Pre-IPO Startup Market Is Red Hot

Demand for a piece of Facebook has reached such monumental proportions that Goldman Sachs ignited a media and investor frenzy when it announced plans for a $1.5 billion private offering of the social media company’s shares. But the Goldman deal was just the highest-profile transaction in the red-hot private market for shares in Facebook and other pre-IPO companies.

In recent months, a growing network of investment vehicles and trading platforms has sprung up to facilitate trades between ‘accredited investors’ and Silicon Valley insiders eager to unload their shares. And some of the hottest companies – including Facebook, LinkedIn, Twitter and Groupon – have seen their valuations soar as investors compete in these arenas for limited shares that must be valued with little information on the company’s underlying financials.

Back in April 2009, LinkedIn was valued at $1.9 billion; today, it has an implied value of $2.2 billion. Facebook was valued at $16 billion as recently as last spring; the price Goldman paid for a 1 per cent stake gives the company an implied value of $50 billion. These soaring valuations are only feeding the growth of those facilitating the trades. New York and Palo Alto-based SecondMarket launched its private company trading platform in April 2009. By the end of 2009, it had completed $100 million of transactions; last year that number increased four-fold to $400 million in 40 private companies, including Facebook, LinkedIn and Twitter, says spokesperson Aishwarya Iyer.

San Bruno, California-based SharesPost, launched in 2009 and now lists more than 100 companies, most of which are venture-backed, pre-IPO stage start-ups in areas like technology, cleantech and social media. It has signed up close to 50,000 registered members, ‘representing more than $125 billion in managed capital and today has more than $1 billion in posts to buy and sell in our online marketplace,’ says Dave Weir, CEO of SharesPost.

Since launching, the company has experienced ‘significant growth as the interest in investing in pre-IPO companies like Facebook, LinkedIn and Twitter has reached an all-time high,’ Weir says. Meanwhile, a number of private equity firms are also attempting to cash in on the hunger for pre-IPO companies – a trend the Wall Street Journal dubbed a ‘secondary fund frenzy’. Felix Investments is among the most widely cited private funds that have raised money from accredited investors to buy a large number of Facebook shares. Another firm, GreenCrest Capital, is reportedly raising $100 million from institutional investors to buy shares from former employees.

Is it all upside?

But the secondary markets come with drawbacks, among them a lack of transparency. Justin Byers, an analyst at VC, which provides research reports based on the limited regulatory filings available for non-public companies, notes that with the companies listed on SharesPost there’s ‘a lot speculation and subjectivity that is going to go into valuations unless you have the numbers right there in front of you’.

Restated articles of incorporation and other obscure public filings can provide some clues as to appropriate company valuations. As the company remains private, however, financials are often unavailable. Given the current valuation of ‘Facebook, you’ve got to think a good bit of it is going to be hype because people just want to own a piece of the company,’ Byers says. ‘But then again, these are supposed to be accredited investors, so you have to hope they are doing their due diligence.’

The lack of transparency can also extend to dealings with those facilitating the investments. One investor responding to a question posted on the website noted that he tried to invest in the Felix fund and had a very poor experience. ‘I do not know if I am alone or not,’ he wrote. ‘I filled out a ton of paperwork and wired a large sum of money. I was told the series was closing that Friday. It took [Felix] over two months to notify me (after the stock increased 80 per cent) that I in fact did not get shares. It sent my money back without interest. I have no idea if it placed the shares with more favoured investors (per its agreement as the general partner, it can do that).’ Felix did not return calls seeking comment.

Others complain that these transactions are limited under the 1933 US Securities Act to individuals with a net worth of at least $1 million, or someone who has made $200,000 each year for the last two years. University of Chicago law professor Larry Ribstein, an expert in corporate and securities law, notes that the migration to private placement is depriving ordinary investors of the opportunity to reap the benefits of investing in a start-up company early.

‘A few years ago, in the early 1980s, you could have bought into Microsoft in an early phase,’ he points out. ‘If Microsoft was going public today, I think – like Facebook – it would think twice. It’s pretty clear that once Facebook goes public, it will be as a more mature corporation than when Microsoft went public, which reduces the ability of the ordinary investor to share in the extraordinary profits.’

That may soon change: in a January 7 filing with the SEC, San Francisco financer Michael Moe disclosed plans for NeXt BDC Capital, a closed-end mutual fund that will buy up stakes in Facebook and other private companies and offer them to the general public. The stock would be traded on an exchange, if the SEC approves it.

Delayed IPOs

The cause of the explosion in secondary markets is clear: companies are delaying IPOs, creating demand from insiders eager to unload shares early and investors impatient to get in on the growth. ‘Companies are waiting much longer to do IPOs,’ says Iyer. Employees holding shares in these companies ‘are looking for liquidity in the mid-term. People are getting married, they send their kids to college: the best way to finance that is through second market,’ she says.

There’s less agreement on why companies are delaying IPOs in the first place, however. Ribstein attributes the trend to a tightening in the US regulatory landscape following the corporate scandals of the early 2000s. ‘It’s related to the cost of being public and going public, which continue to go up,’ he explains. ‘First there was SOX and then Dodd-Frank and now there’s also an increasing cost imposed by shareholder governance in publicly owned corporations.’

But Alan Berkeley, a partner and securities regulatory lawyer at K&L Gates, says the growth has much more to do with the recent economic troubles, which have made it much harder for companies to raise money with IPOs, and forced early investors to liquidate their holdings. ‘There’s a whole community out there that will blame SOX for everything from Afghanistan to nuclear terrorism,’ he says. ‘It’s not the source of all evil. There’s no question that, given the markets of the last two years, it’s much harder for a company to go public.’

SEC questions

Whatever the case, the explosive growth is raising new regulatory questions. In fact, regulatory issues surrounding trading platforms even made it onto the agenda of a bar meeting last spring, Berkeley notes. Last December, the SEC sent letters to several of the entities involved in the buying and selling of shares in Facebook, Twitter, Zynga and LinkedIn on secondary exchanges, according to the New York Times, which cited anonymous sources. The nature of the SEC inquiry is unclear, and an SEC spokesperson declined to comment.

Berkeley says the private sale of securities exists in a regulatory grey area that the SEC has so far failed to explicitly address. Over recent decades, those engaging in these private sales have referred to the informal marketplace that has sprung up for these deals as ‘section 4.1 and a half’ because it falls somewhere between sections 4.1 and 4.2 of the 1933 securities laws.

With the creation of trading platforms that allow these transactions to take place on a larger scale, several logical avenues of inquiry come to mind, Berkeley says. ‘One very likely avenue of inquiry is whether the entities that are matching the seller and the buyer are registered broker-dealers, which would appear to be required,’ he notes. ‘There are lingering questions in the securities laws as to whether transactions effected through an unlicensed dealer can be rescinded.’

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