Private Secondary Market - The Other Side

The biggest criticism that mars Private Secondary Market is that all the activities, all the transactions happen under immense Information Asymmetry and hence these are inefficient markets. The trading takes place in a somewhat opaque market accessible to only a relatively privileged class of investors. The market makers do try to provide as much information as they have access to and are permitted to but at the end of the day what they are doing is simply increasing the velocity of transactions made under poor judgment. So there is a question mark on the reliability on the valuation in these markets:

• Efficient Market Hypothesis says that market prices fully reflect all the available information. Can we say that in secondary marketplace, there is a high level of information asymmetry and hence the stock prices in this market do not reflect a fair value? 
• The volume of transactions in these markets is too small compared the same in a public listing and any valuations derived out of these small number of transactions can be misleading.

Many private companies attract new talent by giving the equities as one of the incentives but restrain their employees to trade in the private marketplace. This makes sense as the employees will have far more knowledge of the company performance and can lead to insider trading. There is no clarity on whether insider information is allowed in the trading of private stocks. But these markets in a way encourage the employees to leave the company as the share restrictions are not binding once the employee is no more in company’s payroll and they can cash out while the company is still growing. Certain companies like Zynga try to tackle this issue by having designated trading windows during which its employees can sell their stocks. But even when employees or founders are allowed to offload their stocks, a lower equity stake might result in a lower effort from them towards the company’s success.

With the rise of these marketplaces for raising capital, the private companies are remaining private for a longer period. Most of the current players like SecondMarket and SharesPost also act as placement agent providing advisory services to the investors. These markets are slowly becoming a strong viable alternative to public offering and hence are proving to be one of the many factors for a steady decline in the number of IPOs listed in U.S. The result is that NYSE Euronext is now ready for a foreign acquisition with NASDAQ OMX group trying to avert it by offering to take over the NYSE.

The market is too young and vibrant to blame on the pertinent gaps. There is little doubt that they are indeed helping in capital generation for early growth start-ups and generating liquidity for illiquid assets. They need to ensure that more data, analytics and research reports are accessible to the market participants to introduce more transparency, increase the number of transactions and improve the fair value of these transactions. One question remains as to how average investors can be part of successful start-ups growth story before these companies go through a public exit or become too matured to have similar growths?

Private Secondary Market - The Utility

Private Secondary Market has been gaining prominence due to the eye-popping valuations of a number of social media companies in such markets where accredited investors (requirement by SEC for exempted transactions as defined under Regulation D of the Securities Act of 1933 to ensure that the participants are sophisticated with ability to bear the economic loss in case any in the investments made and they abide by the resale restrictions as placed by the company whose stock is being traded) generally trade on private companies. This Marketplace allows privately negotiated sales transactions to trade illiquid, restricted securities and facilitate alternative investments like private company stock, collateralized debt obligations, bankruptcy claims and auction rate securities. The investors are promoted to capture the illiquid premium and hold on their stakes for longer period knowing that their assets are not largely co-related with the public market. Eminent players providing such platforms are: Gate Technologies, SecondMarket, Xpert Financial and SharesPost. Through these markets, the small cap early stage start-ups are now getting access to funds without getting involved into the arduous legal process and costly financial disclosure required under the Sarbanes-Oxley Act. Since the trading occurs without any declared financial information of the traded stock, this marketplace attracts investors with a higher risk tolerance such as an archetypal startup investor. LinkedIn is one of the first social media companies to have come out of the secondary marketplace and graduate to full-fledged IPO stardom.

With the advent of this marketplace, investors no longer need to wait for a company’s public listing and private companies get the option to create their own customized liquidity program. The platform currently does not support shorting, margin, derivatives or manipulation and hence seems to be more untarnished. Investors here are actually more interested in flourishing the emerging private companies and make them capable of generating optimal investment returns. With the likelihood of a higher valuation, an increase in brand awareness and a greater ability to attract additional capital, there has been a surge in the number of U.S. based companies participating in the secondary marketplace. 

As per SEC rule, if a private company exceeds 500 shareholders, then it has to register all its equity securities with SEC and start disclosing its financials which is what Facebook might have to follow soon as it has passed this limit. But recently, a new legislation to revise the 1964 Securities Acts Amendments has been introduced which include raising the private company’s shareholder’s count from 500 to 1000 and exempting accredited investors and company employees from this count. Such a change will certainly give a thumbs-up to the marketplace for private shares by enlarging the potential investors’ pool in a company. This will tempt companies to remain private a bit longer using the liquidity derived from the secondary marketplace and enable them to emerge stronger for an eventual public exit. Thus instead of prematurely going public and risking their stocks in the hands of shorters , traders and manipulators, the companies can more effectively control their liquidity and shareholder base using this marketplace.