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Silicon Valley Cashes Out Selling Private Shares


Vince Thompson doesn't appear in any accounts of Facebook's early years. Few of the more than 2,000 employees at the company even know his name. The AOL (AOL) veteran's brief stint as Facebook's first official ad-sales chief lasted less than six months. Even so, when Thompson left the company in early 2006, he exercised his options to buy Facebook stock, as is the custom in Silicon Valley, and took a sizable chunk of shares with him. About 18 months later he moved to Los Angeles and started consulting for media clients such as TVGuide.com on how to tap new sources of revenue, and he began to think about how to create one for himself. He set out on a quest, talking to friends in the New York investment banking world about an unorthodox idea: selling a portion of his Facebook shares, packaged with those of a colleague who left Facebook shortly after he did. (Thompson declined to comment for this story.)

The idea seemed highly impractical since Facebook wasn't—and still isn't—a public company. Who would buy his shares? How could any outsider value a small, private company with hardly any revenue?

One banker introduced Thompson to a New York firm called Restricted Stock Partners, which in mid-2007 had a small office near Battery Park with two windows that looked onto a brick wall. The firm specialized in facilitating trades of illiquid securities, such as assets of bankrupt companies and preferred shares in public companies whose holders have special rights. Moving Facebook stock would be an altogether different kind of transaction, but the tiny firm had been looking for a chance to break into the market for private-company stock.

The resulting experiment stretched out several months, primarily because prospective buyers couldn't come to terms with Thompson on a price. Finally, using Microsoft's (MSFT) $240 million investment in Facebook in October 2007 as a guidepost, a hedge fund purchased the shares at a price that valued the fledgling social network at $7.5 billion. The trade netted Thompson and his partner millions of dollars.

That sale—among the very first of its kind—sent shock waves through the insular world of Facebook employees and investors. Facebook shareholders could get rich regardless of the company's plans for an initial public offering. Soon other former Facebookers were buzzing about the opportunity, and investors and employees at other pre-IPO firms started thinking about cashing out their holdings as well.

Restricted Stock Partners, which over the next year executed several similar trades by Thompson and a few other former employees of private companies, realized it had found the opening it had been looking for. "The speed with which we acquired private-company inventory after that initial trade was shocking," says M. Adam Oliveri, managing director at the firm. It "was a smack in the face that there was something going on in this market, and we started turning our attention to it." In 2008 the firm changed its name to SecondMarket.


Thanks to Thompson's Facebook trade and the other so-called secondary market transactions that followed, the dynamics of wealth creation in Silicon Valley have fundamentally changed. Transforming private-company stock into cash and generating potentially massive wealth—even if you briefly worked at a startup that currently makes little money—is a click away on such sites as SecondMarket and its West Coast rival SharesPost, as well as via an organized network of buyers and sellers that has sprouted up almost overnight.

Whether this new liquidity is healthy for startups, good for Silicon Valley, and beneficial for the U.S. economy overall are other questions. Proponents of these transactions, such as the founders of SecondMarket, cite the market in private-company stock as a cure for the deadly affliction known as IPO Blockage. Owing to the Sarbanes-Oxley Act and other regulatory changes to capital markets over the past decade, the IPO is no longer an attractive goal for many companies: 72 venture-backed startups went public in 2010—up from a mere 12 that made it in 2009 but far below an average of nearly 200 annually in the go-go '90s, according to the National Venture Capital Assn. And those companies took twice as long to go public: an average of 10 years in 2009, up from 4.7 years in 1999, according to the association.

That has left investors and employees at tech startups holding valuable stock they can't unload—and sleeping on the futon long after doing so has stopped building character. The secondary markets, their backers say, act as a stent, relieving the congestion in the arteries of capital formation, freeing employees to diversify, and placing shares of the hottest new companies into the eager hands of institutional investors such as Goldman Sachs (GS) and JPMorgan Chase (JPM). Nyppex, a secondary-market broker and research firm, says these markets are spreading relief widely; it expects $6.9 billion in transactions in private-company shares in 2011—up from just $2.4 billion in 2009. The secondary markets "have added public liquidity to a marketplace that had virtually none," says William Hambrecht, chairman of WR Hambrecht and a longtime Valley financier.

