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What are the financial regulations that a start-up needs to take into account when issuing equity based compensation, whether stock options or RSUs?

It turns out there are quite a few. I will discuss one, which allows private companies to issue securities to their employees without registering the offer with the SEC.

A general rule in US financial regulations is that one cannot issue or sell securities without first registering them with the SEC, unless an exemption applies. We have looked at this before in the context of selling private shares.

The first way to avoid registering securities issued as compensation is by ensuring that the employee who receives the grant is an accredited investor, a director or an executive officer. So that covers your most senior employees. What about everyone else?

The other way to avoid registration is by ensuring that the issuance is ‘non-public’. (remember the section 4 (1 1/2) exemption for selling private shares?). However, determining what a ‘non-public’ offering is can be very difficult. It involves assessing the financial sophistication of the employee and providing information typically found in private placement offerings.

In order to help out, the legislator came up with something called Rule 701 of the Securities Act of 1933.

How to sell up to $1M in stock compensation?

Rule 701 makes is possible for private companies to sell up to $1M in ‘securities’ to their employees as part of a compensation plan (and more than $1M under certain calculations that I am leaving out here). There are some simple requirement such as that the issuance must be made under a ‘written’ plan. This basically means that you must have a contract or other piece of paper which sets out the terms of the plan. So far so good.

How to sell more than $5M in stock compensation, and how not to do it?

If you are a rather large private company and want to issue more than $5M in securities to your employees, things get a little more complicated. In that case, you will need to make certain detailed disclosure to your employees, including financial results. I am not going to go into the details of those disclosure requirements, but let’s say that if you feel that this is too much for your taste, you are not the first. Google chose to ignore those requirements back when it was private, because it ‘viewed the public disclosure of its detailed financial information as strategically disadvantageous’. This became a problem when the company went public and the SEC started looking more closely at the company’s compliance history.

This resulted in a SEC’s cease and desist order in 2005, which also provides a detailed account of Google’s compliance policies and failures.

Google’s path to an IPO, and the $80m in securities issued in the meantime

In it’s first years of existence, Google coud easily rely on Rule 701 as it’s stock option issuance did not reach levels requiring detailed disclosure to recipients. This changed in late 2002, when the company first became aware that it soon would reach such levels as would mandate additional disclosure to employees. The company temporarily stopped issuing stock options because it ‘viewed the public disclosure of its detailed financial information as strategically disadvantageous, and the company was concerned that providing option recipients with the financial disclosures required by Rule 701 could result in the disclosure of this information to the public at large and, significantly, to Google’s competitors‘.

In early 2003 the company wanted to resume issuing stock options. The general counsel, David C. Drummond, came to the conclusion that Google could avoid the additional disclosure that would come from issuing more options by not relying on Rule 701 but instead on more esoteric exemptions(yes the ones mentioned above who are notoriously complicated). If this turned out to be wrong, the company could simply repurchase the issued options under a ‘rescission offer’ as per Mr. Drummond.

Google started issuing stock option again, ultimately resulting in about $80M worth of securities being issued to employees and consultants without registering the offering and without providing financial information required to be disclosed under the federal securities laws. For clarity, when issuing securities you either have to register them(basically go public) or rely on an exemption from doing so(which would be Rule 701 or one of the more esoteric exemptions in this case).

As it turned out, the SEC came to the conclusion that those esoteric exemptions were not available to Google, and that the rescission offer the company made in 2004 did not cure any prior violation of securities law. The company had essentially been issuing about $80m worth of stock illegally.

The lesson seems to be that larger private companies who wish to issue any form of equity based compensation (RSU, options and others) in excess of $5m should meet the disclosure requirements of Rule 701. The majority of your employees are not going to qualify as accredited investors, and attempting to avoid 701 by relying on esoteric private placement exemptions is only going to make your life more difficult and is unlikely to result in a successful exemption.

