Secondary Market Exchanges: A Valuable But Imperfect Path To The Future

The following article appeared in Venture Capital Journal as part of a larger package on the secondary market and its life after Facebook. It is reprinted in full below.

The secondary market for shares of venture-backed private companies will remain largely under served for years to come. More information transparency is needed for it to live up to its potential.

Given that the IPO market remains fickle and the supply of ”hot” pre-IPO stocks unpredictable, secondary market exchanges have no choice but to diversify their trading in order to grow. They will only be able to do so if they start providing information beyond simple share tallies and high-level reports. Without this, sophisticated investors will struggle to comprehensively and rationally value the holdings put up for sale and become more active purchasers.

Private exchanges have emerged over the past few years to play a very visible and sometimes controversial role in creating early shareholder liquidity. Transaction volumes on SecondMarket’s platform grew from $100 million in 2009 to $558 million in 2011, while its competitor Sharespost registered $625 million in secondary trades last year.

The reasons behind such impressive growth are simple. On the sell side, employees and early investors in startups seek liquidity and asset diversification. On the buy side, private and institutional investors look for quick, compelling returns from “hot” pre-IPO investments.

Unfortunately, buyers tend to be drawn to a handful of high-profile companies, and secondary exchanges have become dependent on these “pull” stocks, as SecondMarket CEO Barry Silbert calls them. Trading in Facebook shares alone represented over one-third of the volume of all transactions on SecondMarket in 2011. Given the demand, the exchanges felt marginal pressure to provide detailed information to purchasers. Consequently, little disclosure was and is being provided.

Meanwhile, there is a vast backlog of mature, but lesser-known privately funded technology companies whose employees and VC investors are waiting for liquidity events. In other words, prospective sellers are pervasive in the venture capital private-company ecosystem. While the exchanges have started to broaden trading beyond the likes of Facebook and Twitter to the next generation of pre-IPO companies, this segment of the market – the “push stocks” – remains underserved.

A few specialized direct secondary investment firms, such as Cipio Partners, address this market on a case-by-case basis by buying existing shareholder positions. Broader-based and more information rich secondary exchanges have the potential to more fully address this liquidity need by facilitating a large set of transactions and expanding the buyer universe for private technology company stocks.

However, the cost to create information transparency and demand for lesser known “push” stocks on a private exchange will remain a limiting factor, even more so if the SEC stepped in to further regulate private share trades. Consequently, for many mature private companies, especially in industry verticals that have fallen out of favor with momentum investors, liquidity will remain elusive.

Maximilian Schroeck is Managing Partner of Cipio Partners and can be reached at [email protected] David Mes is Senior Principal of Cipio Parnters and can be reached at [email protected]

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