New exchanges aim to boost trade in promising businesses, but more regulation of an opaque sector may be needed.
In 2014, an Austrian entrepreneur offered investors a rare chance to purchase shares in Jumio, his fast-growing and profitable payments company. The deal was not a typical venture capital transaction. Instead of purchasing new shares, investors could buy out earlier shareholders, in what are known as private secondary transactions.
Daniel Mattes, who calls himself a "visionary" on his Instagram page and has been a judge on the Austrian version of Shark Tank, the American reality TV series for entrepreneurs, told at least one prospective buyer he had no plans to reduce his own stake in the business, according to a US Securities and Exchange Commission complaint filed in 2019.
Mattes also signed off on documents that, according to the complaint, claimed Jumio made a small profit and revenues of more than $100m in 2013 — a significant sum for a three-year-old company.
Two years later, Jumio filed for bankruptcy, and the company's shares became worthless. In reality, according to the SEC, Jumio had only made one-tenth of the revenues it claimed, and Mattes had bypassed his board of directors to sell about $14m of his own shares.
Jumio's case highlighted the risks of an opaque but fast-growing corner of finance: the global market for shares in private start-ups such as TikTok owner ByteDance, Elon Musk's SpaceX and payments company Stripe. In 2019, the market was estimated to host almost $40bn in lightly regulated trades, according to one participant, more than doubling its volume from 2014.
Recently, the market has been hotter than ever. Though private companies have largely tried to restrict trading, brokers say hedge funds, mutual funds and other institutional investors have begun pouring in, buying large blocks of existing shares in start-ups that are nearing initial public offerings or big acquisitions. Often, the investors receive scant rights to information on financial performance.
Technology upstarts and financial institutions including big banks have rushed to capitalise on the interest by brokering deals and forming trading venues, setting up a battle that could fundamentally alter the market's structure and potentially allow companies to stay private indefinitely.
The boom reflects how cash-flush investors are clamouring for stakes in fast-growing businesses, with low interest rates pushing non-traditional funds deeper into private markets. To meet the demand, brokers now face two key challenges: increasing the supply of shares in desirable companies while preventing fraud and manipulation in a competitive market.
Until recently, private secondary markets resembled "that guy with a trenchcoat that's selling you watches in Times Square", says Inderpal Singh, who leads a private secondary market project at the start-up marketplace AngelList. "In the last year, there's been a big shift."
In addition to AngelList, JPMorgan and the software start-up Carta have begun facilitating trades in private companies. They compete with established players like Nasdaq and Forge Global, which purchased the rival marketplace SharesPost in a $160m deal last year, as well as scores of smaller independent brokers.
Carta and some other intermediaries have advocated that the SEC relax restrictions on who can purchase shares in private companies, potentially opening up the market to a broader swath of investors.
But some observers remain sceptical that the growing market can protect investors against bad actors. Mattes, who paid $17m to settle the charges, did not admit or deny the SEC's allegations, though he resigned from Jumio in 2015 following an internal investigation. The entrepreneur did not respond to questions sent to his personal website.
The rush to expand trading could lead to fraud and manipulation, says Stephen Diamond, a professor of law at Santa Clara University who has studied private secondary transactions.
"All too often in Silicon Valley, people want to basically ignore the consequences of unhealthy market structures," Diamond says.
The Facebook episode
The debates reflect a decade-long shift in capital markets as companies grow larger than ever in private — securing billion-dollar valuations and "unicorn" status while pushing back their public debuts. As a consequence, start-ups, investors and employees have accumulated trillions of dollars' worth of shares that cannot easily be bought and sold, barring a public listing or acquisition.
Private secondary markets grew in importance in the lead-up to Facebook's initial public offering in 2012. Investors rushed to buy the social media company's shares, creating a frenzied market where independent brokers facilitated thousands of trades with little oversight from the company.
The trades created headaches. One Facebook executive left the company after he reportedly purchased stock ahead of a big funding announcement. Facebook sometimes lost track of who owned its shares, complicating preparations for its IPO.
Facebook's struggles caused many start-ups to adopt strict clauses in their legal documents that prevented employees from trading shares without company approval. Some companies have gone even further, requiring sellers to receive approval from boards of directors months in advance of any transaction.
Though the restrictions have made trading difficult, brokers say the market has been busier than ever in the past 12 months, with big investors such as Tiger Global Management hunting for shares in start-ups that look like sure bets for blockbuster public listings.
Tiger Global has used secondary sales to gain stakes in companies such as China's ByteDance and the software group Snowflake, according to fund documents and people familiar with the trades. Other hedge funds and mutual funds routinely purchase new stakes in companies worth tens of millions of dollars, brokers say.
On the other side of the trades, existing shareholders such as venture capitalists have sought to unload stakes in highly-valued companies as they delay public listings. The market can also be an important source of cash for start-up employees, who receive a large portion of their pay in stock options.
Several new entrants, such as Carta's private stock exchange CartaX, now hope to formalise the market and capture trading fees that have been spread between dozens of independent brokers.
"There is now, in the past few years, not a push to go all the way back to the days of strict prohibitions on secondary trading, but a push to have more avenues for organised liquidity," says Cameron Contizano, a partner at law firm Goodwin Procter who works on secondary transactions.
