June 3, 2011
Groupon became the latest social commerce company to file for an IPO yesterday, taking it out of the booming secondary market for private share trading. But plenty of hot companies remain in what used to be the exclusive domain of angels and institutions. These days, individual investors are clamoring to buy shares in privately held companies, otherwise known as the secondary market. Goldman Sachs’ $450 million investment in Facebook this past January and its subsequent offering of those shares to preferred clients, put a laser focus on a trading practice that has traditionally been reserved for wealthy elites.
The Wall Street Journal recently reported that the value of private-share transactions almost doubled from $2.4 billion in 2009 to $4.6 billion last year. This year, that number is expected to skyrocket to $6.9 billion. It’s a figure with an inverse relationship to the number of annual IPOs, which have been dropping since the 1990s.
The Securities and Exchange Commission has finally reacted by signaling to Congress during a couple of recent hearings that it is reevaluating regulations that apply to private share trading.
But how exactly does private share trading work? Can anyone do it? And how is it regulated?
How can one invest in private shares? There are several paths to the increasingly coveted off-the--market stock purchase:
-Online Platforms: Websites like Sharespost and SecondMarket provide an online venue that connects wealthy investors either with private companies that want to raise capital or other individuals who want to cash out of private shares they already own. The regulatory precedent for such operations was set in the late 1990s when the SEC issued a “no action letter” to a company called IPOnet, a predecessor of today’s online marketplaces. Today, Sharespost and SecondMarket have become highly monitored gauges of companies’ values. In March, for example, SecondMarket sold 115,000 shares of Facebook at $30 a share, giving the company a $75 billion valuation.
-Special Purpose Vehicles: These are temporary companies or partnerships created for the purpose of circumventing certain regulations, in this case the 500-investor limit for private companies (see below). Goldman created one to skirt the limit for its Facebook offering. In effect, it means that investors put money into an investment firm’s special purpose vehicle, which then directs that money to a private company as a single entity. Some firms, like NYPPEX, specialize in the secondary market.
-Crowdfunding: This is similar to the special purpose vehicle, but in this case individuals pool their money together and collectively invest in a company as a single entity (rather than the money being pooled by an investment firm).
-Friends and Family Shares: If you are seriously close to a company, you can sometimes participate in friends and family offerings, which are private shares sold to individuals the company already knows, and who already know the company.
What are the current roadblocks to trading in private shares? There are a few, and they mostly have to do with wealth and access.
-Accredited investor requirement -- In order to buy shares in a private company, an individual must qualify as an accredited investor with the SEC. To do so, he or she must prove an income of at least $200,000 in each the two most recent calendar years ($300,000 for a married couple), or a net worth of at least $1 million.
-High minimum investments – Companies find large investments by a single individual more appealing than a number of smaller investments from multiple people – things get messier quickly both from a legal and accounting standpoints as the number of investors increases. Companies and investment firms usually require a minimum investment of, say, $100,000 – the typical minimum investment for Facebook shares.
-General Solicitation Ban – This law prohibits private companies from advertising issues of shares, and is intended to prevent companies from exploiting naïve or vulnerable investors with predatory scams. In effect though, say its critics, the ban creates an unnecessary hurdle for small businesses trying to raise capital.
-500-Shareholder Limit – Once a company reaches 500 shareholders, it is required to release its financial statements – in other words, to go public. In theory, this places a tight limit on private-company investors. In reality, companies have been finding ways around the law, with the aforementioned special purpose vehicles and crowdfunding, although these channels tend to make the process lengthier and pricier.
Are changes to current regulations in the works? Almost certainly. In March and again in May, SEC chairwoman Mary Schapiro told a House of Representatives panel that the commission would be reviewing rules relating to private share trading. Some specific regulations up for evaluation:
-Increase the Shareholder limit: Critics say the current limit makes it difficult for small companies to raise sufficient capital. There is also concern that everyday investors will be shut out of the game entirely if they have to compete with the big guns for such limited investment opportunities. To this end, there have been proposals to lift the limit and/or to exempt “sophisticated” institutional investors from counting toward the limit, which would then leave the 500 slots more likely to be filled by smaller, individual investors.
-The general solicitation ban is considered by many, including potentially the SEC, to be outdated. It caused Goldman to withdraw its offering of Facebook shares to U.S. citizens, for fear that the media attention surrounding the deal constituted general solicitation. It also raises free-speech concerns. In an age when a mere tweet can reach the entire population, it can be impossible to avoid what technically qualifies as general solicitation. Schapiro stated that the SEC will be looking into the ban and potential alternatives to it.
-Online platforms for the buying and selling of private shares have existed for over a decade, but their popularity has begun to soar only recently. They are now grappling with issues of transparency and with increasing scrutiny from the SEC. The landscape is certain to change, but the details remain to be seen.
Ultimately, the SEC will be looking to strike a balance between protecting investors and enabling companies to grow, as it adapts its rules to today’s fast-paced, internet driven investment marketplace.