna kill it in this thing,” responded Mr. Lerner.

Mr. Supple lost the SharesPost auction. It closed on Jan. 20 for $34 a share, less than $2 above his bid.

Just two weeks later, Facebook filed for its IPO with the Securities and Exchange Commission, driving the price of secondary market shares up drastically. The next auction was $44 a share, too expensive for Mr. Supple. Mr. Supple turned his energy away from the secondary market and began plotting how to buy shares on the day of the IPO, or shortly after.

On April 9, just after the roadshow kicked off, Mr. Supple said he was getting concerned about the frenzy and rethinking his plan to buy on the day of the IPO.

“Here in New York, it’s on every single news channel, it’s in all the newspapers that the roadshow has started and [Facebook Chief Executive Mark] Zuckerberg was here in New York,” he said at the time. “I’m going to sit on the sidelines on IPO day,” Mr. Supple decided. “We’re going to have to wait until the smoke clears.”


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=’; 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.”

In 2011-12 the media focused on the trading of Facebook stock via brokers such as Secondmarket and Sharespost (who became a broker/dealer in early 2012, after settling with the SEC over allegations of operating as an unregistered broker). What received less attention was the fact that Facebook, as early as 2008, pioneered a form of engagement with common shareholders and outside secondary buyers that  resulted in liquidity for employees and presumably a huge HR benefit for the company itself.

A recent WSJ article reveals to us how the firm, as far back as 2008, through the efforts of its then CFO Gideon Yu, was actively courting sophisticated secondary investors to promote liquidity to its common shareholders (mainly current and former employees). This first resulted in $10m in common stock being acquired by Millenium Technology Value Partners from a dozen employees in 2008.

A year later, DST bought $100m worth of common stock form employees, in another deal orchestrated by the company.

It should be noted that both transactions were the direct result of Facebook reaching out to investors and building relationships with them, even though the transactions themselves were between shareholders and the outside investor. This can be seen from Mark Zuckerbergs comment on the deal at the time(emphasis is mine):

While individuals must make their own decisions about participating in this program, I’m pleased that the price DST is offering is much greater than the price originally considered last fall. This is recognition of Facebook’s growth and progress towards making the world more open and connected.”

Essentially, Facebook built relationships with outside investors, which paved the way for shareholders individually selling to those investors, without the need for a broker. It should also be noted that these secondary transactions were for the benefit of all common shareholders, not just the founders.
The Facebook deals were very different from limited secondary components of funding rounds which often allows founders to partially cash out. Such ‘secondary deals’ are often limited in scope and benefit only the founders, while being used as a sweetener by VC firms(Bill Gurley of Benchmark reportedly called these practices ‘bribes’).
Twitter’s massive secondary component of it’s 2011 funding round on the other hand clearly was orchestrated to provide broad access to liquidity to its shareholder base, similar to the preceding Facebook deals.

Secondary markets are often referred to by company management and boards as a pain and distraction that they wished would go away. It seems Facebook really was a pioneer in addressing and solving those problems, turning the private secondary market to its advantage.

This is best illustrated by a quote from a recent Millennium press release:

“Facebook solved one of the biggest problems facing emerging high-growth companies,” says Millennium’s Sam Schwerin. “Through the company’s unprecedented use of secondary purchase programs that allowed stakeholders to achieve early liquidity, Facebook was able to develop its business model in the relative calm of private company status. The company was able to avoid the inevitable pressures to go public too soon.”

Over time, Facebook developed ways of addressing some of the challenges and complexities of secondary market activity. Schwerin adds, “Facebook pioneered the trend of ‘taking control’ of the secondary process. Having learned from Facebook’s experience, leading companies are now selecting institutional partners for liquidity transactions, using secondary liquidity to attract and retain key talent, and aligning secondary activity with strategic goals, rather than allowing it to become a random or distracting process.”

