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The Primary Colors of Secondary Markets

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Editor’s Note: Guest contributor Semil Shah is an entrepreneur interested in digital media, consumer Internet, and social networks. He is based in Palo Alto and you can follow him on Twitter @semilshah.

I find myself conflicted about secondary markets. My cautionary side wonders how these private stock sales can potentially distort incentives within companies and artificially impact valuations. The libertarian side of me, however, says all in business is fair game. Everything can be bought or sold. Everyone has a price.

Secondary markets for private shares, such as SecondMarket and SharesPost, provide founders, employees, angels, and institutional investors with a new avenue for liquidity, matching them and their shares with outside demand. While the U.S. economy has struggled for the past few years, the pace of investment in technology shows no sign of letting up. And while public markets may have been icy toward public offerings for some time, secondary markets filled the void, a valve to reduce liquidity pressures facing founders and employees, and providing an additional (and attractive) financial option for institutional shareholders.

Those holding shares in hot tech companies were often met with overwhelming demand from buyers, both here and abroad, willing to pay up to own a piece of the next thing. In some cases, demand outstripped supply to the point where private valuations rose to new, unseen heights. Despite these quick increases in valuation, demand persists; for some investors, bored with public markets, there’s more promise, potential, and possible upside in buying these types of shares, rather than ploughing more cash into traditional blue chip companies.

There’s clearly supply and demand in this market, but its effects are unclear and hard to quantify. On one hand, there’s something not-quite-right about the high wealth requirements needed to purchase shares on secondary markets, the opacity of financial information required to be disclosed within each transaction, and the indirect effects trade volatility can have on a private company’s valuation. For instance, Goldman Sachs raised eyebrows when they attempted to execute a special purpose vehicle (SPV) to enable its premium clients to get a piece of the Facebook pie, valuing the company around $50B. As Fortune’s Dan Primack reported, the SPV would’ve helped Goldman circumvent the 500-shareholder limit rules around private companies traded on secondary markets.

On the other hand, if capital markets aren’t ready for public offerings, especially in relatively new industries, and if founders and employees have worked long enough to have their shares vest, and if other investors are interested in owning a piece, why should the government or the company in question regulate or block the transaction? For instance, if I worked at a big company that couldn’t yet go public but I needed some liquidity for student loans or a mortgage, shouldn’t I be able to trade in my shares for some cold hard cash to help offset debts or the cost of living?

Successful entrepreneurs and influential investors also share a range of opinions on the matter. Earlier this year, Eventbrite CEO Kevin Hartz shared some details on why his company will go public in 2012, stating that a big part of his vision for the company is to IPO a bit early. It’s part of his strategic vision for the company to have a long life after IPO and remain independent, as he believes that the controls placed upon public companies instill discipline.

On the other hand, Fred Wilson of Union Square Ventures shared his views on public markets at Techcrunch Disrupt NYC in May 2011, making the case that public markets can potentially ruin a company’s culture and place onerous requirements on it. By remaining private as long as possible, founders, employees, and investors can sell shares while the company is able to maintain its culture and also keep the lid tight on potential technologies it has developed.

These are all great arguments made by experienced people. The truth is probably somewhere in the middle, and that it depends on each company. There may be something unique about Eventbrite that leads Hartz to make this calculation, or something specific to one of Wilson’s investments that has informed his own view. Facebook has been able to avoid an IPO for now by selling shares to private investors, but then there are public companies like Google and Apple which are currently demonstrating unbelievably strong signs of continued innovation.

Through it all, though, one thing keeps nagging me: consumers that will eventually buy public stocks.

It’s a risk to buy stocks on the public market, just like any other investment is a risk. There’s no guarantee Pandora will perform like General Electric, or that General Electric should perform like Apple. If you day trade on a site like Scottrade, well, to me that’s just as risky as taking your IRA to a Vegas roulette table. Other consumers buy positions through mutual funds, which consist of hand-picked stocks based on “equity research,” which I put in quotes because, well….you know why.

No matter how these stocks are purchased, it’s up to the individual investor to make sure that he or she knows the deal. The government mandates that warning labels adorn cigarette packs, but people still buy them despite all the risks. The SEC could put a softer version of a warning label on company offerings that have been traded on secondary markets, but would public investors even care?

One company stock that is sure to generate significan demand is Facebook’s. Some people believe the company’s business prospects are so hot that it could, by 2012, have the same market capitalization as Google. Others believe the company’s valuation has been artificially driven up by excess demand and volatile secondary market trades, and that once it goes public, regular consumers will be left holding the bag.

While I am in the former group, I can understand why someone would be cautious to buy public shares. But, when I line up to buy stock next year, I will be well aware of the fact that there are risks. Despite these obvious realities, it seems as if many have forgotten that even Facebook itself was a risk. There was no guarantee the service would mean anything outside a few dorms at Harvard, or that it would attract venture capital, or that it would become a major cultural phenomenon. Each private investment in Facebook to date carried its own risks, and the same can be said for each future public investment, too.

When the gates open, let the public have their shares. The government and the SEC can investigate or crack down on secondary markets, but that won’t eliminate the risk private and public investors face. The SEC can require more disclosures in S-1 filings, but not only is it unlikely the public will read those statements carefully, it’s also unclear whether experienced financial analysts or journalists will as well. You can put a picture of a tarred lung on a cigarette box, but if someone needs a drag right now, and there’s no promise for tomorrow, then what? Eventually, private companies traded on secondary markets will need some sort of exit. Secondary markets are a short-term solution to offer shareholders partial liquidity.

That said, there is one aspect to secondary markets that does concern me, and it has to do with the potential distortion of incentives of specific company shareholders. If I’m slated to buy a public stock of a red-hot technology company, I don’t just focus on fancy numbers or accounting, or what a journalist or my broker tells me. I mainly want to know who’s steering the ship. I want to know the crew and the deckhands. If a majority of the company’s equity has traded hands from founders and early employees to a range of faceless institutions and passive investors, and less so to current employees, then who will drive the ship once I place my bet?

This isn’t a calculus that generates any finite number—it’s a subjective bet. The public may think they are investing in the promise of rising numbers or other online metrics, but that’s only half of the story. The other half brings us back to how these technology companies start and grow in the first place—with people.

Consumers looking to buy public stocks in companies that have traded on secondary markets should reflect on some of these basic questions while making their decision to invest:

  • Who has owned significant chunks of shares in the company?
  • Who sold their shares on the secondary market, and who bought them?
  • Did the founders cash out and at what rate?
  • How much have investors cashed out, and what do they still hold?
  • Will financial analysts and reporters consider secondary market activity in their recommendations?
  • Will the public market price for shares in any company reflect these concerns accordingly?

These questions get to the essence of the primary colors in secondary markets. Everything around Facebook, for instance, or any company that offers shares publicly, is a risk. There’s no such thing as a sure bet in real life and certainly not in investing.

And, that’s all public investors need to be reminded of: there’s risk everywhere. Public investors shouldn’t expect that just because companies like Facebook go public that it’s a slam dunk investment. Public investors shouldn’t assume that only companies with healthy financials and solidified business models can convince Wall Street bankers to lead their offerings.

It’s all a big poker game, and as the world has economy demonstrated since 2008, the only thing that’s certain is uncertainty. Place your bets accordingly.

Photo credit: Images of Money