Firms such as Facebook are staying private for longer, prompting regulators to examine secondary-market trades
WEALTHY INVESTORS looking for the next Apple or Google are increasingly trading in shares in social networking companies like Facebook, Twitter and LinkedIn. Interest in rapidly growing technology stocks is nothing new, but there’s one key difference regarding the trading of the aforementioned social networking giants – none of them are listed on a public stock exchange.
The trading is being conducted on secondary markets that provide an exchange for shares in private companies. It emerged this week that the US Securities and Exchange Commission (SEC) is investigating the matter, which has come under the microscope following reports that Goldman Sachs is raising $1.5 billion (€1.1 billion) from wealthy clients looking to invest in Facebook.
Goldman, which is itself thought to be putting $450 million into Facebook, is apparently planning a special purpose vehicle, or SPV, that will circumvent regulatory requirements. Sizable companies that are owned by at least 500 people are required to register with the SEC and provide greater financial disclosures to the public. When Google’s investors exceeded 500 in 2003, it prompted the company to go public. Seeing as the SPV is just one company, however, Goldman is hoping to gain its clients access to Facebook while ensuring that the 500-person rule is not breached.
Whether that breaks the spirit, if not the letter of the law, is open to question. SecondMarket, a leading exchange for private shares, said this week that the SEC had written to it looking for information regarding “pre-IPO pooled investment funds”. Facebook is SecondMarket’s most actively traded company, one of about 40 companies that it facilitates trading in. It expects to execute approximately $400 million in such trades this year, a quadrupling since its beginnings in 2009.
SecondMarket is not the only such exchange. According to Alphaville, the Financial Timesblog, numbers from US brokerage NYPPEX claim that the secondary market in private companies was worth $9.6 billion last year, a tenfold increase since 2005.
The increase in trading volumes has been accompanied by a sharp increase in prices. Facebook has seen a fourfold increase in its share price and is now valued at more than $50 billion. Twitter ($3.6 billion) has more than doubled in recent months while a NYPPEX study indicates that the top 11 private technology businesses have jumped by over 50 per cent over the last six months.
Trading volumes remains thin, however, with share purchases limited to so-called accredited investors with a net worth of over $1 million.
Ordinary investors looking for a piece of the action will get their chance following reports this week that business networking website LinkedIn, currently valued at $2.2 billion, was planning to file for an initial public offering within months.
However, flotation is not the status symbol it was in dotcom days. Facebook chief executive Mark Zuckerberg is thought to be cool towards the prospect, as is Mark Pincus, chief executive at social game maker Zynga. Deal-of-the-day website Groupon recently said that it is raising $950 million in new private financing while Twitter last month raised $200 million in new funding. A decade ago, the average venture-backed company went public in the US within three years. Today, it’s closer to eight years.
“The incentive for going public has lowered and the penalty for going public has increased,” according to Ben Horowitz of venture-capital firm Andreessen Horowitz. A Facebook shareholder, Horowitz warned that companies should be “very careful” about going public, citing the regulatory environment and the rise of hedge funds as complicating factors. Stricter accounting standards since the 2002 Sarbanes-Oxley Act have increased the costs of a public listing, allowing SecondMarket to boast that it could offer “many of the benefits of being public without the added costs and regulatory burdens”.
For chief executives looking to raise finance while retaining control of their company, the secondary markets offer obvious benefits. Employees denied the benefit of an early IPO can offload their share options while speculators looking for the “next big thing” are also facilitated.
However, there are obvious concerns. The law warns against companies that allow the “form of holding securities” to “circumvent the provisions” of the Securities Act, leading many commentators to question whether the Goldman/Facebook SPV will be allowed to proceed. The fact that a potentially legally dubious mechanism is being used to grant very wealthy individuals exclusive access to investments leaves many with a sour taste in the mouth. SPVs have a controversial history, their off-balance-sheet structures leading them to be employed in the past by firms such as Enron and Lehman Brothers.
Potential insider trading is an issue, as acknowledged by Facebook last year when it announced an insider trading policy to comply with securities laws.
There are also concerns that illiquid secondary markets will facilitate bubble-like overvaluations. Investors are making bets armed with very little information, with companies providing very limited financial disclosures. The craze to get a piece of the Facebook pie has led to a mind-boggling $50 billion valuation – more than eBay, Dell and Morgan Stanley, to name but a few. Young growth stocks are notoriously difficult to value, but at 25 times 2010’s expected revenues, many argue that Facebook is priced to perfection and beyond.
Regulators are getting involved because the issue is “finally coming on their radar”, said Thomas Foley, chief executive of Xpert Financial, which this week became the first electronic exchange to earn formal approval from the SEC to trade in private company stock. “As soon as they see investors investing in companies without information, and the companies blowing past the 500 investor limit, they have to get involved.”
SEC involvement is likely to lead to increased regulation rather than severe restrictions on the practice, however. With fast-growing companies staying private for longer, private company stock looks like it will become an increasingly mainstream asset class in coming years.