What is most interesting is that Facebook achieved this without resorting to using one of the well-known online marketplaces for private stock such as Secondmarket or Sharespost. While its stock did trade on those platforms, this was through ad hoc transactions where shareholders sold to investors unknown to the company.(While Secondmarket as since shifted to offering company controlled ‘liquidity programs’, Facebook never signed on to those and its shares traded without the company’s involvement on the platform).
While the transactions on these marketplaces did get the bulk of media attention in 2011, they represented deals that went ‘through the cracks’ of Facebook’s control over its shareholder base. Perhaps Facebook’s focus shifted to the public markets in 2011, and the lack of a large orchestrated liquidity program resulted in so many shares being sold on the open market via Secondmarket and Sharespost.
One could argue that as Facebook became so well known by the general public, a market for its shares was created by buyers unknown to the company and with very little access to information about it. The only reason those buyers were willing to buy stock was the public reputation of the firm and the expectation that is was soon to go public in one of the most anticipated IPO. An unprecedented situation and probably the last time we will come across it.

The conclusion we can draw from the Facebook activities in 2008-09 is that when companies realize that the demand for liquidity becomes a distraction for their employees, it is best to address it directly by building long term relationships with selected outside investors. Such direct relationship between the company, its shareholders and those outside buyers pave the way for commission-free private transactions(no broker = no commission), while ensuring that those transactions are in full compliance with corporate policies and financial regulations.

In mid 2011, right in the middle of the private FB shares boom, the Fortune Brainstorm Tech conference in Aspen hosted a panel on secondary markets and private companies. Both venture capitalist and company CEOs expressed concerns about the pain the secondary markets were creating for private tech companies. This was discussed in a NYT blogpost

It’s a distraction,” said Dick Costolo, Twitter‘s chief executive. “We and Zynga and Facebook have retroactively had to put lots of policies in place to constrain that.”

New start-ups are writing bylaws that govern sales of shares on the secondary market, said Matt Cohler, a partner at Benchmark Capital. He encourages start-up founders to do so.

About a year later, at an April 2012 event organized by Wealthfront, Doug Leone from Sequoia was heard saying that “within Sequoia Capital companies, the door is getting shut on the secondary markets.” He further said that “companies are enforcing stricter trading rules on employees and “rights of first refusal all over the place,”

A company can prevent current employees from selling (but in doing so risks creating an incentive for people to leave), and hope to prevent any addition to its cap table by consistently exercising its right of first refusal when an ex-employee tries to sell to an outsider.

Companies could do even better by engaging with shareholders through Investor Relations(IR). Two way communication with and the provision of information about a company’s prospect to common shareholders could reduce the demand for liquidity from (ex-) employees. It could also help companies gauge the need for liquidity and understand where it comes from.

At the 2011 Fortune panel, Frank Quattrone, the investment banker, said that whether private markets are beneficial depends on the employees’ motivation for selling their shares — cashing out, versus buying a house so they can concentrate at work.

If the need for liquidity proves to be a distraction for employees, companies could through their IR program reach out to pre-selected dedicated investors of their choosing, and work with them in setting up a liquidity program for common shareholders. Such deals are already being done, and a dedicated IR platform would make this more efficient.

At OpenShares we are building a shared platform for IR aimed at private companies and specifically tailored to meet their secondary market related needs. As we are not a broker, our goal is not to generate trading volume, it is rather fully aligned with the IR goals of the company. If a company wants to constrain the secondary market in their shares, then our platform could serve exactly such purpose. If companies do want to promote a form of limited and controlled liquidity, this could also be done through the platform by engaging with investors of their choosing. Companies, their shareholders and potential outside investors could build relationships directly with each other, paving the way for commission-free direct transactions between shareholders and company vetted outside investors. Companies could through communication manage the valuation and legal risks that arise from such secondary transactions, and ensure that transactions are in full compliance with both corporate polices and financial regulations.

In other words, OpenShares will allow companies to pro-actively address the needs of their common shareholders and manage their secondary market.

I believe private companies need to start building more meaningful relationships with their common shareholders. Why? For two reasons:

  1. an inexorable increase in common shareholder count. In the past, the 500 shareholder count limit forced companies from Google to Facebook to seek the public markets, as breaching the 500 limit would subject them to the oversight of a public company anyway. With the Jobs Act, that has now been increased to 2.000. This means private company will be able to ramp up their employee share ownership while staying private all the longer.
  2. the rise of the secondary market. This will further grow the number of shareholder, as each trade on average grows the shareholder base by one, assuming shareholders don’t sell their entire holding in one trade. Even if secondary markets have not reached the masses of private companies, their perceived benefits certainly have reached the masses of private company shareholders. This also creates pressure for companies to engage with their common shareholders and understand where the demand for liquidity comes from.