Then there are the prophets of doom, the Silicon Valley veterans who ominously observe that the secondary markets are messing with the rules of the country's entrepreneurial engine. In the old days, they say, investors and employees worked in unison until they reached an IPO or acquisition. Now some founders and employees are motivated to leave before the IPO because they are free to cash out; and new investors are snapping up pieces of tightly held companies, propelling them closer to the important regulatory threshold of 500 shareholders—the point at which they must report their financial data to the SEC and essentially behave as a public company.

"It's just not orderly," says Gordon Davidson, chairman of Silicon Valley law firm Fenwick & West, which represents startups such as Facebook and Twitter that have sought to control and in some cases outright block the sale of their shares. The secondary market, Davidson says, "has created a natural tension between employees who have worked hard in a startup for many years and want to balance their portfolios and the philosophy of companies that you really shouldn't cash in until the job is done."

That tension is on ample display in Silicon Valley these days. The new liquidity has yielded at least one lawsuit, one embarrassingly public firing of a junior executive at Facebook, and an investigation by the Securities and Exchange Commission into the massive new funds being created on Wall Street to snap up pre-IPO stock of tech startups. It has also pitted companies against their employees and some of high-tech's best-known angel investors against each other, and prompted a surge of greed that, to some observers at least, evokes ominous signs of an earlier phase of irrational exuberance. Everyone remembers how that ended.


There were exchanges of private-company stock long before Vince Thompson made his paradigmatic trade, but these were clubby affairs, restricted to the inner sanctum of venture capitalists and founders. When Richard Melmon, a co-founder of Electronic Arts (ERTS), left the video game pioneer shortly after it was founded in a dispute with his co-founder, he sold a portion of his holdings to a Valley financier named John Glynn, who recalls working hard to cultivate a relationship with EA before the deal. "These were very occasional transactions, and it was done the old-fashioned way," Glynn says. "You earned the respect and trust of the company, and they ended up wanting you as a shareholder."

After the dot-com bust in 2000, prescient investors began to detect investor demand to sell their stakes early even in the most promising startups. The companies couldn't go public, and distressed investors and cash-poor employees needed a way to ditch, or at least diversify, their holdings. Millennium Technology Value Partners was among the first such investment funds, founded by two veterans of buyout firm Blackstone (BX). The fund spent the early part of the decade buying shares in startups from executives and investors that needed cash. In one of its first organized, companywide "liquidity programs" in 2006, Millennium bought shares from employees, executives, and investors of TellMe Networks, a Silicon Valley voice recognition company. Microsoft acquired the startup the following year, reaping Millennium bounteous profits.

These transactions were still tame, well-orchestrated, and carefully negotiated affairs, always conducted with the imprimatur of the company in question. And then Facebook changed everything.

The social network was a reluctant pioneer of pre-IPO stock sales. Prospective investors knew Facebook; perhaps their children used it, or they had read the ample media coverage. And Facebook's young employees "began to realize they owned in shares more wealth than most people could ever dream of, and they wanted to get some cash and do things with their lives," says Daniel L. Burstein, one of Millennium's co-founders.

In 2008, Facebook employees knowledgeable about Thompson's early windfall began reaching out to investors such as Millennium, inquiring how to sell their shares. Mark Zuckerberg, according to people familiar with these early efforts, made it known to employees that selling shares without the sanction of the company was a career-limiting move that could curb an employee's eligibility for promotion. Nevertheless, inside the now seven-year-old startup, pressure was building for some form of early stock sale, especially since its willful founder believed the company was best served delaying an IPO for as long as possible.

Facebook responded to that pressure by trying to create an organized liquidity event it could tightly control. Gideon Yu, then Facebook's chief financial officer, scoured the world for an investor willing not only to invest in the social network in uncertain economic times but also to buy stock from investors and current and former employees whose shares had already vested. Yu left that spring after he found a willing partner: the Russian venture capital firm Digital Sky Technologies and its founder, Yuri Milner.

In what would become a hugely profitable deal that would establish DST as a Silicon Valley powerhouse and create a blueprint for the numerous other secondary deals over the ensuing years, DST invested $200 million in Facebook in May 2009 and agreed to buy an additional $100 million of common stock from employees and investors. (The value of those shares has since more than quintupled.)