Meanwhile, investor demand has pushed up prices for companies such as ByteDance, SpaceX and Stripe. Barrett Cohn, chief executive of the private securities broker Scenic Advisement, says he advised companies on twice as many secondary transactions in 2020 compared with the previous year. Of the last dozen deals Scenic worked on in the past few quarters, only one resulted in shares being sold at a discount to a company's most recent stock price, he says.
Competing for business
The rise in trading volumes and the rush to capture the market will shape the way private shares change hands. San Francisco-based Carta, a company best known for selling shareholder management software to start-ups, has become a lightning rod in debates about the market's direction. Its 45-year-old chief executive, Henry Ward, has set out an ambitious goal to build the "private stock exchange" for tech start-ups.
Ward wants the CartaX marketplace to compete with the Nasdaq exchange, providing a listing venue where companies could potentially stay private indefinitely. The exchange uses an auction model that Ward says will result in higher prices for sellers.
But the project has already drawn strong responses from rivals and market participants. Some brokers and start-ups say CartaX amounted to an attempt to monopolise the market, and the company is naive to think it could unseat public exchanges. Scenic's Cohn says Carta has made it increasingly difficult for its clients to export their shareholder data for use in other kinds of secondary transactions, such as tender offers.
"We're not trying to make the New York Stock Exchange go away," says Kelly Rodriques, chief executive of the brokerage Forge, which has begun offering software that companies can use to manage secondary transactions. Forge also bills itself as the "stock market for private companies".
Others say the most desirable start-ups would not want to use CartaX because few private companies want to subject their shares to monthly or quarterly auctions marketed by the exchange.
Eric Folkemer, head of Nasdaq Private Markets, says it has already set up a similar marketplace with price discovery tools for companies such as the workplace collaboration company Asana that want to facilitate trading in their shares before going public.
"We have it," says Folkemer. "The question is, does the market want it?"
JPMorgan has put its money behind Zanbato, a private share trading system that is taking a different approach from Carta, acting as a central matchmaker for more than 100 banks and brokers executing orders on behalf of clients.
Nico Sand, chief executive of Zanbato, says the exchange has made a conscious choice to focus on trades between large, qualified buyers with more than $100m in assets, who regulators assume have high amounts of financial expertise and require less oversight.
Zanbato has applied for a patent for a trading system with "firm orders", a legal contract that forces buyers and sellers to transact shares in a private company after they have submitted orders with desired prices and quantities, says Sand.
He says the concept, which is standard in public markets, is necessary for creating efficient trading in private shares. "At the end of the day, it comes down to formalising the market structure in a way it's not currently formalised."
'The third configuration'
So far, Carta is the only company that is listed for trading on CartaX. This month, investors purchased almost $100m in shares following the company's first auctions on the exchange, in trades that valued the company at $6.9bn — more than double the valuation it received from venture capitalists less than one year ago.
Marc Andreessen, the Netscape co-founder and Carta board member, said in a blog post that he would encourage start-ups backed by his venture capital firm Andreessen Horowitz to consider listing on the exchange. He also said the firm would buy shares in companies on the exchange.
"The third configuration — beyond the false binary of simply private or public — is here," Andreessen wrote.
But Ward has set targets for the exchange that some people familiar with its workings described as overly ambitious.
Ward told investors he expected CartaX to generate about $1.1bn in annual revenues by 2024, according to a presentation viewed by the Financial Times. Under the most optimistic scenario, the marketplace would bring in $3.9bn in revenues that year, the presentation said. Carta declined to comment for this article.
CartaX charges 1 per cent fees to both buyers and sellers, implying it would need to facilitate about $55bn in trades a year to reach Ward's expectations.
Those volumes would require about 3 per cent of the shares in all billion-dollar start-ups to change hands every year, according to Financial Times analysis of data from CB Insights, which estimates that 546 "unicorns" hold a collective value of $1.8tn.
Platforms like CartaX may struggle to meet their targets if private companies remain selective about who owns their shares. SpaceX, one of the most active companies in secondary trading, already hosts an internal marketplace where employees and venture capitalists can sell stock to invited investors.
"They have a lot of demand from buyers," says Hans Swildens, chief executive of Industry Ventures, which has invested in Carta. "The question, like all the other marketplaces, is supply."
Venture capitalists say the new exchange could also face competition from an unlikely source — special purpose acquisition companies (Spacs), which have recently lured relatively young start-ups to public markets.
CartaX would force companies to share two years of financial statements prepared using generally accepted accounting principles, in order to comply with a securities exemption the exchange is using to allow participation from an unlimited number of accredited investors.
Lawyers and governance experts say the requirement could help solve inconsistencies in information disclosure in private markets. But others say it would be a burden for young companies, which often remain private to avoid sharing their financial information to a broad audience of investors, reflecting a central tension in the market as brokers and traders attempt to capitalise on the surge of interest in secondary transactions.
"The 'move fast and break things' culture of start-ups militates precisely against this," says Diamond at Santa Clara University. "That, to me, is the fundamental paradox here."
Written by: Miles Kruppa
© Financial Times