For companies, a rise in shareholder counts and secondary transactions create various headaches, which were very well summarized in this quora answer:

  • Increase in total number of investors (which causes securities law compliance issues and adds to administrative burden).
  • Inability to control the identity of shareholders. (Even if the company has a right of first refusal on transfers of shares, which is common, if the buyer offers a high enough price and/or the company doesn’t have the cash lying around to exercise the ROFR, the shares can end up in anyone’s hands.)
  • Leakage of financial and other proprietary information. Buyers understandably want to know as much as possible about the condition and prospects of a company before paying serious coin for a relatively risky, illiquid investment. The company is put in a tough position where it either cooperates and discloses financial information under Non-Disclosure Agreement to the potential buyer or refuses to cooperate, putting strain on some relationships and encouraging buyers and sellers to circumvent the NDA (tough to prove).
  • Messing up 409A Valuations, which the company pays real money for. By setting a new market price for the shares, secondary sales can force the company to price stock option grants higher than it would like going forward, undermining the incentive value of equity.
  • Inability to control the process. Most private companies would prefer no secondary sales be made at all before an Initial Public Offering (subject to some narrow exceptions), but as the lesser evil, the company is better off doing a controlled, structured process the way Facebook reportedly does.
  • Distraction and resentment among employees. There are always equity haves and have-nots, but it’s worse with private sales where investors usually don’t want to bother unless the block of shares is large enough. So generally top execs and founders have no trouble selling while rank-and-file employees may not have enough shares for anyone to bother, leaving them SOL.
  • Complex legal documentation and administrative burden. The standard documents used by a firm like SharesPost can run 30 pages. Selling shares in a publicly traded company requires only a couple pages in most cases. Everything has to be vetted by the company’s (inevitably overworked) legal and finance teams.

Companies can resolve these problems with IR tools. Its all about communication with your common shareholders really. First of all, employees and other common shareholders might be clamoring for secondary liquidity, but the real reason might simply be a lack of engagement and information coming from companies. An ex-employee might want to cash out on his shares simply because he now feels disconnected from the company. An IR campaign aimed at common shareholders could do a great deal to reduce demand for liquidity in the first place.

Shareholders might also feel the need for liquidity due to their personal financial situation. When they reach 30 and get their first child, the need for cash for a deposit on a house might be greater then that for an ownership stake in a risky venture. If the need for liquidity becomes a distraction for current employees, or prevents the company from competing with publicly traded rivals over talent, a private company might consider pro-actively enhancing the liquidity of its common stock.

Again, such liquidity can be achieved through IR tools as well. Back in the days that ‘secondary market’ was not yet a buzzword, transaction were occasional and conducted with outside buyers with a long standing relationship with the company. the following quote from John Glynn is telling:

“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.”

Another example is the leading role played by Millennium Technology Partners, a pioneer secondary investor in VC backed companies. Here is an excerpt from the same business week article

Millennium Technology Value Partners was among the first such investment funds, founded by two veterans of buyout firm Blackstone (BX). The fund spent the early part of the decade buying shares in startups from executives and investors that needed cash. In one of its first organized, companywide “liquidity programs” in 2006, Millennium bought shares from employees, executives, and investors of TellMe Networks, a Silicon Valley voice recognition company. Microsoft acquired the startup the following year, reaping Millennium bounteous profits. These transactions were still tame, well-orchestrated, and carefully negotiated affairs, always conducted with the imprimatur of the company in question. And then Facebook changed everything.

The frenzy that followed to acquire FB shares did not represent the dawn of a new era, which would see the private secondary market virtually replacing the public markets. It was just a blip, albeit a very big one, in the history of the secondary market.

Companies wishing to pro-actively enhance the liquidity of their common stock for the benefit of their shareholders should do so the ‘old fashioned’ way: by building relationships with one or several sophisticated secondary buyer such as Millemium.

