Second Chances: Will Mid-Market Shares Trade on Private E-Platforms?

By Myra Thomas for PRESIDENT&CEO Magazine

Tech phenoms Facebook, Zynga and Twitter brought investor and media attention to the trading of shares in private companies. More recently, the outsized and long anticipated  Facebook IPO has shined a brighter spotlight on what is becoming a popular funding path for hot, sought after issues: moving from the private secondary markets to an eventual initial public offering. At this point, most middle market firms, lacking well-known brands and the sex appeal to create demand for their private shares, have yet to participate in these secondary markets in a meaningful way.

Even so, some investors are counting on the evolution of an increasingly robust secondary marketplace for pre-IPO stock that includes mid-sized companies. With IPOs not yet at pre-recessionary levels, the motivation to raise money through secondary electronic markets is gaining traction. Meanwhile, the increasing regulatory oversight of publicly traded companies and the short-term expectations of analysts who cover them are causing more companies to remain private longer or opt out of going public altogether. Some believe that electronic trading of private shares could be one answer to the sustained cash crunch middle market firms have experienced during the lagging economy.

Those offering secondary trading platforms include a cross-section of financial services providers, including the online private exchanges SecondMarket and SharesPost, electronic marketplace Liquidnet and a bevy of established and lesser-known banks, investment firms and brokerages. As interest grows, questions remain. Market observers wonder how quickly a relatively illiquid trading arena can become more dynamic and transparent. Others worry that only technology startups and investor darlings will benefit from trading in pre-IPO shares.

The Electronic Trading Post

According to Ali Byrd, regional head of the New York private company market team for SecondMarket, mid-sized companies are prime targets for qualified institutional investors looking to trade in private company shares. The new medium, he says, simplifies the process and adds transparency.

“Trading in private company stock isn’t new, but the driver is,” says Byrd, adding that an electronic platform allows buyers and sellers to connect more easily and provides the requisite company financial documents and material disclosures accessible online. “We’re a registered broker-dealer, with a dedicated enterprise platform and market specialists, so companies can manage their liquidity needs,” he says. “The seller controls the parameters, who is allowed to buy or sell, and at what point or time, and at what price.”

Byrd concedes that for now most shares trading on SecondMarket are those of tech companies in the consumer, ecommerce, advertising and financial arenas. In the first quarter of 2012, software companies made up 53.7 percent of SecondMarket’s completed transactions. Consumer web and social media companies represented 43.7 percent, and financial services firms tracked in at 2.7 percent. Even so, Byrd sees non-tech firms in the health, energy and education sectors as obvious and attractive targets.

To be sure, not all interested investors can invest using SecondMarket or its competitors. The SEC mandates that only qualified institutional buyers are allowed to participate in the secondary market in pre-IPO shares. QIBs, as defined by securities regulators, are investors with a minimum of $100 million in assets under management, a level considered sophisticated enough to handle financial risk.

A New Asset Class

PE Source, an alliance of market maker Knight Capital Americas and private company research provider GreenCrest Capital Management, joined the list of secondary direct trading firms in December. Bill Kelly, managing director and head of equity capital markets at Knight, says the move was a natural evolution. “We’re an all-institutional firm and our clients were beginning to trade Facebook and other private companies, and it simply became more visible,” he says.

While there is yet very little price transparency in the trading of private company shares, Kelly contends that is changing. For now, the market in pre-IPO shares doesn’t offer what public trading provides—real-time published bid, ask and last sale stock prices. “The element of price discovery comes with more market participants,” he says. “It’s wrong to say it will work or not based on the volume of transactions. You have to think of this as a new asset class.”

Boaz Rahav, managing director and founder of GreenCrest Capital, said that with any new platform, the market will inevitably see an influx of sellers. The slowdown in the IPO marketplace is sure to push more middle market companies to go to the secondary direct market, he reasons, as underwriters pick and choose only the largest companies to go public. “The underwriters of the 1980s and 1990s are gone,” he says. “Now you have a team of mega-underwriters leading IPOs.”

Shifting Regulatory Sands

Some in the financial services industry are expecting the Jumpstart Our Business Startups Act, passed in April, to boost the secondary direct market. Rahav notes the legislation increases the number of shareholders permitted before companies are required to register with the SEC, easing a restriction that historically forced them to go public. “What it’s designed to do is to make capital access easier for companies, and there are implications for the secondary market,” he says. “This opens an alternative route for seed-stage and early investors.”

Even so, the SEC has forged ahead with closer scrutiny of the private secondary market. In March, the agency accused two managers of private investment funds of attempting to buy shares of Facebook and other Silicon Valley firms by “misleading investors and pocketing undisclosed fees and commissions.” As part of the same investigation, the SEC also went after SharesPost for “engaging in securities transactions without registering as a broker-dealer.”

The agency’s lawsuit against fund manager Frank Mazzola and his firms Felix Investments and Facie Libre Management Associates is ongoing, while the suit against EB Financial Group and Laurence Albukerk was settled. Without admitting or denying the SEC’s findings, EB Financial Group and Albukerk “agreed to pay disgorgement and prejudgment interest of $210,499 and a penalty of $100,000,” the SEC said in March.

The SEC settled with SharesPost and company CEO Greg Brogger for penalties of $80,000 and $20,000, respectively. Following the investigation, SharesPost acquired a broker-dealer license and its membership agreement was approved by the Financial Industry Regulatory Authority.

Words of Wisdom

Mark Greenfield, a partner in the West Coast corporate practice of the law firm Blank Rome, says the regulation of secondary direct trading remains a “moving target.” “The SEC is paying particular attention to this arena,” he says, “and the key players are very anxious to make sure they are in lockstep with the SEC.” He urges executives at private companies looking to find a platform to sell their pre-IPO shares to seek investment and legal advice. “If a company is searching—use the same criteria that they would when selecting an underwriter for an IPO,” Greenfield says. “Look for a firm that’s willing to provide strong compliance, market and aftermarket support…(one) that will create a marketplace to support the company’s value and meet the requirements of the SEC.” Rob Brighton, corporate and securities partner with law firm Shutts & Bowen, advises middle-market firms to be aware of the inherent risk of litigation associated with secondary transactions, including potential for stock manipulation and insider trading. Current investors and company leaders must ensure that all financial and material disclosures are made to avoid increased regulatory scrutiny and lawsuits, he says. Even when the ducks are in order, a secondary trading platform is not always the best vehicle for a mid-sized firm looking to raise capital, says Jay Ritter, professor of finance at the University of Florida. Some companies require the expertise of hands-on private equity investors. Many middle market companies are “not only looking for capital, but they also want advice,” Ritter says.

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