Photo: DEMO Conference/Flickr
Interest in the private markets for trading stock in hot startups is at an all time high.And one company that’s benefiting from this interest is SharesPost, an online platform for buying and selling shares in companies like Twitter, Facebook, and LinkedIn.
While the company is entirely focused on swapping shares now, it’s about to expand its business and become a truly intermediate step between an IPO and raising money from VCs.
It’s going to allow startups to do stock placements within SharesPost, and the stock could also be auctioned on SharesPost’s platform.
It’s a bold and risky move, putting the startup in a new territory. It could also lead to a disaster causing less than sophisticated investors to dump money into terrible investments.
We asked CEO David Weir about that risk, and how he can avoid it when he was in our office yesterday. What follows is a lightly edited transcript of our conversation.
Business Insider: The private market world seems to be a pretty murky place. What is SharesPost doing differently than the rest?
DAVID WEIR: I would say the biggest challenge recently is that the media wants to compare the private marketplace to the public marketplace, which I think is an unfair comparison.
One of the things that you and others have identified is the informational constraints around the secondary market, and some of the asymmetry that exists, and how it compares to the public marketplace, which I think are perfectly fair things to call out. What I’m trying to do is get people to recognise and acknowledge the fact that these private company transactions have always existed on a smaller scale, and they’ve really existed in the dark.
What we’re trying to do at SharesPost is bring those transactions into the sunlight and to provide the buyers and sellers with efficient access to each other as well as to provide them with as much potential context as possible so that they can make reasonably informed investment decisions.
On third-party research, we have eight research providers, 250 different research reports available for download on the site. All that’s available for free to our members. We post all the offers to buy and sell stock, keeping them fully visible to accredited participants, as well as all the contracts that have been entered into, fully visible to accredited investors. We have data feeds that come from places like VC Experts.com imported into the site. We are constrained by the fact that private companies generally do not want to fully disclose their financial information.
We’re trying to provide that context to the extent that we can. That’s not to say that we don’t acknowledge that there are some pretty meaningful information constraints. Those information constraints are being considered by the buyers and sellers when they consider what’s a fair and reasonable price at which to transact.
BI: From our perspective, what you guys are doing is great, but we think it’s headed for a disaster. I think that regardless of what you’re doing, some dentist is going to get socked with some stock that he didn’t even know what the fully diluted share count was. It’s going to be sold by venture capitalists and the SEC will get involved.
DW: From business model standpoint, obviously we’re trying to build a sustainable business. To the extent that your expectations come true, that’s obviously not good for either the market or SharesPost.
We’re trying to create an interim market between the VC investing world and the public markets. You know the private to public handoff has really broken down over the last few years and as kind of a recovering investment banker, my experience is that it is a wrenching process to see private companies go through the IPO process and then see their shareholder base get completely recapitalized over a 6-12 month period of time. This process has never made any sense to me.
What we’re trying to do is create an interim solution where companies can recapitalize their shareholder base in a much more measured way over a 2 or 3 year period of time, replace the angels and the employees and the early stage VCs with the T. Rowes and the Fidelities of the world.
We’re all dying to find a private investment product and to do that in a way that can be controlled by the companies that’s based on full disclosure of information. Investors want full disclosure, so that when they actually do go public at some point and sit down on the road show with T. Rowe Price, hopefully that portfolio manager at T. Rowe Price already knows the company and may actually be an existing shareholder. So they’re really having a conversation about building their position as opposed to an initial investment.
BI: So what different about what you do versus SecondMarket?
DW: Glad you asked. We’re trying to use technology in innovative ways to create more of an online marketplace. We do have registered brokers because we need it. We believe that the process of doing a private company transaction is complicated enough that most people and sophisticated investors need some handholding from a process standpoint.
But SecondMarket is primarily brokers with telephones. They take more of a traditional Wall Street approach to creating transactions. We’re using the Internet to aggregate a much broader universe of investors. We have 60,000 members, 16,000 that have taken the time to qualify themselves as accredited. They range from accredited individuals to mutual funds, hedge funds, family offices, and small and medium sized funds that by and large have not had access to this asset class in the past.
