Secondary Pre-IPO Markets

Introduction

On March 29, Lyft executed the first of many highly anticipated IPOs in 2019. Other household names such as Pinterest, Zoom, Beyond Meat, Uber, and Peloton also completed IPOs last year. Although each firm has unique reasons for going public, one of the main benefits of an IPO is the dramatic increase in liquidity for stockholders. Stockholders may wish to liquify their holdings because they have an immediate need for cash, want to lock in unrealized gains, or wish to diversify their holdings.

Historically, IPOs have been the primary mechanism by which private companies achieved liquidity for their shareholders. Today, with an increasing number of firms choosing to remain private for longer periods of time—and others choosing not to go public at all—many founders, early investors, and employees have been forced into other, more costly methods to cash out their ownership in pre-IPO companies¹. On the other hand, some investors have shown a strong desire to invest in pre-IPO companies to capture gains that they believe will occur before the IPO. While venture capitalists, company insiders, or others with connections to a pre-IPO company may be able to purchase these shares, other investors are forced to navigate the opaque secondary² pre-IPO market to invest in these companies.

This article will explain the structure of the secondary pre-IPO market, identify its current inefficiencies, and discuss how these inefficiencies could be resolved.

Pre-IPO Methods To Obtain Liquidity

Transactions on the secondary pre-IPO market are more difficult to execute than those on public markets. Nevertheless, several options exist for founders, employees, or other investors wanting to sell their shares before a major liquidity event. These options include (1) finding a private buyer, (2) soliciting help from a broker, (3) convincing the company to repurchase shares, or (4) requesting a secondary stock sale with help from the company.

Private Buyer

One way for current shareholders to sell their investment is to find a buyer and negotiate a price. Typically, public exchanges match up buyers and sellers based on submitted bids; however, because no such exchange exists for pre-IPO shares, sellers must find a buyer on their own. Additionally, the buyer in most private stock sales must be an accredited investor³, which further complicates the process. While the US Securities and Exchange Commission’s (SEC) definition of an accredited investor contains various requirements and exceptions, the most common rule is that the individual purchasing the stock must have a net worth that exceeds $1 million⁴. Finding such a buyer can require significant time and resources, all of which add to the transaction cost. Over-the-counter (OTC) markets can help facilitate this process, but many companies do not meet the necessary requirements to be traded on these markets.

Even if a suitable buyer can be found, pre-IPO companies almost always place restrictions on employee stock sales. These restrictions make it very difficult for employees to sell stock to third parties without approval from the company. Some financial firms, however, help employees evade these restrictions by allowing “employees [to] pledge their shares as collateral for a loan” or “designing derivatives that deliver payments to employees based on a stock’s perceived value.”⁵ These questionable practices go unregulated and almost always take place without the company’s knowledge.

Sellers face many obstacles in navigating the secondary pre-IPO market, but buyers may encounter even greater challenges. Because private shares are not registered with the SEC, buyers may be unable to confirm that a seller truly owns the stock being offered for sale. For example, the Wall Street Journal reports that Jonathan Sands, an investment manager, tried to create a fund that would purchase shares from current Uber shareholders and provide a return to the investors in the fund even though Mr. Sands did not actually own any shares in Uber nor did the company have plans to sell him shares. Ultimately, he was shut down by Uber lawyers before he could raise any money. His attempted scheme, however, is just one illustration of both the demand for pre-IPO stock and the high level of counterparty risk faced by buyers in the secondary pre-IPO market.

Brokers

Some firms, recognizing the liquidity problem in the secondary pre-IPO market, have attempted to create a more centralized system that facilitates trades. The Nasdaq Private Market, SharesPost Inc., Forge Global, and other players have emerged as brokers (and sometimes dealers) in this market. Brokers serve an important function in this financial market by matching buyers and sellers and ensuring that the trades are compliant with SEC regulations. These actions increase liquidity; however, the fees charged by brokers for facilitating these trades present a significant transaction cost. Additionally, because many such brokers have entered the market independently of each other, the market continues to be decentralized, making it difficult to gather information and match buyers with sellers.

Share Repurchases

One alternative that avoids the transaction costs of finding a buyer or going through a broker is working directly with pre-IPO companies to facilitate a share repurchase. In a share repurchase, the company buys back shares directly from shareholders. This arrangement can be favorable for shareholders because it reduces counterparty risk and eliminates the need to circumvent the company’s restrictions on stock sales. However, share repurchases are uncommon for pre-IPO companies because they generally lack adequate cash on hand for major share repurchases, and most prefer to use capital to fund growth. Furthermore, because many pre-IPO companies award stock-based compensation to incentivize employees, these same companies may be reluctant to remove this incentive by offering premature liquidity. Even if a share repurchase is authorized, there is no guarantee that the company will be able to purchase the shares of every shareholder who wants to sell.

