Ever since secondary market trading of Facebook shares began, various industry participants have debated whether the market would continue and how it would (or if it should) evolve. Three years later, the debate continues in the press, but investors continue to vote with their investment dollars for its growth. NYPPEX, a private equity advisor and research firm, has projected that the secondary market will facilitate $17.7 billion worth of transactions this year, up 43% from 2013.
The nature of the secondary market has also changed with an increasing number of investment company giants actively participating in an increasing number of transactions. Second Markets, once an active marketplace for individual investors, has changed its business model to execute these institutional transactions and reported a few weeks back that they had executed nearly $1 billion in private company stock transactions in the first half of the year.
While this has led some to think that individual investors are being shut out of this attractive market place, the truth is that as the market has grown, so have the alternative entry ways to participate. Clearly, the markets for Angel investing and crowdsourcing are well known and easy to find, but access to the growth and late stage companies with well-known names such as Palantir, DropBox and Uber can be found in a number of instruments for a range of investors:
- Interval funds, mutual funds that offer daily purchase for investment but typically only quarterly liquidity, have been increasing in number as part of the Liquid Alternative movement. The SharesPost 100 Fund is perhaps the most familiar of this mutual fund type, which is open to all investors.
- A large number of Closed-End Funds (CEFs) have also entered the marketplace in recent years, offering clients a variety of private company portfolios in which to invest. The investment stage of the underlying companies ranges from fund to fund, with some CEFs focusing on later-stage private companies and some investing across the entire venture capital range. Several have had good deal flow and have demonstrated a repeat ability to include marquee names within their portfolio.
- Private Custom Portfolios are another option, although usually open only to Qualified Purchasers. These structures allow investors and their Advisors to select each investment in their portfolio at a specific price. These offerings, however, are more difficult to find as they typically cannot market themselves under the general solicitation guidelines of Rule 506(b) of Regulation D. NASDAQ Private Market, offers a similar investment opportunity into individual companies to Qualified Purchasers through their member Broker / Dealers.
- Forward Purchase Contracts are also still used by many to invest in private companies, but are not for the faint of heart. In these contracts, the investor provides cash (typically to an existing or former employee of a private company) in exchange for the forward purchase contract. The contract obliges the seller to deliver a specific amount of their private shares after the company executes its initial public offering. The legal risk (usually spelled out clearly in the contract) is that the contract may be in direct violation to the seller’s employment contract with the company and the transaction itself is still subject to the company’s right of first refusal, which may not occur for several years out.
The secondary market is very likely to continue to grow, mature in its formal nature and increasingly win the favor of private companies themselves for a number of reasons:
- Employee Recruitment and Retention are both improved by clarity in remuneration at private companies, just as they are in public ones. Companies that create liquidity plans to meet the internal demand to convert their paper wealth after an appropriate vesting period are likely to have more engaged employees and higher ratings in glassdoor.
- Structured programs also lower legal and management expenses as they reduce the time and energy (and billable hours) of considering one-off secondary market sale requests.
- Management control of insider liquidity also allows for control of the secondary market prices at which these trades are taking place, retaining the control of valuation communication to the management team and their VC-backers.
- Another benefit to the company and its financial backers is that less money needs be raised if a greater percentage of the funding at the official rounds is funding company growth rather than meeting employee needs.
- Reduction in the percentage of capital funding employee liquidity also reduces the perceived lack of commitment to the firm, which can be a significant depressant to a newly IPO’d stock price. Furthermore, Fenwick & West just released a report showing that VC-backed technology companies that went public in 2013 experienced a 24% reduction in stock price in the two weeks after the expiration of their waiting period compared with two weeks prior to the 180-day mark.
- Finally, individual investors are increasingly driving market demand for access to alpha in their portfolios, which Family Offices, Pension Funds and Foundations have enjoyed for years. Not only is the desire for alpha driving this demand, but often a personal interest in a private company’s business model motivates the investment. After all, not only is an equity-interest in ZocDoc a good investment, it’s also fun.
Regardless of how an investor chooses to invest in secondary market shares of private companies, there is no doubt that demand will keep the market growing. And while the lion’s share of the market may continue to be the domain of large funds and endowments, Advisors and their investors, both accredited and not, are being given opportunity to invest alongside the behemoths. Where the jury is still out is how Private Companies themselves will choose to participate in these markets, despite the evidence that a structured approach is a win-win situation for all involved.
Michael Goering is a Managing Director at Buttonwood Group Advisors
Michael Goering is a Managing Director at Buttonwood Group Advisors, responsible for Institutional product and business development. Michael has over 20 years of experience in the financial services industry in a variety of roles at Citi and Morgan Stanley. He received his BS in Electrical Engineering from Washington University in St. Louis and a Masters in Business Administration from the Tuck School at Dartmouth College.