Suddenly the secondary markets came alive. That spring, after months of experimental transactions, SecondMarket formally opened its market for pre-IPO securities. The company, which now has 140 employees and expansive offices overlooking the Statue of Liberty in New York Harbor, was founded by Barry Silbert, a former investment banker whose interest in brokering the sale of illiquid assets stemmed from hard-won experience. As an associate in the restructuring group of investment bank Houlihan Lokey in 2001, Silbert had been charged with selling assets of bankrupt energy giant Enron. "I was a naïve 25-year-old with not much of a Rolodex, no resources, and it was impossible to find buyers," he says. "I was saying, 'why is there no eBay (EBAY) for this sort of thing?' "

With interest in the shares of startups like Facebook mushrooming after the DST transaction, the firm brokered $100 million in transactions in 2009 and $400 million in 2010. By the beginning of 2011, SecondMarket concluded that it would work only with Internet companies, which now get to approve the sale of their stock on the site, vet prospective buyers, and limit the transactions of their stock to finite windows of time. Companies such as Facebook, Groupon, and Pimco, the asset manager, take advantage of these rules and permit limited trading of their shares on SecondMarket.com. Zynga, the social video game startup, has blocked the sale of its shares on the site, while the marketplaces for startups such as LinkedIn and Twitter are currently labeled as inactive. SecondMarket makes money by taking up to a 5 percent commission on each transaction, split evenly between buyer and seller. It announced $35 million in revenue for 2009, the last year it divulged financial information.

As SecondMarket emerged in 2009, SharesPost also took flight. That firm sprouted out of IdeaLab, the Pasadena (Calif.) startup incubator founded by technology entrepreneur Bill Gross, and recently moved north to small, featureless offices in San Bruno, a few miles from the San Francisco airport.

While SecondMarket is an accredited broker-dealer with Finra, the Financial Industry Regulatory Authority, SharesPost is not (it says its application for accreditation is pending). It resembles an online bulletin board like Craigslist, where buyers and sellers of private-company stock can meet up, agree on a price, and then take their transaction to a registered broker who is also a SharesPost employee.

Unlike SecondMarket, SharesPost does not seek approval from companies to allow trades of their shares. Accredited investors—those worth more than $1 million and with incomes north of $200,000 a year—have recently bid on blocks of shares even in startups most resistant to the secondary markets, such as Zynga, at an implied valuation of $9.3 billion, and Twitter, at more than $7.3 billion.

In December, SharesPost initiated a more complicated type of transaction. In these deals, a SharesPost investment subsidiary establishes a fund that is used to purchase large blocks of private-company stock from one or more sellers. Shares of that fund are then divided among accredited investors who have the highest bids in a sealed-bid auction.

It's difficult to find anyone in Silicon Valley who's entirely comfortable with that model. Investors wonder how and when they would be able to sell these shares in the holding companies. And some companies privately complain that SharesPost's sales staff cold-calls their employees, touting inflated prices for their shares and urging them to sell (Twitter lodged a complaint with the firm over this matter, says one person familiar with the discussion). SharesPost CEO David Weir says the company does not cite high valuations in its pitch and that the majority of sellers on the site are referred by other SharesPost members. Weir also says the firm has "taken these transactions out of the dark and provided a way for buyers and sellers to connect and transact with each other in a much more efficient way."

Some sellers, at least, appear satisfied with the prices they have gotten for their stock on SharesPost. It "allowed me to access compensation that my company was trying to keep me from accessing," says Bernadette Bosinger, a former vice-president of human resources at SugarCRM, an enterprise software outfit in Cupertino, Calif. Bosinger was one of the first to sell shares on SharesPost in 2009; she says SugarCRM tried to stop her from exercising her options and then tried to drag out the obligatory 30-day review period each company has to approve private sales of its stock. The transaction, Bosinger says, allowed her to cover the tax liability that came with purchasing her stock options—and to remain at home with her toddler daughter ever since.