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Today I saw and answered the following question on Quora:

“I’m working at one of the best post-IPO companies in Valley and have an offer from Square with 20% pay cut but stock options which at today’s valuation compensate for the pay cut over 4 years. However, I don’t have any savings and with this pay cut I don’t think I’ll save a lot. So I’m not sure if I’ll be able to exercise my options anyway. What are the alternatives for that?”

This question is a very good example of why private companies, especially in the tech sector where competition over talent is extremely high, should court prospective employees as  prospective common shareholders. The shares component is extremely important for such a prospective employee.

Private companies who want to enhance their ability to attract talent need to build a relationship with their current common shareholders and option holder as well as prospective ones. Public companies build relationships within their shareholders and the wider investor community so that people end up buying and/or holding on to their shares, supporting the public stock price. Private companies equally need to build relationships with current and prospective holders of their common stock. They should be answering questions and having a dialogue with their (prospective)shareholders about issues related to the company itself and also the intricacies of private shares.

Here is the answer I provided on Quora:

I think the question you need to answer for yourself is whether equity based compensation from a private company like Square is an attractive proposition compared to that of a public company. I assume that you are also receiving equity based compensation in the public company where you currently work.

The benefit of equity based comp from a public company is that you have access to the same information about the company as every other shareholder or investor on the planet, and you have instant and cheap liquidity at your disposal in the form of the public stock market. You know a lot about the health and direction of the company, and if you don’t like what you are seeing or you simply need cash you can sell your vested shares easily and cheaply.

The drawback of a private company is that you do not have access to much information about the company, and also not as much as some other shareholders. The VCs, who are preferred shareholders, always negotiate for information rights and usually also a seat on the board, which gives them access to information beyond that which is provided to common shareholders.

In general private VC-backed companies provide very little information to their common shareholders as there isn’t much in the way of disclosure requirements that compels them to do so.  One such requirements that does exist is that under Rule 701 of the Securities Act, which compels companies to provide information under their employee stock compensation plan, however the execution of this requirement differs widely between companies.

Without getting into the specifics of the success of Square as a company, you should also realize that due to the low or non-existent liquidity of private stock, you are essentially tied to the long term success of the private company and an eventual exit for the preferred shareholders and yourself.
Preferred shareholders not only have access to more information, but they also have the benefit of various financial preference over common shareholders. One such benefit is the ‘liquidation preference’ that VCs commonly negotiate for.

This preference entails that a particular class of shareholders is entitled to receive an amount of money equal to their original investment and any ‘unpaid dividends’ that would have accrued over time, before anyone else is entitled to share in the spoils of an eventual exit. This could create problems for common shareholders such as current and former employees in the event that the ultimate valuation upon exit is disappointing.

Because these are the most innovative and fast growing companies out there where you could individually create much more value than you ever could at a more mature public company. You could be involved in the creation of an entirely new market or the disruption of an old and stodgy one. In the event of a successful exit by the company, the value of your share options is likely to have compounded over the years.

And the above mentioned problems can be easily overcome by companies themselves. While private companies are not subject to much in terms of disclosure requirements, most great CEOs will want to foster a sense of common ownership among employees and provide more information to share- or option-holders then is necessary. Liquidity for private shares can be created, as Facebook or Twitter did in the past by building relationships with secondary buyers who then provided liquidity to common shareholders.

Finally, I’d liked to quote Stephen Cohen, co-founder of Palantir:

“We tend to massively underestimate the compounding returns of intelligence. As humans, we need to solve big problems. If you graduate Stanford at 22 and Google recruits you, you’ll work a 9-to-5. It’s probably more like an 11-to-3 in terms of hard work. They’ll pay well. It’s relaxing. But what they are actually doing is paying you to accept a much lower intellectual growth rate. When you recognize that intelligence is compounding, the cost of that missing long-term compounding is enormous. They’re not giving you the best opportunity of your life. Then a scary thing can happen: You might realize one day that you’ve lost your competitive edge. You won’t be the best anymore. You won’t be able to fall in love with new stuff. Things are cushy where you are. You get complacent and stall. So, run your prospective engineering hires through that narrative. Then show them the alternative: working at your startup.”

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.

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