A Second Look at Secondary Markets

Howard Caro
June 3, 2016

Twenty years ago, the standard life span of a privately held technology company was a mere flash in the business cycle pan. Even as late as the mid-aughts, privately funded start-up companies typically ran out of money, moved steadily toward a relatively early IPO, or were quickly acquired by larger players – often in as little as four to six years.  A seven-year-old private technology company – let alone a decade-old one – was relatively unheard of.  The average age of companies that went public in 1999 was four years old, compared to 11 in 2014.[1] Private companies tended to be acquired or go public at valuations in the hundreds of millions of dollars and post-IPO, successful technology companies tended to see the bulk of their valuation increase in the public markets.  For example, Microsoft’s enterprise value at IPO was approximately $534 million and its current market capitalization is currently over $400 billion.

Today, dozens of privately held companies boast an enterprise valuation of a billion dollars or more, with some commanding valuations above $20 billion.  Many of these so-called “start-ups” are bringing in substantial revenues, operating with positive sales margins, and holding hundreds of millions of dollars of cash on their balance sheets – an enviable position, and one that theoretically allows for an even longer runway as a private company.

This has all been playing out in an ecosystem in which the public capital markets, in the U.S., Europe and elsewhere, are not as stable and inviting as they once were.

Falling oil prices, anxiety over Federal Reserve actions and other factors have caused volatility in the U.S. markets. Europe’s markets have been roiled by an immigration crisis and an upcoming referendum on a possible exit from the EU by Britain. With fewer reporting requirements as a private company and better access to investment capital, filing for an IPO is no longer the finish line that private companies sprint for.

As a consequence of these phenomena, large institutional investors, which historically focused on public equities, have been chasing returns in private markets and writing the checks that enable such companies to fund their growth without turning to the public capital markets.  In this climate, companies can stay private for as long as it suits them.

A New Asset Class and the Need for a New Marketplace

Given the pre-IPO valuation growth of many of these companies, and the lure of often groundbreaking technology, shares of privately held companies are valuable and desirable, and becoming more so. They have rightfully become an asset class of their own.

Take Uber Technologies, Inc., as one oft-cited example. Uber has been privately held for seven years and is valued at more than $60 billion. Airbnb, private since its founding more than eight years ago, is valued at more than $20 billion.  Space Exploration Technologies, private for 14 years since its founding, is shooting rockets to Mars, spending hundreds of millions of dollars on technology and growth, and commanding a valuation of more than $15 billion.  Google, by contrast, went public six years after its founding at a valuation of $23 billion.

Though shares in such companies are extremely valuable, it is difficult for private shareholders – from founders to early investors to employees – to get liquidity for their stakes.

There are a slew of issues with the open trading of secondary shares, whether on small trading “exchanges” or in direct sales to small, typically unsophisticated investors.  First, the sellers typically do not have, or are not allowed to share, information about the company’s performance and fundamentals.  This naturally depresses the price that most investors are willing to pay – perhaps depriving selling shareholders of some of the value of their positions.  Second, when shareholders are seen to be “in the market,” rumors can circulate, or the perception of a “discounted” share price can impair the company’s primary fundraising activities.  Third, when the company is not involved in the process, it has no say in which investors will show up on its cap table, and may fear the unintended consequences – including with respect to 409A valuations and growing shareholder counts[2] – of the development of a secondary market in its shares.  Finally, and relatedly, when the company (its management and board) are not cooperating in the process, potential new investors are not properly welcomed to the table and do not easily become part of the company’s strategic future. The purchase of shares by non-additive, non-strategic investors means management misses an opportunity to attract strategic investors – investors typically not interested in small transactions with little information about performance.

From the perspective of the large institutional investors, who may otherwise be interested in an investment in an exciting, profitable private technology company, small opaque transactions not blessed by the target company are not typically of interest.

Regardless of these issues, secondary share sales are happening today – in large part because the long path from founding to exit (i.e., to stakeholder liquidity) creates a build up of pressure among private company stakeholders.

Many employees simply cannot hold their shares and options until the company reaches an exit. Some have been working for years, investing their own sweat equity while drawing a salary often much smaller than that available at a large public company.  A “baby” engineer fresh out of college in 2007 may now be having a baby him- or herself; he or she may seek partial liquidity in the short term for housing or family growth, or simply to pay off student debt.  Unfortunately, their company’s roadmap may include staying private for years to come.

In short, the ecosystem has evolved in a way that has created an asset class that lacks clarity and leadership, to say nothing of the sort of regulatory regime and institutional (banking) support befitting its importance.

The Marketplace for Secondary Trading is Here

Secondary shares for late-stage private companies have blossomed into a proper asset class. They should be traded in a marketplace that is as open, transparent and structured as any public market.

Small allotments of stock should not be traded haphazardly and with little or no information about the the private company itself. Privately held companies should know the investors on their cap tables and not be distracted by unknown investors.

Employees should be rewarded and appreciated for their tenure and hard work, rather than becoming frustrated by holding something valuable for which they can’t realize returns.

Scenic Advisement is a purpose-built investment bank for this new asset class.  Scenic is crafting the best-practices that will bring some of the same consistency, size and transparency to secondary trading that exists for primary capital raising activities by pre-IPO companies.

We work with investors and employees of private late stage technology companies, as well as the companies themselves.  This helps selling shareholders achieve liquidity and investors to achieve access in a way that adds value for the company.  As a consequence, employees can pay off their loans and buy their houses, venture investors can achieve the sort of partial liquidity outcome that can be passed along, in turn, to their limited partners, and companies can buttress their investor rolls in preparation for additional primary capital raising and, eventually, an IPO.

 

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[1] Jay Putter, Economist, July 25, 2015, “To Fly, to fall, to fly again”, economist.com
[2] Indeed, the active secondary market in the shares of then-private Facebook, Inc., led to more than 500 investors on the Facebook cap table, resulting in public company-like report filing obligations – which in turn led to an earlier-than-desired IPO filing.  While the 500-investor ceiling has been increased to 2,000 with the JOBS Act of 2012, cap table management is still obviously paramount.
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Howard Caro
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