10 Jul The Secondary Markets Are Becoming the Wild West Again
Early this week the WSJ reported that the Securities Exchange Commission is investigating the selling of pre-IPO company stock, which has seen a recent surge in activity as companies remain private longer and valuations continue to rise.
The SEC also put the clamps on a startup ‘exchange’ that was in gross violation of the securities laws.
The resurgence of unfettered secondary markets is a concern for both private companies and shareholders. Take it from us. We started the first incarnation of this market in 2010 to help private company shareholders find liquidity. We pivoted to a technology focused, company centric solution which has become the industry standard. Still, the growth in the broker market presents a problem that cannot be ignored.
For private companies, unfettered secondary trading perverts employee incentive structures and requires significant financial and human resources to contain. Prior to Title V of the JOBS Act, high volume of activity on secondary markets forced companies to go public before they were ready. Private companies have reacted with a two-fold response, choosing to: 1) run regular secondary buybacks [or third party purchases] with complete control and privacy, and 2) place significant or full restrictions on transfer in the company’s bylaws.
Option 1 has become routine.
Option 2 can be effective up to a point, but once a company becomes highly valued with a large number of vested shareholders, the pressure for liquidity typically overcomes the roadblocks provided by transfer restrictions.
Shareholders in need of liquidity are willing to travel down the food chain to obtain liquidity, and are welcomed by brokers bearing swap agreements.
A swap is just a legal agreement between counterparties, the shareholder and an investor. The shareholder receives cash for their shares now in exchange for a promise to deliver the economic dollar equivalent of an observable event in the future (in this case, an IPO or acquisition of the company).
But since ownership of the shares does not actually change hands, the shareholder does not notify the company of the transaction.