During the three or so years leading up to the Facebook IPO, something important happened to the startup and financial industries. As late stage startups like Facebook and Twitter delayed their IPOs, early employees and investors seeking to cash out found a new way to get it: by selling stock through secondary markets.
On the other end of these deals, a whole new class of brokerage firms and funds sprang up, promising everyday rich people access to companies with valuations that only seemed to go up.
The implicit promise was that these companies would have explosive, Google-like IPOs.
There was some danger in this transaction – insiders with information selling, outsiders without it buying – but almost everyone seemed to ignore it, glad to see the good times roll.
But then these companies actually started to go public, and the results have been very disappointing. Facebook, Zynga, and Groupon are a mess following their IPOs.
So what’s happened to the market? What’s happened to the firms that pushed late stage stock on outsiders?
Back in 2011, a hedge fund called Felix Investments, which had taken large stakes in Twitter and Facebook by buying stock on secondary markets, pitched clients with an aggressive email suggesting Twitter and Facebook “will continue to trade up in price rapidly!”
If you do not own stock in Twitter already it is a must. If you already own Twitter you need to add to your position. There are two absolute must have positions – Facebook and Twitter! This is the first Twitter stock we or anyone else has had in the past six months and like Facebook it will continue to trade up in price rapidly!”
On its Web site, Felix Investments has the following text next to Facebook, Twitter, and LinkedIn logos:
“We offer our investors the opportunity to invest in companies that don’t want money, don’t need money, and won’t take money. This is when you want to invest!”
These types of pitches worried us.
Facebook and Twitter were private companies that did not disclose their financials to Felix or its investors. Felix Investments was to telling its clients to buy stock in companies which they know very little about. Further, this stock was being sold by insiders – early investors and employees with intimate knowledge of Facebook and Twitter’s businesses. That’s a dangerous type of information asymmetry.
As long as Facebook and Twitter continued to “trade up in price rapidly,” as Felix put it, this wouldn’t be a problem.
But what about when things went wrong?
Well, these days, Facebook and Twitter have not continued to “trade up in price rapidly.”
Twitter’s valuation has stalled on private markets. Facebook is doing even worse. It had its long-awaited IPO at $38/share in May, and the stock has cratered since, reaching new lows of $21/share today.
So – how are Felix Investments and its clients faring?
Felix Investments clients have to be sweating through their shirts watching Facebook’s nosedive. The fund cannot liquidate its Facebook position until November, thanks to lock-up provisions in the IPO.
Felix partner Frank Mazzola says the fund hasn’t lost money on Facebook yet. He says it bought most of its holding when the company’s share price was in the single digits. But he admits: “a lot could happen between now and [November].”
Meanwhile, Felix itself has profited mightily from the whole enterprise.
According to a Bloomberg story, Felix charged clients a 5% fee on assets under management. Hedge funds also typically charge, every quarter, a 20% fee on any quarterly gains on asset values. Facebook spiked mightily during the dozen so quarters between when Felix took its 2010 stake and now, creating lots of quarterly gains.
Despite those profits, pitching late stage, pre-IPO startup stock to investors is probably in the past for Felix, says Mazzola.
“The market for secondary stock right now is not nearly what it was prior to Facebook’s IPO, for obvious reasons. I don’t ever foresee us being as active as we were, for a lot of different reasons.”
What might some of those “different reasons” be?
Mazzola didn’t elaborate.
According to the SEC, Mazzola and his firms engaged in self-dealing, earning secret commissions above the disclosed 5 per cent on two funds’ purchases of Facebook stock and resales to new investors. The fees essentially raised prices investors paid for Facebook stock by creating a disincentive for Mazzola and his firms to negotiate for investors, the SEC said.
Mazzola and his firms also misled an investor into believing a Felix fund had acquired stock of Zynga Inc. (ZNGA) and made false representations about Twitter’s revenue to attract clients, the SEC said.
In his public broker filings, Mazzola said that he acted appropriately and “will aggressively defend himself.”
Separate from SEC’s settlement, Finra filed a disciplinary action today against Felix, alleging that Mazzola and his colleagues engaged “in the improper public offering and sale of unregistered securities,” and made misleading claims to potential investors in private-company shares, among other offenses, according to an electronic copy of the complaint on Finra’s website.
Finra has imposed a fine of $250,000 on Felix and a total of $80,000 in fines on Mazzola and other representatives of the firm. It has also asked that Felix hire an independent consultant to review its policies and procedures, according to the document.
So, no surprise: Felix has pivoted into a new line of businesses.
It’s now investing directly in startups, though it doesn’t seek board seats or voting rights. Portfolio startups include Badgeville, Jumio, and Adipar.
According to Mazzola, its pitch to entrepreneurs is: ” We’re looking to just fund the entrepreneur and get out of the way – [to] give [entrepreneurs] the opportunity to get the points on the board so [they] can get the leverage with more traditional, better VCs.”