Secondary Stock Sales

Alternatively, when founders or other significant shareholders wish to liquidate their investment, many pre-IPO companies facilitate secondary stock sales to new or current investors. Secondary stock sales are more common than share repurchases and have less counterparty risk than finding a private buyer. For instance, venture capital firms or other large investors frequently wish to increase their ownership in a pre-IPO company without diluting existing shareholders. In such cases, a secondary stock sale is often the best option available for them to accomplish this goal. Despite its benefits, secondary stock sales are often limited in scope and may not satisfy all shareholders wishing to liquidate their shares.

Inefficiencies In The Secondary Pre-IPO Market

For a market to function efficiently, it must have low transaction costs, widely available information, and protection for investors. Secondary pre-IPO markets, however, have significant deficiencies in all three areas. In addition to the transaction costs already mentioned, information asymmetry and adverse selection create additional challenges for both buyers and sellers.

Information Asymmetry

Information asymmetry occurs in private markets for several reasons. First, while public companies are required to release financial statements and disclose material information, private companies have no such obligation⁶. Furthermore, private companies are extremely hesitant to provide inside information even to potential buyers, because buyers may “look under the hood” of the selling company without ever closing out a deal. As a result, sellers prefer to keep these transactions quiet and ensure privacy through non-disclosure agreements (NDAs). This cautiousness greatly slows the rate of private market transactions, as even if buyers sign an NDA, the subsequent due diligence process often takes at least 90 days to complete.

In addition to reducing the efficiency of market responsiveness, information asymmetry also reduces the accuracy of private company valuation. Buyers, without necessary financial information, must price private company stocks based more on speculation than financial valuation. In such an environment, adverse selection becomes a serious concern when sellers, as company insiders, leverage their superior information to take advantage of buyers.

Adverse Selection

The information asymmetry between buyers and sellers can lead to adverse selection in the secondary pre-IPO market. Buyers who lack information regarding a company will typically demand lower prices; however, shareholders who know their company is undervalued will not be willing to sell at a discount, leaving mostly those who believe their shares are overvalued. In such a market, most transactions take place at the expense of buyers, who purchase the shares of an overvalued company. However, individual sellers may be willing to sell at a discount if they require immediate liquidity. In either case, secondary markets experience significantly greater inefficiencies than public markets. If these inefficiencies result in widespread adverse selection, the market could entirely lock up. While such a lock up has yet to manifest itself in the secondary pre-IPO market, adverse selection issues continue to be a significant contributor to the illiquidity of pre-IPO shares.

Increasing The Efficiency Of Secondary Pre-IPO Markets

Clearly, the problems described in the above section have a negative impact on secondary pre-IPO markets. However, increased centralization of brokers and blockchain technology could help resolve these issues and increase market efficiency.

Centralization Of Brokers

More centralization among brokers could help make information more available and increase confidence in the market. For example, the Nasdaq Private Market, which facilitates private stock sales, could increase investor confidence in secondary pre-IPO markets because of the reputation of Nasdaq as a public stock exchange. If the Nasdaq Private Market or another reputable secondary market provider was able to capture more of the market, it would create a powerful network effect.⁷ In this case, the network effect could allow one or two larger players to compile and release more information about trades, improving the availability of information for everyone in the market. As more information is made available, more transactions would take place and more informative data would be generated. The NYSE and Nasdaq have already taken advantage of this network effect in public markets, which bodes well for implementing a similar strategy in private markets.

Blockchain Technology

Blockchain technology presents another opportunity to increase efficiency in the secondary pre-IPO market by decreasing counterparty risk and ensuring that transactions are properly recorded and executed. While blockchain technology has been viewed as risky because of the boom and bust of cryptocurrencies such as Bitcoin, blockchain can actually decrease market risks if used properly. For example, Funderbeam “uses blockchain to secure issuing tokens, trading tokens, keeping track of investors (i.e. cap table management) and clearing the trades.”⁸ These services decrease counterparty risk by (1) ensuring that the seller actually owns stock in the pre-IPO company, and (2) making these trades easier to track. Furthermore, Funderbeam has found other ways to solve the liquidity problem of pre-IPO companies by issuing digital tokens for startups that are identical to stock but are more easily traded on the company’s blockchain platform. Despite the benefits of blockchain technology, most investors currently lack confidence in its reliability, which represents a significant hurdle to blockchain adoption.

Conclusion

Founders, employees, and other pre-IPO investors are greatly benefited by liquidity; however, as companies delay IPOs for longer periods of time, adequate liquidity is difficult to achieve. Even though private sales, brokers, share repurchases, and secondary sales all provide some liquidity, each method comes with drawbacks that prevent it from being widespread. Furthermore, information asymmetry, adverse selection, and other transaction costs create inefficiencies in the secondary pre-IPO market that make it a costly—and sometimes dangerous—market for both buyers and sellers. Despite these challenges, increased centralization of brokers and the implementation of blockchain technology, while not a perfect solution, would significantly increase market efficiency in the secondary pre-IPO market.

Resources Consulted

• The Wall Street Journal: “IPO Hopes Trigger Scramble for Shares of Top Unicorns”
• Forbes: “The $50 Billion ‘Pre-IPO’ Market’s Next Step Could Be Turning To Blockchain”
• The Wall Street Journal: “How Wall Street Middlemen Help Silicon Valley Employees Cash In Early”