What we’ve done is try to provide them with more market power than they would have as individuals, bringing them together. The purchasing power of this group is huge. If you pool the capital, it’s probably a trillion dollars worth of capital.
That’s the first thing we did. We brought them together around the platform, we’ve automated the transaction processes, we’ve standardized the contracts. Again, one of the things that’s always been a problem from a compliance standpoint is that every transactions is over-lawyered. They all look different. Sometimes if you’re an employee selling stock to your neighbour, you get your brother-in-law to do the contract. He’s not a securities lawyer. The contracts are not compliant.
We’ve taken the compliance process and the legal aspects of this to a higher level where there’s more consistency between transactions. The transparency is obviously being able to look and see where other transactions are being done so I actually know what it’s worth and don’t get taken advantage of by VCs or other investors in my company. Some other investor might have that information and I don’t, and we are eliminating those discrepancies. We’re much more transparent, I think, than SecondMarket. We’re going to continue to use technology to continue to break down the friction points in the process. We do online ordering, for example. We’re doing auctions. The front end right now is all automated through technology. The back end we’re doing by hand. These are things we’re trying to use technology to really fix what I perceive to be the problems in the process.
BI: Really specifically versus SecondMarket – any other differences?
DW: They just rolled out their technology platform, but it’s really just a social media site that imports 12,000 companies and information from TechCrunch and other sites. The other big difference is that their minimum transaction size tends to be a million bucks or greater. Ours is $25,000. We’re trying to make the asset class more accessible to a broader universe of investors. We’re going to be doing primary offerings with full company participation and disclosure through a secure password-protected portal with all of the technology applications that would allow a CEO to present to 16,000 investors at one time rather than to do lots of road shows and hopscotch around the country. Are we similar in a lot of ways? Yes. However, we are a Silicon Valley company and I think we’re using technology much more aggressively than they are. We’ve also aggregated a much broader universe of investors. It’s not just guys who can write million dollar checks.
BI: To become a member and to buy stock, you have to be an accredited investor? Can I be represented by someone? Are people who are buying all registered with you?
BI: They are. So I can’t be sold by a broker dealer into some fund that owns Facebook stock?
DW: No. There are two levels of membership. First level is you just register to become a member. You give us a little information about yourself, you become a member. That gives you access to the site and to research basic information. You don’t see any transaction postings, you don’t see any contracts that have been complete. So all the transaction data is only reserved for accredited investors. If you want to become accredited, you go through a full accreditation process. Fill out a form and questionnaire that gets submitted and vetted by one of our brokers. Once you’ve been qualified, you’re then approved to purchase stock in the marketplace. Every investor has to be known by us to be an individual or an entity, someone representing an entity, and every transaction before it gets posted is fully vetted by a licensed broker before it can actually go live on the site. We have multiple levels of security built into the process.
BI: Where is the SEC on this? Do the same securities laws apply? What happens with insider trading? What happens when Kleiner sells stock to someone who doesn’t know anything? Has the SEC chatted with you? Have they weighed in on this?DW: We are governed by the securities laws of 1933 and 1934. That said, what we’re doing was not contemplated then. We’ve had to build a business around some existing no action letters. Our business was structured initially as a passive bulletin board. There’s a bunch of no action letters out there that we built our compliance strategy around. As we’ve evolved our business and as the market has developed, we’ve realised that having active participation of licensed securities brokers is an important part of the process. So we’re actively pursuing a broker-dealer licence.
Right now we work through Emerson Equity, which is an affiliate of ours. As far as what the SEC is looking at, I’d just be speculating. They provided us and others with a voluntary request for information back in December. We have fully cooperated and responded to their request for information. Like everyone else, we’re kind of waiting to see what’s going to come out of this process.
BI: So they are looking at it?
DW: No question. They’ve confirmed that they’re looking at it, which is why I can confirm it.
BI: What’s your business model?
DW: Our brokers get paid by the buyer and the seller, both sides of the transaction. 2-5 per cent of the transaction value, depending on the type and size of transaction.
BI: Each side?
