Stanford: Secondary Market for Private Shares: Overview and Challenges

The Rock Center for Corporate Governance at Stanford Law School hosted a session on “Secondary Market for Private Shares: Overview and Challenges” at 6 pm.

There were 4 panelists:

  1. Annemarie Tierney, General Counsel and Corporate Secretary, SecondMarket, Inc.
  2. Marianne Baldrica, VP of the Corporate Cient Group, NASDAQ OMX
  3. Frank Currie, member of Corporate Department, Davis Polk & Wardwell LLP
  4. Joseph Grundfest, Professor of Law and Business, Stanford Law School (moderator)

Besides Stanford law students, there were several professors and local business attendees.

Until the time is right for an IPO, startups can benefit by remaining private to save $2-$3 million in IPO filing expenses and recurring $2-$3 million in staffing and compliance costs. Also, private companies can keep strategies and business model ideas secret, and reduce outside distractions, while building their company.

However, issuing private stock options is still beneficial in attracting and retaining employees.

Currently about 20 social media companies (including Facebook, Zynga and Twitter) are able to attract private equity, so no need for an IPO to raise capital.

Problems can occur when the public starts buying these private shares though:

  • asymmetric infomation: insiders vs. outsiders
  • is that a registered stock certificate, or a lottery ticket?
  • different levels of investor sophistication (widows and orphans, doctors and lawyers) want a piece of the action?

SecondMarket only works with accredited investors with $1 million in escrow. They started by listing auction rate securities and bankruptcy-related paper, but have listed $800 million in pre-IPO shares in the last 2 years. They have an app for companies to approve and transfer their shares. Generally a trade takes 30 to 45 days. Transfer fee is $2,500 to $6,500 per transaction, average trade is $1 million.

NASDAQ cannot get involved until the company is public.

Under SEC Rule 700, insider information is still “special” even for private companies with employee options, leading to the absurd situation where European investors may buy shares in an American company and Americans can’t, out of FUD regarding SEC enforcement.

Private Company D&O Insurance starting with Series A now. Boards now are being recruited with an eye for an IPO. But how does insurance for private companies protect a Board essentially selling shares through the backdoor to the public?

Read SEC Chairman Mary Shapiro’s letter to Congressman Darrell E. Issa for a primer on modern securities rules.

Assignable right of first refusal helps control who amasses shares without the issuer spending all their capital on buybacks.

Transfer restrictions avoid the problem of 1 shareholder with 500 shares splitting them amongst 500 shareholders.

Delaware ยง202 defines what changes to restrictions are allowed, and beyond that a company may need to reincorporate to make substantial changes. Make sure all employees and contractors fall under ROFR for fairness.

Lawfirms likely need to revise boilerplate legal documents, and existing incorporations may need to be reincorporated.

Under SEC Rule 144, ex-employees can sell after 3 months with almost no restriction, subject only to transfer and right of first refusal agreements.

RSU is a Restricted Stock Unit. RSUs vest like options but cannot convert to stock until say 6 years/IPO/sale. But top recruits may understand and want stock. Also, the IRS setup RSUs, so there are complex compliance and tax implications for bother issuer and grantee, as well as possible plan disallowment by the IRS.

Problems will arise as these pre-IPO shares decrease in value. So choose buyers carefully (mezzanine investors, experienced early-in institutions, etc. who are supposed to know everything) to avoid lawsuits. Perhaps even Calpers is not the right investor for this category of investment?

It was a fascinating 90 minute discussion with numerous questions from the audience.

Check back in 18 months or after Dow declines 2,000 points to see what shoals lie below the surface. :)

Big Changes to SEC Rules Impacting Small Business Capital Raising?
How do you report RSU income to the IRS?
dealbook.nytimes.com: Facebook Readies Track for I.P.O.; Goldman Faces Questions
Facebook’s Painful Secondary Impact
SEC Cracks Down on Pre-IPO Trading
SecondMarket expected to lay off 20 percent of staff
How SecondMarket is Staying Relevant, Post-Facebook

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