Inevitably there's a dark side. Companies complain these secondary markets have created a legal quagmire that must be navigated—at great expense—while they try to remain focused on building their businesses. Illustrating the new burden, and the awkwardness that comes with it, is the tale of former Facebook employee Mike Brown.

Brown was an enthusiastic manager in the social network's corporate development group who worked on "talent acquisitions," the purchases of tiny startups for the purpose of recruiting their top execs and engineers. During the summer of 2010, Brown placed a bid to purchase additional shares of Facebook on SharesPost, according to a person familiar with the matter who did not want to be identified because it is considered an internal company issue. This person, who has spoken with Brown about the situation, said Brown had no insider knowledge about the company's finances and merely wanted to increase his stake in the company's success. The transaction, for $100,000 of additional Facebook stock, closed in September, and for the next five months nothing happened. In February an outside securities lawyer, working for Facebook on its compliance with the SEC's investigation into secondary markets, called Brown into a conference room, confronted him about the purchase, and suspended him.

A Facebook spokesman later said Brown violated the company's prohibition on buying and selling company stock, part of an internal policy announced to employees in April 2010. Brown, this person says, was dumbstruck: He claimed he was unfamiliar with the policy. A few weeks later, he was again summoned to Facebook's offices and fired. His attorney, Edward Swanson, declined to comment.

The episode proved mortifying for Facebook and for Brown: The technology blog TechCrunch later incorrectly reported that Brown had obtained advance information about the January 2011 investment in Facebook by Goldman Sachs and was fired for insider trading.

To avoid similar situations, tech startups are taking strong countermeasures and trying to exert more control over who gets their hands on their stock. Companies such as Zynga and Facebook have all begun to charge fees of several thousand dollars for each sale of company shares. (They hardly need the cash; they just want to deter stock sales.) They are also increasingly exercising their right to review each transaction—the right of first refusal, or ROFR—which allows them to buy the stock themselves or steer the shares toward an approved investor. The tactic frustrates buyers who believe they have struck a deal to acquire shares of a hot startup, only to have the deal scuttled at the last minute. David Williams, a San Francisco investor who has bought shares of Twitter, Zynga, and LinkedIn, says buyers have come to call this ignominious outcome "getting ROFRed."

In their most dramatic move, tech companies have imposed new restrictions on stock options and in some cases changed the kind of stock they give new employees. Instead of the traditional stock options, which allow employees to buy shares outright, tech startups are now giving out so-called restricted stock units, or RSUs, which convert to equity only after an IPO or acquisition and cannot be resold on any exchange. Facebook, for example, began giving most employees RSUs, instead of options, in late 2007, when it was mindful of staying under the 500-shareholder limit.

Of all the private companies whose shares are sought after on the secondary markets, Zynga has gone the farthest to impede and control stock sales. In a meeting last fall, Zynga executives demanded that SecondMarket not conduct any more transactions of its stock. Around the same time, Zynga's opposition emerged in another way. In August 2010, Andrew Trader, a Zynga co-founder who had left the company, agreed to sell $12.87 million in Zynga stock on SecondMarket to an investment group in Abu Dhabi. Zynga let its 30-day right of first-refusal period expire without approving or denying the transaction. When the investor, Alpha Investments, inquired about its status, Zynga said it would greenlight the sale only if the firm agreed not to sell the shares until 180 days after a Zynga IPO—a restriction that would limit the flexibility of the shares and reduce their value.

Alpha Investments sued Zynga in Delaware's Court of Chancery; the lawsuit is pending. The investment firm and Andrew Trader declined comment. In a written statement, Karyn Smith, Zynga's deputy general counsel, said Zynga has "created a definitive process for these trades that is premised on compliance with contractual obligations with our stockholders and federal and state securities laws."


Secondary markets for private-company stock may now be approaching a crossroads. Wall Street institutions such as JPMorgan, Goldman Sachs, and T. Rowe Price have rushed to snap up shares of the most desirable private companies. In January, in one of the highest-profile deals, Goldman Sachs created a special purpose investment vehicle to funnel $1.5 billion into Facebook, valuing the social network at an astounding $50 billion.

The SEC has signaled its concern about this gold rush mentality. In December, SharesPost, SecondMarket, and companies such as Facebook and Twitter received letters from the agency, inquiring into such pre-IPO pooled investment funds. An SEC spokesperson declined to comment.