DW: Each side?
BI: So you get two to five of each side? So overall 4-10?
DW: Yeah, 4-10.
BI: And how is the 4-10 determined?
DW: Depends on the size of the transaction. There’s variability and if someone’s coming in and wants to buy or sell a million dollars’ worth of stock, they’re probably going to get a discount off of list price, if you will, relative to someone who’s posting $50,000 worth of stock to sell.
BI: At this point, are most of the transactions driven by buyers looking, or is most of the stock listed?
DW: Great question. It really depends on the company. It really depends on the week, which has been really interesting to watch. If you were to go to our site and look at Groupon right now, you’d see lots of offers to buy stock. No sellers. If you were to go to Facebook, you’d see lots of offers to buy and sell. A pretty active marketplace. There are other companies that are lesser known where there are posts to sell and no buyers.There’s a pretty high level of variability based on the visibility of the company – how well known is it, where is it in terms of maturity? It’s hard to judge. Even the bigger names. Some weeks we have higher visibility names where we seem to have tons of buyers and no sellers and some weeks where the sellers for whatever reason get more active and go post some stock for sale. I think a lot of it goes in waves. The sellers at some point have sold enough stock and think, “I’m done for now.” And then they wait a little while and the price changes and they say, maybe I’ll go sell a little more stock at that price. What’s happening in the market tends to catalyze interest.
BI: Where do you get the stock?
DW: On the secondary market, it’s existing shareholders. It can range from founders, employees, angels, consultants who worked there early on. VCs have become active.
BI: I mean, are you approaching those VCs and employees, or are they approaching you?
BI: So you would go pitch Andrew Mason at Groupon, or whoever.
DW: Yes. Individuals. Or VCs. Often times, particularly if we know we’ve got a lot of selling interest, we will track down sellers and say, “We have interest at this kind of size at this kind of price level.” We have other times where we have sellers come to us and they say, “I got 50,000 shares and I don’t want to sell all at once, but I’m thinking about selling a portion of it.” They’ll create a posting to sell a portion of the stock that gets vetted by our brokers and eventually shows up on the site.
BI: How long is that process? Quick turnaround?
DW: The process of posting happens very quickly. They could go on and click on “post to sell,” fill out a bunch of information, how much they want to sell. They have to then upload their stock certificates, their shareholder agreement. They click “submit,” that information goes to one of our brokers who reviews it, talks to the seller to find out how they got the shares and how long they held them, makes sure there’s a valid securities exemption they can operate under, makes sure they actually have communicated restrictions appropriately, make sure they own stock and not options, it all gets fleshed out before the post goes live on the site. Depending on the price that gets posted on the site, a stock could transact relatively quickly.
BI: You do this for all class of stock, so it’s common, preferred, Series A, all that stuff?
BI: Do the information rights and the voting and the security transfer with everything?
BI: Series A stays Series A. There’s no conversion?
DW: That’s right. The new owner inherits both the rights as well as the restrictions.
BI: When I talked to a bunch of companies a couple weeks ago, they were saying that they were starting to rewrite all their stock agreements so that they had the right of first refusal, which they didn’t in a lot of cases.
DW: That’s pretty rare though. A lot of companies already have it.
BI: Is that so?
DW: I think so, yeah.
BI: Are a lot of companies buying it back?
DW: High level of variability. Depends on the price where the transaction is occurring. It even depends on the company.
BI: Do you have a deal in place with the smaller companies before the stock can be traded?
DW: On the secondary market, the companies don’t have any direct participation with what we do. This is very important because eventually you’ll get around to asking me about the 500 shareholder rule which is really designed for the company to make sure they don’t actively exceed 499 shareholders. Because they are not a direct party to any of these transactions, that 500 shareholder rule doesn’t apply to the transactions that we do, unlike the Goldman deal, for example. Facebook was an active, direct participant in the transaction, so I always try to make sure that people understand the difference between those two.
On the primary side, we will be working directly with the companies that want to raise primary capital. That will all be done on a full disclosure basis. They will be direct participants in the offering.
BI: And when are you going to do that?
DW: We’ll be rolling that out over the next three months.
