United States: Show Them The Money

One creative solution is a private secondary market for hard-to-trade assets, one bright example of which is the aptly named New York-based SecondMarket.

Barry Silbert, formerly an investment banker specializing in corporate restructuring and the sale of distressed, illiquid assets, founded the firm in 2004 initially as an online exchange for restricted stock in public companies. Registered with the SEC and also as a broker-dealer belonging to FINRA, MSRB, and SIPC, SecondMarket has since expanded into other asset classes including auction-rate securities, bankruptcy claims, fixed-income products, and its signature discipline, private company equity. In early 2010, the firm introduced capabilities on its platform that allow investors to "watch" thousands of private companies and receive publicly available information in the form of a newsfeed on their SecondMarket dashboard.

Based in the firm's San Francisco office, Senior Vice President Jeff Thomas (pictured above) leads business development for SecondMarket's Private Company Market division. As he explains, the firm remains focused on bringing structure and order to a prohibitively inefficient marketplace. "Historically, small growth companies have had unfettered access to the traditional capital markets," explains Thomas, who worked with private equity and venture capital firms on deal sourcing and structuring at global consultancy Gerson Lehrman Group before joining SecondMarket in 2010. "From the mid-'90s forward, however, structural changes, from SOX to high-frequency trading to the narrowing of spreads, have effectively closed the door to small- and micro-cap firms."

In fact, according to a 2010 report from Grant Thornton LLP, the U.S. IPO market is "closed to 80 percent of the companies that need it." Without research and brokerage coverage—the economics aren't there anymore, says Thomas—and with the market cap for admission to the public equity markets inhospitably set at $1 billion, venture-backed startups are stuck in an unnaturally protracted wait for the exit door. "Especially given the state of the economy, it's impractical to handicap growth by sticking investors and employees with shadowy liquidity prospects," he says. "Equity without liquidity is not an incentive."

Not all companies want their employees cashing out equity before an IPO, however. Some fear early cash-outs could threaten relationships with key employees or dilute their control over the company. "While private market trading can be a great vehicle for the orderly sale of securities by employees, some CEOs and boards view it as a negative," says Lion, who works closely with SecondMarket. "It's important to manage the process carefully." Forming close relationships with management teams and educating them on the benefits of the private market are integral to the game plan.

"Our approach is based on making the market work for the company, not the other way around," says Thomas. "When you go public, the market controls you, through daily stock churn, quarterly earnings pressure, and other factors. First, we learn the type of investors a company wants on its cap table. Then, by facilitating trading windows, which essentially set liquidity schedules for their stock, we help to control and optimize the buying and selling process."

Adhering to strict SEC rules, SecondMarket has created an automated system for pre-qualifying investors, who must meet the "accreditation" standard of possessing $200,000 or more in salary over the past three years, or a net worth of $1 million or more (excluding primary residence), and an assumed level of investment acumen and sophistication. Heavily concentrated on the institutional side, the firm's investor base can make informed investment decisions via the "watching" platform, where sellers can disclose select financial and other sensitive data in a controlled environment. With the SEC now closely "watching" the private secondary market, SecondMarket's diligence is paying dividends: two competitors were recently fined for allegedly misleading and overcharging investors.

Reporting over $1 billion in private company stock transactions since forming its private company division in 2008, SecondMarket is hitting milestones while also finding itself at an intriguing crossroads. In early February, Facebook, launched the same year as SecondMarket, had just announced its monster IPO. Transacting pre-public Facebook shares in 2007 propelled SecondMarket's private company business into life and has formed the bulk of its trading activity since—but with Facebook now following fellow social media giants Zynga, Groupon, and LinkedIn off the table, some have asked if the model can survive.

"We are maturing into a viable alternative for the many companies still unable to access the capital markets," says Thomas. "Even if the IPO market starts to turn around and more companies get funded earlier, this will let us work with an even broader range of companies, further enhancing our business."

Breathing Room For Young Companies

Over the past twelve months, a number of regulatory issues hindering startups and small businesses caught DC's attention. Several measures aimed to help small companies' ability to grow were introduced in Congress last year, including the Private Company Flexibility and Growth Act, which sought to update the antiquated "500 Shareholder Rule." In early March, the Private Company Flexibility and Growth Act, along with related pieces of job-creating legislation, were combined to create the Jumpstart Our Business Startups (JOBS) Act.

In addition to raising the 500 shareholder threshold to 2,000 and exempting current and former employees from the count, the JOBS Act's various components included lifting the ban on general solicitation, easing the path to the public markets and allowing companies to raise small amounts of capital through crowdfunding.

The new package of bills saw overwhelming bipartisan support and passed in the House in a matter of weeks. As the bill moved to the Senate, thousands of entrepreneurs, venture capitalists and members of the tech community championed for immediate passage, through robust social media campaigns and a successful online petition created by AngelList that gained over 5,000 signatures in just a few days. With the support from the tech community and the House's approval, the Senate passed the JOBS Act in mid-March, after including some additional investor protections.

"We were thrilled to see how quickly Congress took action on the JOBS Act," says Thomas. "These provisions will have an immense impact on how companies raise capital. Now startups can hire new employees and provide them with tangible stock options without the fear of being forced into the public markets before they're ready."

On April 5, 2012, President Barack Obama signed the JOBS Act into law, and noted that "these proposals will help entrepreneurs raise the capital they need to put Americans back to work and create an economy that's built to last."

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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