‘But as originally conceived, the model for an intermediated secondary market for private company shares fairly soon proved to be unsustainable. There were federal and state regulatory challenges in the operation of the platforms, but more significantly there were major practical challenges to the marketplace model presented by the private company issuers themselves.’
Following the March 2013 announced joint venture between NASDAQ OMX (now Nasdaq Inc.) and SharesPost Inc. to launch Nasdaq Private Market (NPM), a new secondary market trading platform to buy and sell private company securities, an Accredited Investor Markets (AIMkts) article, (May 8, 2013), chronicled the emergence of platforms aimed at providing access to liquidity for holders of restricted securities.
NPM joined “SecondMarket,” a secondary market platform established by SecondMarket Holdings Inc. in 2009, largely in response to the desire of employee shareholders of Facebook in the time before that company’s initial public offering in 2012, to sell some or all of their shares while the company was still private. SharesPost likewise operated a competing secondary market platform for the purchase and sale of private company shares. Both SharesPost and SecondMarket presented opportunities for individuals who had held restricted securities for at least one year to exit those investments via an intermediated electronic marketplace.
Historically there was no organized secondary market in which private company shares could be sold. Holders had few, if any, unfettered paths to liquidity and, absent an eventual initial public offering (IPO) or sale of the company, were indefinitely locked in to their investment – unless the company itself created liquidity events or opportunities.
Although they were intermediated marketplace models, the new platforms like SecondMarket and SharesPost were not “trading” markets as such. Rather, they were designed to provide private company shareholders the means to connect with investors looking to purchase private company shares who were pre-qualified through the platform, and then to facilitate execution of the transactions, all within a legally compliant transaction setting.
Buyer participation in these secondary markets was limited to accredited investors. As noted, this was based on factors including the absence of information about the private company issuer available to market participants and an expectation that accredited investors were capable of evaluating the merits and risks of the investment decision. It was also consistent with the notion that individual sellers could structure a sale of their restricted securities as an issuer’s private offering equivalent. This, along with other means of protected access to the platform, also avoided any determination that posting on the platform would constitute a form of general advertising or solicitation, which at the time was a meaningful consideration for a seller of restricted securities to avoid being engaged in a public offering.
Sellers, whether founders, early stage investors, former employees or simply employees at whatever level, held restricted securities –acquired directly from the issuer in transactions not involving any public offering. Their securities could not be resold except in compliance with registration and offering process requirements of the federal Securities Act of 1933, or pursuant to an available exemption from those requirements and in compliance with state securities laws to the extent applicable. Limiting buyer participation to accredited investors was an important consideration in addressing those regulatory issues and potential roadblocks. NPM was to operate essentially in the same manner.
The joint venture with SharesPost to create NPM was particularly motivated at the time by the fact that an increasing number of private companies were choosing to remain private longer. Indeed, there was, and is, an incentive to do so provided by the Jumpstart Our Business Startups (JOBS) Act, which significantly increased the shareholder number threshold for companies to remain private. NPM was introduced in 2013 as “the preeminent marketplace for private growth companies.” But as originally conceived and discussed in the AIMkts May 2013 article marking the introduction of NPM, the model for an intermediated secondary market for private company shares fairly soon proved to be unsustainable. There were federal and state regulatory challenges in the operation of the platforms, but more significantly there were major practical challenges to the marketplace model presented by the private company issuers themselves.
A critical factor in the operation of the new secondary market platforms quickly became control by issuers of the marketplace for their shares. SecondMarket’s early favorable experience with a market for pre-IPO Facebook shares notwithstanding, it became clear that the largest, most highly valued private companies were hostile to the notion there should be an unfettered marketplace for their shares. Many simply did not want secondary trading. Some even threatened legal action to stop the secondary market platforms from facilitating transactions in their securities against company wishes. Citing numerous reasons for their hostility, the bottom line for these companies was simply maintaining control over their equity –their “cap table”–and every facet of transactions in their securities.
It also became apparent that the secondary market platforms would operate in an information void. Private companies have no obligation to create and disseminate information concerning their business and financial position to the marketplace, and accredited investor participants in that marketplace have no right to obtain it from the company. To the extent a secondary market was seen as a means of valuing private company shares through a traditional price discovery function of any financial market, it would not work. Secondary market transactions in Facebook shares while it was still a private company, illustrated the point. Ahead of the Facebook IPO, transactions in restricted shares of the company through the on-line secondary market occurred at prices far away from the value ultimately assigned in an open and efficient IPO aftermarket.
The share transfer and settlement processes completed through the secondary market platforms were also negatively impacted by company controls. Transactions could not be settled, for example, without compliance with whatever right of first refusal was in place for shares of a particular company. The secondary market platform could comply, but the process was cost inefficient and shown not to be scalable.