By communicating with existing common shareholder and selected outside potential secondary buyers on an equal footing, private companies can assert control over their secondary share price, their shareholder base and the information used as the basis for transactions. This would effectively deal with the above mentioned problems, as well as with the risk of insider trading arising every time a shareholder with some corporate information sells to an outsider with none.

This is taken from a recent Quora answer which I felt was material enough to warrant a blog post as well 😉

If you want to sell shares of a private company you will have to take applicable financial regulations into account, as well as the contractual rights of the company and other shareholders (Right of First Refusal). I won’t go into the rarely exercised Right of Co-sale.

Regarding the contractual rights: The contractual rights (ROFR) entail that the company whose shares you hold and/or your fellow shareholders have a right but not an obligation to preemptively purchase the shares that you want to sell to an outsider. So in fact you should usually first find a willing buyer at a particular price, then go to the company and give them notice of your intent to sell. Then the company will go through the procedure and notify you out its outcome. ROFR usually have to be exercised at the same price as whatever the outside buyer is willing to pay. So in case the ROFR are exercised you don’t really lose out, however the outside buyer does not get to purchase the shares he wanted.

These are the usual steps to go through:

  • Best thing for you to do is first sign an Stock Purchase Agreement(SPA) with the buyer. The SPA should take the existence of the ROFR into account of course (you can’t really promise to sell shares until you know the outcome of the ROFR). So it should be a contract were you and the buyer agree to transact subject to the outcome of the ROFR procedure.
  • Next you need to notify the company of your intent to sell. The company usually has up to a month to go through the procedure, and will then notify you of its outcome.
  • At this point you know how many shares you can sell to the outside buyers, and it would be best to retain a lawyer and get a legal opinion about the compliance of this prospective transaction with applicable financial regulations. The company is likely to request such an opinion before transferring the shares.
  • You should then sign a Stock Power directing the company to transfer your shares in the name of the buyer, and send it along with the legal opinion to the company. You should also send a copy of those to the buyer, along with a copy of your stock certificate.
  • I would say that at this point the buyer should wire you the funds.
  • Once the company has received the Stock power and legal opinion and is satisfied of the legality of the transfer, they will change the name of the shareholder in their registry and issue a new stock certificate in the name of the buyer.

The cost of the above is likely to run into the hundreds of dollars, mainly to obtain the legal opinion. If you go through Secondmarket or Sharespost or another broker you will have to pay them a fee as well, I believe its around 3% of the transaction. If you go through a broker, then obviously the above process will be slightly different as you will be assisted by the broker, but the steps will still have to be walked through.

Regarding financial regulations:
I can’t tell you everything on this topic, as it will also involve complying with State ‘blue sky’ laws and also with insider trading laws, but here are the main points:

  • private shares are likely to qualify as ‘restricted’ or ‘control’ securities (control securities are the same as restricted, but are called control securies when in the hands of an affiliate of the company, i.e. someone with a form of control of company management). This means that they can’t be sold without first being registered with the SEC, unless an exemption from registration is found.
  • Such an exemption is found in Section 4 (1) of the Securities Act of 1933 ( see here). It is available to anyone who is not an issuer, a dealer or an underwriter.
  • You are unlikely to qualify as an issuer(the company itself) or a dealer(a professional involved in the buying and selling of securities).
  • The main risk is to act as an Underwriter. This is because the definition is very broad and includes anyone involved in the ‘public offer’ of securities.There are two ways to avoid the status of underwrite, one is Rule 144, the other is the so-called Section 4 (1 1/2) type of transaction.
  • Rule 144 is a rule promulgated by the SEC to provide a ‘safe harbor’ for compliance under Section 4(1). It’s not exclusive and you should see it as one concrete example of avoiding the status of underwriter. If you are an affiliate, you will need to comply with quite a few requirements, however if you are not an affiliate you will only need to comply with the holding requirements. This is in most cases one year, meaning that you should have held the actual shares(not the options) for one year before being able to rely on Rule 144. If you did held your shares for one year and are not an affiliate, then it’s relatively simple to sell you shares relying on this rule. If you do not fufill with the requirements of Rule 144, you could still try to do a Section 4 (1 1/2) transaction.
  • Section 4 (1 1/2) type of transactions are an invention of lawyer to allow people to sell private shares without having to rely on Rule 144. It’s useful if you didn’t hold your shares for long enough or if you otherwise are unsure of complying with the requirements of Rule 144. There is no Section 4 and a half in the Securities Act, there is only Section 4 (1) and (2). (1) deals with secondary transactions and we discussed it above, (2) deals with private placements by companies (primary transactions). The thinking goes that since an underwriter is someone involved in the public offer of securities, to comply with 4 (1) you need to avoid doing anything that could be a public offer. Since a private placement is the opposite of a public offer, the best way to do avoid the underwriter status is to make sure that you comply with the appropriate requirements of 4 (2), even though these are in fact meant for primary offerings. This is what people refer to as a Section 4 and a half type of transaction, as you are relying on the requirements of 4(2) to secure compliance under 4(1). So essentially you need to take the same precautions as a company when doing a private placement, even though you are not a company and are actually doing a secondary transaction.

