SharesPost Gains Traction - Issues Remain With Private Exchanges

A few days ago I received the first member update e-mail from SharesPost, one of the newest online private exchanges providing liquidity to holders of private company shares. I covered how the exchange works in a previous post – essentially, holders of qualifying private company stock can post to sell a block of stock to accredited investors who are allowed to purchase these shares through a bid/ask system. Participants pay a $34 month fee for the right to post (buyers and sellers) and transactions incur a $2,500 escrow fee (to both buyers and sellers).

Sharepost is one of the most open answers to the liquidity problem faced by holders of pre-public private tech company shares (including founders, employees and investors such as venture capital firms) in the face of a narrow IPO window. According to the e-mail I received, the service has signed up over 4,000 members and is adding hundreds more each week (registration is free). There have already been transactions involving LinkedIN, eHarmony, Linden Lab, XDX, Tesla Motors, and SugarCRM, with postings out there for the sale of stock in at least seven other companies, led by Facebook. In fact, there are 250,000 shares of Facebook up for sale and bids out for over 900,000 shares, though a transaction has yet to close.

One feature of SharesPost I did not touch on in my last post is the free research reports offered on select companies. These reports provide insight into the valuations of private companies - information that is usually kept a bit more private, although generally attainable if you dig around. The figures always have to be taken with a grain (or handful) of salt since it’s so difficult to accurately ascertain the true value of private companies. This is where I think SharesPost, or most any other private exchange falls short. There is a lack of controls and transparency typically associated with public exchanges – a buyer can easily be taken advantage of because the seller has so much more information on the true value of the shares. There’s not enough volume to determine fair value for a company’s shares either and I’m not sure private exchanges will ever get there.

A potential source of volume, particularly on the sell side, could be venture capital firms (which most private exchanges are trying to attract), who, just like the founders and employees of many pre-public tech companies are facing liquidity issues with their portfolio companies. But the problem I see there is, why would companies/VCs looking to reward their employees by providing some early liquidity simply post, or allow employees to post, shares on a private exchange like SharesPost? The term “private exchange” then becomes an oxymoron. Instead, there are other options available to less publicly provide liquidity, such as direct secondary funds. These funds are private equity funds formed for the sole purpose of providing liquidity to the shareholders of pre-public companies. Think of them as large buyers on SharesPost, except with more capital, the ability to “buy in bulk” and access to more information since they maintain privacy of the transaction. These types of funds have been growing in number and size of late, meaning sellers still maintain the ability to get bids on the shares they want to sell.

The CEO of SharesPost has also suggested the exchange could be used by venture firms looking to wind down funds. One of my earlier posts on this blog was about the huge issue looming over vintage year 1999 and 2000 venture capital funds. These funds will soon be desperate to unload investments - so, yes, they will be hungry for liquidity, but will a private exchange like SharesPost be the solution? I’m not so sure. The question is who will buy the companies’ shares? And why? If after 10 years the companies are still not “exitable” then VCs will be forced to sell at huge discounts. Not only that but selling on SharesPost provides no guarantees in terms of a complete sale or timing.

While SharesPost and other similar private exchanges might be good for individual sellers of private company shares, they are still very much targeting a small niche. They have their place and could even thrive, but I don’t think they are the solution to any of the venture industry’s liquidity issues.

Exploring Private Exchanges

It’s no secret that the venture industry is reeling from a liquidity crisis – we’re constantly reminded that venture-backed IPO and M&A activity is at historic lows. And while there have been recent glimmers of hope via the IPOs of OpenTable and SolarWinds, we’re far from the proverbial IPO window being open again. To address the issue, the National Venture Capital Association (NVCA) laid out a “Four Pillar Plan to Restore Liquidity” back in late April. As part of the plan (the second “pillar”), the NVCA encouraged the use of enhanced liquidity mechanisms such as private market exchanges. While yet to gain much traction, a number of these newer private exchanges have garnered attention of late. They might turn out to be great for the venture industry, but I see a few issues, including the fact that they all seem to be doing very similar things meaning the space is very fragmented right now, and volume is much too low to put a dent in the liquidity issue. Here’s a rundown of some of the major new players:

Backed by venture firm Draper Fisher Jurvetson, XChange will use a bid/ask pricing system to allow the sale of private securities to qualified institutional brokers. I’m not clear on whether or not this includes LP interest in venture funds or just shares in a start-ups employees or venture firms may hold. XChange will also offer companies the ability to do a primarily issuance of shares (they’re calling it an “XPO”). Still new, the exchange is not yet fully operational.

