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.
Restrictions on transfer also prevent encumbering or hypothecating the shares as security for a transaction. Since taking a security interest in the shares would violate the transfer restrictions, no security interest is taken by the investor.
Instead, the shareholder receives today’s valuation in cash, and the investor, having put up the capital for the swap, receives an unsecured pledge from an individual person (the shareholder). The swap agreement stipulates that the shareholder will deliver X dollars in the event Y happens in the future. Sound like a good deal? It gets even better.
For the privilege of taking on unsecured consumer risk, the investor does not actually get to be the direct beneficiary of the swap. Instead, brokers and intermediaries are creating Special Purpose Vehicles (SPVs) to be the counterparty.
The SPV then raises money directly from several individual investors, pools it together, and writes a swap or swaps on the same reference company security. Investors end up owning interests in an LLC, managed by the intermediary. The investor is now taking on servicing risk (can this intermediary actually wind up this SPV and collect when its time, can they provide tax reporting every year until then, will this intermediary be around in 10 years?). One need only look at the ashes of Advanced Equities to understand just how messy this can get.
Investors are taking on significant additional risks in their attempt to participate in this market and investing in private companies is already risky to begin with. This leads us back to the SEC investigation of Sand Hill. Dodd Frank changed a lot of rules when enacted. Without delving into the gory nuance, Sections 5(e) and 6(1) of the Securities Act of 1933 require that anyone affecting a security-based swap file a registration statement, or effect the transaction on national securities exchange.
Both of these requirements are focused on the goal of investor protection, as they ensure the swaps have disclosure information available for investors to review. It is safe to assume that swaps in this current secondary market discussed above are not meeting either of these requirements. Absent these requirements, swaps can only be traded between “eligible contract participants,” which means the counterparties have $5-10 million in discretionary investments.
While an individual SPV may be larger than $5 million, SEC look-through rules come into play as the SPV has a direct beneficial ownership of the swap, and thus all the investors in the SPV may have to meet the eligible contract participant hurdle.
So how do individual investors get a piece of the hottest private tech companies without delving into these murky swap transactions? There are several viable ways for investors to participate in this market. There are closed end funds that buy private company shares directly. There are mutual funds that allocate a portion of their holdings to private company stock available. Wealth management platforms sometimes offer access to private company investments through performance linked notes or diversified funds.
The main point of differentiation is these options are either liquid, or serviced by a reputable counterparty. Of course, another viable option would be to apply for a job at your favorite private company and negotiate a nice options grant!
Shareholders also have other viable options for liquidity. Most companies don’t have full restrictions on transfer, just a Right of First Refusal should the shareholder find a buyer on their own. Shareholders can try to find a buyer on their own or use a reputable broker to find a buyer, but this may still lead to unfettered trading and an administrative burden and cost that most private companies would prefer to avoid.
The amount of disclosure available to both the shareholder and the investor will be limited, but no bylaws will be broken and there is less risk of a 10b-5 violation by the broker or attorney advising the parties.
We believe the most effective and transparent path for pre-IPO secondaries is through regular liquidity events run by private companies. Companies can control who owns their stock, approved investors can get own a piece of the company while shareholders receive partial liquidity. Most importantly, these events offer information symmetry and transparency.
Companies are broadly adopting this but the market like this will always produce bad actors looking for a fast dollar. Swaps are a side effect that can easily be mitigated by company proactivity. Private companies can get ahead of these issues by putting solutions in place that absorb demand for secondary activity. Passivity will catch up with companies in the long term, and there won’t be many winners (except the litigation attorneys that come in to clean up the mess).