The challenge of maintaining a marketplace for shares of private companies while dealing with company involvement took its toll. SecondMarket shifted its focus from facilitating one-off trades to managing company-sponsored transactions, such as company-sponsored tender offers. In 2015, SecondMarket was acquired by NPM, which also then divested its part ownership of SharesPost and shifted its focus to managing company sponsored liquidity programs and events, focusing on the NPM proprietary ExactEquity™ cap table stock plan management program. SharesPost operates independently today to facilitate transactions for sellers of private company securities, including actual transfers of share ownership, and also to provide “liquidity solutions” for private companies, with heavy emphasis on private tender offers, and managing transactions according to company preferences. NPM competes in this process. Both look to providing a broad range of services to private companies heavily focused on company controlled liquidity events rather than facilitating secondary market transactions as platforms for buying and selling shares. Transactions may be made through the NPM platform, but only “company approved” investors may participate.
SharesPost continues to act as a broker for selling private company stock by shareholders who need liquidity ahead of an IPO or sale of the company. It does so largely based on established relationships with private companies and accommodation of the particular investor preferences and rights of those companies and their transfer processes.
With the shift from a pure marketplace model to one of service provider, facilitating transactions for private companies as they create and execute liquidity events for their shareholders, the desire for a true secondary market platform designed to connect private company shareholders seeking liquidity without regard to whatever liquidity events might be made available by their company, and circumventing company involvement, was not satisfied. A new secondary market model has emerged based on a derivative market structure, which transfers the economics of private company shares. Two electronic platforms have emerged as what some call this “second wave” of secondary markets for private company shares and “pre-IPO” liquidity:
“Equidate,” the platform operated by Equidate, Inc., creates contracts tied to the value of an individual’s private company shares. As characterized by one of the platform’s founders, an Equidate contract allows an investor to buy rights to the economic upside of a private company share, while avoiding “legal hoops” a company must go through when adding extra shareholders to its cap table. Legal ownership of the shares is never transferred. The initial shareholder retains his or her ownership, any associated voting rights, and position in the company’s cap table. When that company conducts an IPO, the investor who bought the Equidate contract will receive the cash value of the shares on the first day after whatever lock-up period is imposed in connection with the offering. Equidate permits only accredited investors to participate. The Equidate model is based on what has been described as a cross between a derivative contract and a collateralized loan. It is obviously not a secondary market trading model in any sense. It does, however, provide liquidity to private company shareholders who receive cash based on the value of the private company shares covered by the contract.
“EquityZen,” a platform operated by EquityZen, Inc., also involves a derivative structure, but in which a special purpose vehicle (the “Fund”) is the key component. The Fund actually purchases private company shares, with approval of the company, and subject to any right of first refusal held by the company. The shares are then held in the Fund.Investors are members of the Fund (organized as an LLC) that purchases a specific company’s Shares. EquityZen acts as the Managing Member of the Fund. The assets owned by the Fund (and its Members) are the Shares that the fund has purchased from private company shareholders via a “share transfer.” Membership interests in the Fund are offered and sold only to pre-qualified accredited investors.
In both the Equidate and EquityZen models, the private company shareholder receives cash representing the value, however determined, of his or her shares. Unlike Equidate, however, shares on the EquityZen platform actually change hands, as between the shareholder seller and the EquityZen Fund, a single counterparty, in which investors purchase interests. Valuation of interests in the Fund is a process in which the company’s last round of financing’s pricing is a guidepost. Ultimately, the shareholder seller chooses the price at which an offer to buy is listed on the platform. Other factors include investor demand, access to the company, other secondary transactions that have occurred and publicly available information. EquityZen does not make a market in the resale of interests in the Fund. It holds out a willingness, however, to facilitate resales of those interests in the event a replacement buyer can be found.
As noted above, SharesPost now independent of NPM, continues to provide an intermediated market for the purchase and sale of private company shares. It is, however, very much a hybrid market model. The SharesPost focus for both an intermediated secondary market for direct investments and dispositions of private company shares, and a special purpose vehicle for indirect investments, is on a group of late-stage, venture-backed private growth companies assembled each quarter and identified as the “SharesPost 100 List.” SharesPost directly intermediates purchases and sales of shares of these private companies, to the extent available, looking to a stable of pre-qualified accredited investors as buyers, as well as institutional investors and private offices. The hybrid character of the SharesPost model comes with the creation of a special purpose vehicle –the “SharesPost 100 Fund”–which invests directly in shares of private companies that make up the SharesPost 100, interests in which are offered and sold to a broader spectrum of investors.
Clearly, much has happened to transform the “private trading platforms” for restricted securities in the short time since the AIMkts assessment in May 2013 sparked by the appearance of NPM. SecondMarket, now part of NPM, is essentially a service provider, assisting private companies in conducting liquidity events for their shareholders. Repeat and recurring private company tender offers, for example, as well as company approved third-party private tender offers, have become a common path to liquidity. And while opportunities for intermediated –brokered– direct sales of private company shares still exist, as with the SharesPost hybrid secondary market model, the derivative or special purpose vehicle models that have lately emerged portend the future of an actual secondary market. Most importantly, with large private companies choosing to remain private much longer, the critical liquidity objective of a secondary market, however structured and described, can be achieved and continues to develop.
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Partner at Calfee, Halter & Griswold LLP, lecturer and author of Blue Sky Regulation.
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