Viewpoint

SEC Should Back Off Markets for Startups' Shares


New companies like SecondMarket, Felix Investments, and SharesPost have sprung up in recent years to match accredited investors seeking to buy stakes in high-flying private companies with shareholders who want to sell. To the surprise of many entrepreneurs, venture capitalists and angel investors, the Securities and Exchange Commission is investigating these efforts. This is a waste of the SEC's limited resources, which would be better spent finding the next Bernie Madoff.

The secondary market for the shares of private companies is growing rapidly. Nyppex, an investment house that tracks such sales, estimates that transactions will reach $2.4 billion this year and $3.6 billion next year, a sizable figure when compared with the $46 billion that venture capitalists and accredited business angels invest in young companies annually.

Critics raise two objections to these new marketplaces. First, they say the transactions on secondary markets are risky for investors, because private companies disclose much less information than publicly traded corporations. Second, they say these markets are unfair because wealthy individuals get access to lucrative investments at a lower price than the broader public, which cannot invest in such companies until the companies list shares on an exchange.

Risk-Reward Ratios

These criticisms are easily dismissed. To begin with, they are contradictory. If limited disclosure makes investing in private companies risky, those who buy shares before an initial public offering should earn higher returns than post-IPO investors as compensation for bearing that additional risk. On the other hand, if access to investments in pre-IPO companies, such as Groupon and Facebook, unfairly benefits wealthy investors because they offer higher risk-adjusted returns than investments in public issues, then limited disclosure isn't really a problem.

Moreover, many of the investors buying shares on these new secondary markets are the same people who finance the startup and growth of these companies. The SEC permits accredited investors­—people with high incomes and net worth who are assumed to have greater financial sophistication—to buy shares in private companies with less information disclosed to them than is required in a public offering. So it's the same accredited investors making investments under the same limited disclosure, whether they buy shares by investing directly in the startup or through the new intermediaries.

One might even argue that buyers on the secondary market face less risk than investors who first funded the companies. That's because investors learn more about companies' potential for success as the businesses develop.

The SEC's concern about how the shares in these companies are valued also seems misplaced. The process isn't very different from how venture capitalists and business angels value shares when they invest in the companies in the first place. Unlike in public markets, valuation in private markets is more art than science.

Even the fee that buyers and sellers of the shares are paying for the transactions seems reasonable. The cost of putting together a Series A investment round is around $25,000. On a $1,000,000 investment, that's not far off what the secondary marketplaces charge buyers and sellers to broker a trade, fees that generally range between two percent and five percent of the value of the transactions.

The Need to Cash Out

These secondary marketplaces have emerged for a reason. The pace at which shareholders in private companies have been able to cash out of their investments in the 2000s slowed significantly from the 1990s. From 1991 to 2000, the number of IPOs and acquisitions averaged 30 percent of the number of companies that venture capitalists funded five years earlier, according to my analysis of data from the National Venture Capital Assn. But from 2001 to 2010, that rate was down to 13 percent.

At the same time, the financial crisis has reduced the ability of employees in private companies to get loans using company stock as collateral. While rich on paper, many employees at venture capital-backed companies earn less than they could working for public companies. With loans harder to come by and exits fewer and less frequent, employees need intermediaries such as SecondMarket to get the cash they need to pay their mortgages, send their kids to college, and do all the other things that their peers at more established companies can use their salaries to pay for.

We need these intermediaries to give employees and investors in high potential startups confidence that they can get cash for their stock when they need it. Without these intermediaries to ensure liquidity, fewer employees and investors would be willing to work for and finance these high-growth companies, and that would not be a good thing for entrepreneurship in America.

I'd prefer that the SEC not spend its precious resources investigating a perfectly logical, needed, and legitimate financial market innovation. If the agency focuses on intermediaries making markets in private company stock, I'm pretty sure it will claim it doesn't have the resources to investigate the next billion-dollar Ponzi scheme it gets a tip about. Then people will really get hurt.

Scott_shane
Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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