The SEC recently concluded its investigation of the emerging market for pre-IPO shares of private companies, resulting in charges being brought against three market participants. I am proud to say that SecondMarket was not among those investigated or charged with wrongdoing.
While the press focused on the SEC “cracking down” on the private company market, the investigation actually focused on wrongdoing that has existed in the securities markets for decades: broker-dealers using improper sales practices and charging inappropriate fees, and unregistered middlemen improperly acting as broker-dealers.
Nonetheless, the investigation should result in a better private company marketplace. Because of market structure changes and regulatory hurdles, companies are remaining private longer than ever before. The public markets work well for the largest companies, but many observers believe a company has to have a market capitalization of more than $1 billion before it receives the sales and research coverage to successfully navigate the public markets.
That is an extraordinarily high barrier to entry and supports the notion that a robust private company market is critical to the startup ecosystem. An efficient private market can help a company provide its shareholders with interim liquidity, so that a company is not prematurely forced to go public or pursue an M&A transaction. At SecondMarket, we continue to develop practices and procedures that we believe all participants should adopt as we move forward.
Regulatory oversight: Quite simply, anyone facilitating trades of private company stock should be registered as a broker-dealer. Trust is an essential element of an efficient market. The ability to conduct trades in a regulated environment confers accountability on the part of the broker-dealer and provides assurance to participants that there is regulatory oversight of a transaction. SecondMarket was fully regulated as a broker-dealer before we ever conducted a private company stock transaction.
Robust Accreditation: Private company stock is not for everyone. Investing in a private company is inherently risky, and investors must have the financial means and risk tolerance to participate in the market. While we require companies that exclusively sell secondary shares with us to provide financial disclosures, the information is less detailed than public company disclosures.
Only “accredited” investors are eligible to buy private company stock on SecondMarket, and we have established a process to ensure that only accredited investors buy stock. We conduct online accredited investor questionnaires, background checks and reviews prior to a transaction, and contact each potential buyer to understand his or her investment intent.
Company Engagement: Every private company is different. Each company has unique goals, circumstances and objectives. SecondMarket works with each company to design a customized liquidity program to meet that company’s needs. The companies control who can buy and sell, how much each shareholder can sell, frequency of transactions, and share price. Most importantly, as noted above, we require companies that allow secondary transactions on SecondMarket to provide financial disclosures to the company-approved buyers and sellers. Providing financial information to participants ensures transparency and information symmetry, but it is important to private companies that only the eligible buyers and sellers (and not the entire world) have access to that information.
We will not permit a transaction if the company is not willing to work with us, and we encourage other marketplaces to follow suit. It is critically important that companies support secondary trading of their shares. A managed secondary trading process can provide a company with numerous benefits, including retaining existing employees and attracting new talent.
Mitigate Conflicts of Interest: It is important that buyers and sellers understand that a marketplace is an impartial intermediary that is not on either side of a transaction. We actively seek to minimize conflicts of interest in a variety of ways. We do not produce or pay for research. We do not buy private company stock for our own account or make investment decisions on behalf of our platform participants. And we do not offload our regulatory responsibility to third-party broker-dealers.
As we look ahead, I firmly believe that the continued success of this overall market is predicated on honesty, integrity and reliability. By following these guidelines, we can ensure that bad actors are forced out of the market and a healthy, prosperous secondary market for private company stock can continue to flourish.
[image via Flickr/Katrina. Tuliao]