With the support of the NVCA, a number of venture capital firms (Oak, NEA, Venrock, Versant, DCM to name a few) and apparently 200 institutional investors, InsideVenture might be the private exchange with the most industry support right now. InsideVenture offers “Hybrid public-private offerings” in which start-ups would have to file the same way as they would for a regular IPO, but the shares would first be offered to investors that are affiliated with InsideVenture. It does not seem like there is the options to do smaller secondary sales of direct ownership stakes in companies like with XChange. InsideVenture is open to only institutional, PE and accredited investors.

SecondMarket is one of the better established private exchanges. They claim to have 3,000 market participants, with $10 billion in traded assets. In addition to shares of private companies and limited partnership interests in private equity funds, the exchange is for all types of illiquid assets including auction-rate securities, bankruptcy claims, CDOs, and MBSs. To help attract bidders for these illiquid assets, SecondMarket has developed a proprietary "ManhattanAuction" which essentially pays bidders for bidding. The exchange is open to institutional and accredited investors only.

The newest private exchange on the block is SharesPost. In fact, it just went live with its public beta release yesterday. The interface is much more open than other private exchanges - after a basic registration process, you are able to view the shares of top venture-backed companies that are for sale, what the bid and ask prices are and, for some companies, the implied valuation (more on this later). It costs $34/month to post or interact with other posts (buyers and sellers), there are no commission fees, but there is an escrow fee of $2,500. Sellers remain anonymous except to the buyers of shares (who must be institutional or accredited), but all SharesPost members can view restrictions sales are subject to and prior agreements once even one trade is made on a company. The minimum proposed transaction size is $25,000.

Of the four private exchanges I've highlighted (there are plenty more that are not as sexy, including NASDAQ's PORTAL Alliance, the NYPPEX, and TSX Venture Exchange), SharesPost stands out the most due to its openness. Both SharesPost and SecondMarket only allow for the secondary sale of private company holdings. InsideVenture seems to do just primary (semi-public) issuances and XChange looks to do both. All complete the mission of providing liquidity, particularly for employees and smaller shareholders (save for InsideVenture), but I still think the larger liquidity issues will remain. It’s unrealistic to expect many substantial full-blown venture-backed exits through any of these exchanges, at least to the point that it alleviates the industry’s liquidity issues. They’re more of stop-gaps in my opinion, and I think they know that.

The fragmentation I mentioned earlier probably hinders all of them which is why I think there eventually will have to be some consolidation in the space to allow for more efficient marketplaces. For now, they will all face competition from not just each other, but traditional IPO and M&A exit avenues (if/when they come back) and a growing crop of direct secondary and traditional secondary funds which have the upper hand when it comes to negotiating terms since they can make purchases in larger chunks while keeping the transaction private. Speaking of which...

It probably hurts companies that list on a more open exchange like SharesPost if they are looking to obtain additional rounds of funding. It’s understandable why SharesPost went the more open route (because it should attract more buyers and sellers), but a lot of private equity and venture capital firms would not be comfortable with investing in a company that has so much of its information public (sorry, but obligatory: “it’s called private equity for a reason”).

One interesting piece of information that ends up out there is a company’s valuation – and even if it’s not out there or accurate, there are implications for venture capitalists invested in the companies beyond just maybe having that information public. A layer of complexity could be added to valuating companies under FAS-157, which has established the framework for measuring fair value. Under FAS-157, investors have to mark an asset to market, which I think would mean that venture and private equity investors in companies listing on a private exchange would have to take into account transactions occurring on those exchanges when it comes to quarterly reporting to LPs. Not a fun prospect.

It will be interesting to see what impact these exchanges have. I’d like to do a follow-up examining each one in more detail if possible. I’d also like to examine the SharesPost model a bit further in a future post because of the tie-ins to my previous look into crowdsourced venture capital; the purely on-line transactions, openness of information, and allowing regular individuals to participate.