BI: You have clients all set?
DW: I have some teed up, yeah.
BI: That’s great, that’s going to be exciting.
DW: It’s a natural extension of our business. If you look at the Money Tree data, on average, late stage companies raise north of $21 billion every year. That late stage money, historically, has gone to 30-50 institutions that everyone has on their list if you’re a private placement agent. We can broaden that universe out much broader.
If you go around and talk to growth investors, public company investors, there’s nothing to buy. They’re basically saying, “These companies I’m buying on the private market are at the same stage as when I used to buy them when they went public. So why not buy them?” Some of them have carveouts in their existing funds or are setting up dedicated funds to become more active. But their disclosure demands are going to be stricter than a typical secondary buyer might be. So we’re trying to create mechanisms using technology that companies can actively provide selective disclosure on a password protected basis to people they want to build relationships with.
BI: It will not be publicly disclosed?
DW: No. All controlled by the company.
BI: The term sheet for this stock — when you do primary, are you going to do just common, or are you going to sell preferred?
DW: We’re open to doing either one.
BI: And is it a negotiated transaction, or are you saying, “Here’s the term sheet, take it or leave it.”
DW: It’s the same way that a private placement would be done offline. Somebody will step up as a lead and you’ll negotiate.
BI: So there will be negotiation?
BI: So basically, in that scenario, you are using technology, but acting like a normal private placement agent.
DW: In some aspects. You can’t replace human intervention in some aspects of the transaction. You can use the Internet to aggregate purchasing power, you can use it to facilitate communication and information dissemination in a much more efficient way, and to automate certain processes. But when it comes down to negotiating final terms with someone, that has to be a human being.
BI: The companies that raise money through you, will it be just a regular VC deal where it won’t stay liquid in the thing, or would it become almost like a mini-IPO where they’re going out saying, “We’re going to raise money?”
DW: Great question. Obviously once we do a primary offering, we can create a bulletin board for that offering. So at some point in the future if someone does want to sell that particular security through SharesPost, they’ll be able to.
BI: What’s the advantage? Is it that it’s that much harder to hit the public market and people need to have a private market for something like that? What’s the problem you’re solving?DW: There’s a long list of contributors to structural changes that have occurred in the capital market in the last 7-10 years. We look at everything from decimalization to the separation of investment banking and research, Sarbanes Oxley, the consolidation of the boutique investment banks. They used to take these companies’ little $30-50 million offerings. None of that’s happening anymore. Companies are staying private longer. On average 10 years up from 4.5 years 10 years ago. You just look at the amount of capital that’s gone into the number of venture-backed companies over the last seven years. $168 billion invested in 24,000 companies and only 2,600 exits. There’s this huge amount of money coming into the front of the funnel and very little coming out the back, creating this huge liquidity need for these angels, employees and early-stage investors. The secondary markets really are growing because of that need.
BI: Is the reason the money’s not coming out the back because of these companies that aren’t working?
DW: Facebook, LinkedIn, Twitter, Groupon – all these guys – they can go public anytime they want. They could’ve gone public a long time ago but they’re choosing not to because it’s expensive and the benefits of going public are a lot less than they used to be. Two of the biggest reasons to go public are to get liquidity for your existing shareholders and to gain efficient access to growth capital.
We’ve stepped back and said, “Can we provide those two solutions for these companies?” And if so, give the companies the opportunity to go public over their time frame as opposed to “I’ve got a gun to my head.” Now the companies have much more control over the process and timing of if and when they do a public listing.
BI: So are the economics the same to you in a primary? The issuer pays?
DW: The issuer pays.
BI: It’s at a typical…
DW: 4-6 per cent.
BI: Then that can be either preferred or common? You can do whatever you want?
DW: Yeah, and again, when you think some people say, “Why don’t you just go do another VC round?” by the time you’ve done 2 or 3 rounds of financing, you’re 5, 6, 7 years old. You’ve already got more VCs around the board table than you can manage. So the value of getting another VC is not value added, it’s actually probably a negative thing. You really should be focused on efficient access to capital at the cheapest price.