The agency is likely mindful of securities laws that place limits on the solicitation of private-company shares and allow only sophisticated investors to buy stock in companies that do not disclose financial information. Some investment houses may be brushing up against these rules. In January, Felix Investments, a New York investment group, sent an e-mail to prospective clients excitedly promoting a new opportunity to buy into Twitter. "If you do not own stock in Twitter already it is a must," read the e-mail. "This is the first Twitter stock we or anyone else has had in the past six months and, like Facebook, it will continue to trade up in price rapidly!" Frank Mazzola, a partner and CEO at Felix, did not respond to a request for comment but has confirmed that Felix has also received an inquiry from the SEC.

In a public appearance on Apr. 6, Mary Schapiro, the SEC's chairman, suggested that the agency wanted to make sure "investors have the information that's important for them to make informed business decisions." Yet the SEC is sending mixed signals. According to a letter Schapiro sent to Representative Darrell Issa (R-Calif.) on Apr. 8, the agency is also evaluating whether to raise the 500-shareholder limit, which would allow companies such as Facebook to stay private longer and further boost the brisk business of buying and selling their shares.

Sitting in the middle of all this are the startups trying to stay focused on the task of building their businesses. Twitter, which has yet to develop its revenue model and could be years from going public, is particularly vulnerable to the prospect of crossing the 500-shareholder limit prematurely. Recently the five-year-old social media phenom decided to exercise its right of first refusal on most major stock sales and steer them to two of its own early investors, who raised sizable funds to buy these shares. Chris Sacca, a former Google (GOOG) executive with a penchant for embroidered Western shirts, raised a billion dollars from JPMorgan and others to buy Twitter shares on the secondary market. Ron Conway, a garrulous angel investor who backs many new Internet companies, raised his own considerable fund and has represented such investors as venture capital firm Andreessen Horowitz and Israeli financier Aviv "Vivi" Nevo.

But even this tactic to foil the secondary market has had unintended consequences. Several people familiar with the sale of stock in Twitter say the process has turned fiercely competitive, with the two investors undercutting each other for deals and privately complaining about each other's tactics. People sympathetic to Conway contend that Sacca has exploited his close friendship to Ev Williams, Twitter's former chief executive and a board member, to learn about and intercept other buyers' deals for Twitter shares. Sacca's sympathizers contend that Conway has personally threatened to raise roadblocks in the careers of former Twitter employees if they did not sell their shares to his fund.

Twitter, Sacca, and Conway would not comment on the rivalry. What's clear is that ego and greed are affecting the future of one of the Internet's most promising companies, and secondary markets have turned Silicon Valley's best startup advisers into something they could have never imagined—money managers.

The conversion of private shares to cash also raises basic questions about how the secondary markets will affect the fabric of the high-tech community. Could they be divesting startups of vital entrepreneurial energy? Founders such as Andrew Mason of Groupon and Jeremy Stoppelman of the review site Yelp have sold millions of dollars' worth of their stock in organized sales to venture capitalists. How does their calculation of risk and reward change if they've already secured their financial future? Mason recently told The New York Times that the sale allowed him to "focus on the interests of the company" instead of his own. Early riches have paved the way for early exits, too, such as that of Twitter co-founder Ev Williams, who reportedly sold $100 million worth of stock to Chris Sacca before his departure from the day-to-day operations of Twitter.

What happens to the new markets for private-company stock when, as it surely must, Silicon Valley's optimism fades and once-hot Internet companies cool? Secondary-market proponents believe there will simply be more sellers than buyers and valuations on the exchanges will decline. Others see a more apocalyptic outcome, as investors who bought stock are unable to dump the shares they purchased at overinflated valuations. "With relatively illiquid instruments in any kind of free-fall situation, the market often just freezes up," says Joseph Grundfest, a former commissioner at the SEC and a professor at Stanford University Law School. "Some of these investors are going to get burned."

Stone_190
Stone is a senior writer for Bloomberg Businessweek in San Francisco. He is the author of The Everything Store: Jeff Bezos and the Age of Amazon (Little, Brown; October 2013). Follow him on Twitter @BradStone.

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