So that’s it. I’m not a lawyer so I hope this is all close to the facts as it can be. If any lawyer could help correct any mistakes or elaborate it would be greatly appreciated. I still haven’t covered compliance with State ‘blue sky’ securities law or with the potential risk of insider trading. For that last point you can look at this quora answer.

Regarding a company’s involvement in the process: Brokers such as Secondmarket have started offering tailored ‘liquidity programs’ which gives a company control over and involvement in the trading of their shares via the Secondmarket platform. I would however argue that companies need to start thinking of adopting investor relations(IR) programs independently of brokers, as this will best ensure that they meet their own IR goals, which not necessarily match that of the broker. If companies really want to promote liquidity in their stock, they can also provide an infrastructure to their shareholders and selected investors without necessarily relying on a broker either.

Private company shares were being ‘traded’ since the dawn of their existence, however thanks to Secondmarket, Sharepost and Facebook, trading private shares became a buzz word in the tech and financial communities. for a moment, a new era seemed at hand where the difference between the public and private markets would be irrelevant. The private secondary markets seemed unstoppable in their growth of participants and liquidity.

However, behind the headlines, the transformation of private markets proved short-lived and mainly driven by hype. Facebook stock made up almost half of the total turnover on these markets, followed by other hot consumer web companies such as Zynga and LinkedIn. Those last two went public in 2011, and were followed by the hotly anticipated Facebook IPO in May 2012. Since then, people have been wondering What’s next for private markets?.

With hindsight, it seems clear that private company stock achieved huge trading volumes in 2011 mainly because buyers were willing to pay anything to get their hands on hot consumer web stocks, hoping to benefit from a company’s inevitable IPO. And even in those days, the private markets did not resemble the public markets in liquidity or volume. When you buy shares on the private markets, you cannot resell them the next day, unless you want to face the risk of of breaching securities regulations.

More importantly, the red hot private company market of 2011 failed to benefit the majority of holders of private company shares. It was a typical case of a few participants (brokers from their commissions and holders of stock of a handful of companies from increased liquidity) benefiting enormously from what was a relatively small segment of the total market. Why did the market failed to expand? I believe is was because of a lack of IR coming from private companies. The few consumer web companies that did achieve a semblance of liquidity did so because they were hugely popular household names and buyers did not require any company information to be disclosed. This ended in nothing but disappointment. Bear in mind also that buyers of FB stock pre-ipo paid a 3% fee to either Secondmarket, Sharepost or another brokers, and also likely incurred additional legal fees during the transaction. They could have bought the same shares, (actually not the same ones, pre-IPO they bought ‘restricted securities’ that they have to hold until the window for selling for insiders opens) through a click of their mouse and by paying 0.15% in fees with no additional legal costs.

The private company market of 2011 is not a sustainable model that will bring liquidity to the masses of common shareholders of private companies. In the past, private shares would trade through occasional transactions between parties with pre-existing relationships, and with the participation of the private company involved. Buyers had to work hard in earning the trust of management and become long term shareholders. Information would be provided to would be buyers, and usually no broker was involved. These were old fashioned deals between people with an established business relationship. (read my other blog post on the history of private markets for more info)

I believe these ‘old fashioned’ deals are the way forward. Private shares are an illiquid and difficult to value asset class with a lot of regulatory baggage, and are best left to be purchased by experienced accredited investors or dedicated funds.

%d bloggers like this: