Innovation Finance: How Has Declining Volume Affected IPOs, Venture Capital and Secondary Securities Markets?

The harsh reality is that the number of shares traded on US exchanges peaked in 1997, IPOs saw their heyday in that decade and entrepreneurs now want to delay going public or, ideally, seek only private funding. The trend is driven by a desire for flexilibity. As always, sophisticated investors can benefit, but it is when the unsophisticated want to get in on the action - as they always do - and lose money - as they almost always do -that regulators intercede. The following analysis from EAM Captial Partners (hat tip to Greg Satell)explains what is happening in venture finance and the monetization of innovation:


“It highlights three points made by all sides in the debate to explain this surge: (1) the U.S. markets for many years were the largest and most liquid but are now in decline. The number of IPOs had dropped since the 1990s; (2) the number of shares traded on U.S. exchanges peaked in 1997; and (3) fast growing companies now seem to try and delay an IPO as long as possible”

"Over the New Year’s weekend this year is was announced that Facebook has raised $500 million from Goldman Sachs and DST (the Russian investment fund) — with more investment coming — in a deal that valued the company at $50 billion. The deal maked Facebook now worth more than companies like e-Bay, Yahoo and Times Warner. For the story from the New York Times’ Dealbook click here.

More interesting was the news that Goldman created a “special purpose vehicle” to allow its high-net worth clients to invest in Facebook. As the Dealbook post states “While the S.E.C. requires companies with more than 499 investors to disclose their financial results to the public, Goldman’s proposed special purpose vehicle may be able get around such a rule because it would be managed by Goldman and considered just one investor, even though it could conceivably be pooling investments from thousands of clients. It is unclear whether the S.E.C. will look favorably upon the arrangement.” Goldman later limited the offering to non-U.S. investors but the S.E.C. is still investigating the transaction.

For Goldman it was a win/win/win because it will start earning a return on its investment long before it sells its stake: (1) its first source of income was the millions of dollars in fees it charged Facebook and the wealthy private clients who wanted to participate in a $1.5bn fund; (2) it can charge fees to manage the fund; and (3) it could make tens of millions of dollars if it is chosen to underwrite Facebook’s initial public offering, which could come next year. The IPO is not a slam dunk and the myriad law suits over Facebook’s origins has escalated (click here) which could hold up an IPO. And Goldman’s arrangement of the private investment is not a guarantee of an IPO mandate and rival Wall Street firms will mount a campaign to land the IPO deal.

So more light on the thriving secondary market for shares in private Internet companies … and the S.E.C. investigation of that market. Disclosure: I bought Facebook shares in that secondary market.

The market for private company stock has been growing at a rapid pace in recent years, thanks in large part to the vast appetite for shares in technology companies such as Facebook, Twitter and Zynga. Given the deep pockets of private money to be tapped while private companies’ revenue models continue to evolve, investors looking for growth potential in technology businesses can bet more than in the public markets. But it also highlights three points made by all sides in the debate to explain this surge: (1) the U.S. markets for many years were the largest and most liquid but are now in decline. The number of IPOs had dropped since the 1990s; (2) the number of shares traded on U.S. exchanges peaked in 1997; and (3) fast growing companies now seem to try and delay an IPO as long as possible. To get a feel for the details and nuances behind these arguments read the exchange between Representative Darrel Issa, Chairman of the House Committee on Oversight and Government Reform, and S.E.C. Chairman Mary Shapiro. You can access two summaries here and here.

The rapid growth of this market (and its somewhat opaque nature) has understandable drawn the scrutiny of the S.E.C. which launched a preliminary investigation into the secondary market for private company stock (a series of letters went out to various market participants inquiring about “pre-IPO pooled investment funds”). According to a variety of media reports, the focus of the SEC investigation is two pronged: (1) how these private companies are valued, and thus how shares are priced, and (2) are these attempts to skirt the public disclosure rules.

Existing SEC rules mandate that buyers and sellers of equities have equal access to information about a traded security. But because the buyers of private company stock rarely have access to a company’s books, there is inherent information asymmetry between investors eager to get a piece of a pre-IPO company, and the companies themselves.

Clearly there is going to be a disconnect between what is going on in the secondary market and what’s going on with the company. I doubt these transactions are a good representation of the value of a company’s stock. But it is a great way to participate on the upside if you can afford the bet. And it is a bet. In the case of Facebook, does the Goldman Sachs deal “validate” an upcoming IPO? This disconnect certainly has not stopped the market for private company stock from growing. Nyppex, an investment group, estimates $2.4bn worth of private stock traded hands last year in the US, and says that figure could grow by 50 per cent this year. And there are now scores of boutique analysts producing reports on the companies that are most actively privately traded for investors and participants in the private market. Note: in most cases, when investors are seriously interested in buying shares, they sign a non-disclosure agreement and are then privy to material non-public information about the company.

But more intriguing, a new company has won SEC approval to serve as an online exchange for shares in private companies such as Facebook. Xpert Financial will be the first electronic exchange with formal approval from the SEC to deal in private company stock. It will allow companies to make primary offerings of stock to new investors, and facilitate secondary market transactions. Analysts say that by offering equity to investors directly through an electronic exchange, private companies will be able to bypass traditional venture capital financing. By automating trades on the secondary market, the company could bring order to what has been a disorganized and loosely regulated market.

It’s still a question whether all this new money will pressure Facebook to go public (hotly discussed in the securities blogs). Many pundits note that the popularity of shares of Microsoft and Google in the private market ultimately pressured them to pursue initial public offerings. At LeWeb2010 last year (click here) many suggested (despite Zuckerberg’s protestations to the contrary) that Facebook’s board has positioned a public offering in 2012. Given the new developments in the “Facebook origin” litigations, we’ll see.

As a result, Facebook has been able to bring in important strategic allies, including Goldman, Microsoft and Russian internet investor DST, while fuelling its rapid expansion (more firepower to steal away valuable employees, develop new products and possibly pursue acquisitions, providing an outlet for early investors and employees who want to cash in some of the paper profits on their shares) without being a publicly traded company. For the S.E.C. the question is whether this new money — without being a publicly traded company — is all within the rules.

But the private money is expected to flow. Twitter was being valued at $4.1bn by a new investment fund set up by Felix Investments. The investment firm has formed a group called Pipio Associates specifically to invest in the micro-blogging site (it’s a Series C round). The move comes less than a month after Twitter raised $200m in a round led by Kleiner Perkins Caufield & Byers. That funding round valued the site at $3.7bn and was the largest investment round in the tech sector in 2010. Groupon recently closed a financing which included T Rowe Price and Fidelity, $500m of an expected $950m.

But be wary of the numbers being bandied about. While it appears that Facebook and Twitter are increasingly encroaching on Google, $2bn will not go very far. Google was prepared to spend as much as $6bn to acquire Groupon, and Facebook can’t compete in that sort of a bidding war without the massive capital provided by an IPO. Even if Facebook’s shares are worth an extraordinary amount to a limited number of private holders, it will not be easy to use them as currency in a takeover. This is not an everyday liquid market and an agreed upon valuation for the company. An IPO must come, if only for the investors. And Zuckerberg knows that. If he doesn’t, I am sure his investors will remind him.