How to Trade Private Company Stock using Secondmarket

eBay of Illiquid Securities

SecondMarket is an SEC-registered alternative trading platform, an online broker-dealer whose primary business is to create and maintain a marketplace for illiquid – hard to sell or buy – securities. They focus on a number of hard-to-trade asset classes, including private company stocks. By the end of 2010, they facilitated over 500 private company stock transactions in a total value of over $700 million dollars and are becoming the ‘hotspot’ or the eBay for trading the most sought-after shares of private businesses.

Private companies

Privately held companies, also called unquoted or unlisted companies, are businesses owned by a relatively small number of shareholders, many typically employees or company members. The private shares are not listed or traded publicly on stock exchanges, but may be offered and traded privately, typically in arms-length or expensive transactions.

Many private companies are smaller businesses, but the largest ones, such as Bechtel, Publix, S.C. Johnson are well-known businesses with hundreds of billions of dollars of annual revenue. A third category of private companies includes start-up or early-stage businesses that have not wanted or been able to ‘go public’ yet and have not listed their securities on the stock exchanges yet.

Hot private stocks

It is the third group of private companies whose shares beg for a more efficient and structured market. Pre-IPO companies like Facebook, Twitter, Groupon are of special interests to investors who hope to buy into them as early as possible to participate in the big gains that high-growth, new businesses’ values experience between their establishment as viable businesses and the period during which their shares are first offered publicly.

Investors are especially hungry for pre-IPO private shares due to the anemic IPO activity of recent years compared to the feverish initial public offering market of the late 1990s, when an average company went public after four years of existence while in 2010 the average time before the IPO was almost 10 years. On the other side of the hypothetical transactions are employee and venture capitalist owners of private company stocks who may also look for a faster exit for at least a portion of their positions.

Difficult and costly private stock transactions

In the absence of structured markets for private stocks, the meeting of potential buyers and sellers is extremely difficult. Even if the interested parties manage to connect, both potential buyers and sellers incur significant costs in closing such trades. Transactions are complicated by the private companies’ interests. Due to strategic or regulatory reasons, the businesses often want to maintain private status, avoid dilution and control the number and entities of owners. Securities regulations and laws governing who and under what circumstances may acquire ownership in privately held companies add another dimension of complexity to these transactions.

The SecondMarket transaction process

SecondMarket’s online trading platform makes these trades easier, faster and less expensive. The registered broker-dealer works with private companies to structure share sale programs meeting the companies’ strategic goals. The programs designed together with the companies allow employees and other holders of private stock to liquidate positions in an orderly and transparent way. Some programs allow for continuous trading of private shares, while the majority offers specific windows for transactions.

SecondMarket lets private and institutional investors, interested buyers to register on their trading platform and to express an ‘indication of interest’ or IOI in specific companies’ shares. SecondMarket aggregates and tracks these IOIs and uses them for the allocation of available transactions and for solicitation of additional deals. SecondMarket’s registered broker, called the ‘market specialist’ vets interested buyers to assess their needs, their financial goals and to ensure that they meet the requirements for trading in private securities. The market specialist broker also facilitates potential negotiations with the sellers and makes sure that the prospective buyers meet the issuing companies’ approval as most businesses have the first right of refusal in these transactions.

SecondMarket deploys operations specialists to guide the transaction through the complex anti-fraud and money laundering regulation requirements and to ensure that all securities and insider trading rules have been met.

SecondMarket has implemented a highly structured, efficient and comprehensive process to streamline the initiation, negotiation and closing of private equity transactions while making sure that all transactions remain within a fairly narrowly defined and heavily constrained regulatory space. The eBay of broker-dealers charges a 3-5 percent fee for arranging the private stock transactions.

While SecodnMarket has reported a robust growth in the volume and size of transactions, many IOIs are never filled as current demand significantly outpaces supply of private stock. SecondMarket uses innovative strategies to track and showcase aggressive buying demand by allowing users to create ‘watchlists’ of desired private stocks.

Accredited investors only

The majority of investors on SecondMarket are sophisticated institutional investors. Individual investors participate in the market, as well, however, SecondMarket or trading in illiquid assets are not for the small investor. By regulation, private company investments can only be offered to ‘high net worth’ individuals, people with over $200,000 of annual income for the last two years or own over $1 million in net assets. This long-standing rule was put in place to protect individuals with more limited financial means from the risks of illiquid investments.

‘Blind’ investments

The biggest risk of private stock investments is associated with the almost complete lack of reliable information for these businesses. As private companies are not required to file financial statements, outsiders have no visibility at all into the state of the business and its financial conditions.

SecondMarket and broker-dealers in the space attempt to mitigate these risks by working together with private companies to compile information packages that provide some transparency into the company to facilitate transactions, but also allow the business to retain ultimate control over its information to maintain its competitive edge and favorable position for future transactions. The online, community-like platform built by SecondMarket is also meant to support the efficient dissemination of important signals and information, to the extent possible in capital markets where closely held, unique information is extremely valuable. In addition, the broker-dealer itself seeks to provide additional information and research to lower the extreme risk of totally ‘blind investments’

SecondMarket has big plans

The new model for trading illiquid assets propagated by SecondMarket offers significant benefits for both buyers and sellers of private company shares. Qualified and interested buyers can gain access to a market that has been previously barricaded from them with high walls. Sellers can find cheaper and faster exit strategies and potentially reinvest their capital in new, even earlier-stage enterprises. The efficiency improvements across the board would eventually benefit the entire market allowing for faster, cheaper and more efficient re-allocation of capital in the funding of new businesses.

SecondMarket maintains a ‘wish-list’ covering over 12,500 private companies based on their research and their users’ flags. Thousands of SecondMarket users ‘watch’ Facebook, Twitter and Groupon shares, yet almost none of them own any of these investments. The evolving markets still have a long way to go: in terms of supply, more efficient processes and increased security and transparency. Nevertheless, there is a growing and maturing market that has started structuring and organizing supply and demand: the first step in making sure that the demanded products will eventually be delivered and exchanged in a way that maximizes value for buyers, sellers and the broker, as well.