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Why Startups Hate Private Stock Sales

Valuations of companies could be skewed

One of the perks of working for Silicon Valley startups is the restricted stock ladled out to employees. If the companies go public, the riches can come pouring in. So what happens when the IPO market freezes up, as it has over the past two years? Increasingly, employees have turned to private, secondary markets to squeeze cash from those shares. And that has some high-profile startups miffed.

The complexities of secondary markets became clear last month when Facebook clamped down on the sale of its shares. Now networking site LinkedIn is considering similar limitations, according to several people familiar with the company; so is game developer Zynga, says Chief Executive Officer Mark Pincus.

Pincus says he fears that an employee, trying to get the best price for his shares, may divulge company secrets: "I worry about someone buying my stock and I worry what they're told at the point that they're buying my stock."

The recent rebound in U.S. IPOs has heightened concern because sales of shares on secondary markets can affect the valuation of a company. There were 9 IPOs of venture-capital-backed companies in the first quarter of this year, compared with 12 in all of 2009 and 8 the previous year, according to the National Venture Capital Assn.

Facebook says an IPO is not in the works, but anticipation is building. On SecondMarket, a private exchange based in New York, shares of Facebook are selling at $50. In November, buyers paid roughly $21. "It would make a lot of sense if a company is getting close to a public offering to not be having these kinds of transactions," according to Dixon Doll of venture capital firm DCM. "It would make it hard for an underwriter to determine a fair valuation if people are buying and selling shares in private transactions."

Facebook spokeswoman Annie Ta says the company wanted "to better comply with insider-trading laws and to protect the interests of the company and its employees and shareholders." LinkedIn declined to comment.

SecondMarket handled $130 million in nonpublic equity transactions in the first quarter—more than all of last year. Managing Director Adam Oliveri says he is mindful of concerns that such trading could encourage leaks of privileged information. "Our business model is organized to address those concerns," he says.

The bottom line: Silicon Valley startups want to shut the lid on backroom share sales in advance of possible IPOs.

Womack is a reporter for Bloomberg News . Galante is a reporter for Bloomberg News in San Francisco.

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