Trading of privately held companies such as Facebook Inc. is likely to surge 51 percent to almost $7 billion this year, drawing new exchanges such as Xpert Financial Inc. and Gate Technologies LLC to vie for commissions.
Xpert and Gate will be competing with SecondMarket Inc. and SharesPost Inc., which gained popularity last year as investors poured billions of dollars into Facebook, Twitter Inc. and Groupon Inc. The value of the transactions may almost triple to $6.9 billion in 2011 from $2.4 billion in 2009, according to Nyppex LLC, a New York research and advisory services firm.
Investors flocked to the secondary market last year to seek growth after a two-year slump in initial public offerings and a half decade of muted gains in the Dow Jones Industrial Average and Standard & Poor’s 500 Index. With fees of about 3 percent a transaction, these exchanges are vying for upwards of $200 million in sales this year, a number that may grow as more technology startups stay private longer.
“There’s an enormous need for liquidity,” said Mona DeFrawi, who’s worked with the venture capital industry for more than 20 years and recently founded Equidity Inc., a Woodside, California, startup that helps investors build relationships with pre-IPO and newly public companies. “There’s a ton of value that’s being created and none of that is appearing in the Dow Jones or S&P 500.”
Xpert and Gate are trying to automate the process, so they work more like public stock exchanges and require fewer phone calls and e-mails to brokers.
For the exchanges to succeed, they may have to deal with increased regulatory scrutiny. New York-based SecondMarket said last month that the U.S. Securities and Exchange Commission asked for information on investment funds that are pooling together shares of companies like Facebook.
Private companies with fewer than 500 shareholders aren’t required to disclose financial data, so buyers on SecondMarket and SharesPost often don’t know key figures like revenue, profit, cash flow and debt obligations. Venture firms, by contrast, make direct investments into startups after extensive analysis and meetings with management. Regulators may start to clamp down, said venture capitalist Maha Ibrahim.
“Given restrictions around public markets and public shares, you have to make sure information rights are being shared,” said Ibrahim, a partner at Menlo Park, California-based Canaan Partners. The SEC “should get involved at some level.”
High Net Worth
The exchanges also have to deal with restrictions on who can buy the securities. Investing in private companies is considered high risk and limited to so-called accredited or qualified investors. That includes institutional investors and individuals with at least $1 million in net worth. Sellers are typically past or current employees and early investors.
Thus far, the bulk of secondary activity has involved Facebook, Twitter, Zynga Game Network Inc. and LinkedIn Corp. Shares of about a dozen companies are being traded each quarter on SecondMarket and that number may double in the next 12 to 18 months, said Chief Strategy Officer Jeremy Smith.
“As this market has really gained traction, more and more companies are coming on board,” Smith said. SecondMarket said last week that it completed $400 million in transactions last year, quadruple that of a year earlier.
Thomas Foley, chief executive officer of Xpert Financial, is betting that expansion will continue. With funding from venture investors including Tim Draper, managing director at Draper Fisher Jurvetson in Menlo Park, Xpert is in the process of registering investors that want a piece of emerging companies.
Foley’s San Mateo, California-based company said last month that it received SEC approval to operate a trading system for private company securities. Clients can use the program to sell secondary shares or raise new capital. Xpert takes a 2 percent commission on transactions, while Gate Technologies charges 1 percent to the buyer and 3 percent to the seller.
“There are a lot of companies out there that are good enough to be on the public market but the investment bankers aren’t taking them out,” said Foley, 26, who started Xpert under a different name in 2009. “They could really utilize our system as a pre-IPO capital raise or option for liquidity.”
Gate, based in New York, introduced its electronic trading system in November and expects to have private-share transactions among 25 to 50 companies within a year, said CEO Vincent Molinari.
Regulatory issues aren’t the only obstacle to growth. A more amenable IPO market may also be on the horizon. After a total of 18 venture-backed companies went public in the U.S. in 2008 and 2009, that number jumped last year to 72, according to the National Venture Capital Association. Dixon Doll, co-founder of venture firm DCM, predicted last week that there will be 80 to 85 IPOs this year.
LinkedIn announced plans on Jan. 27 to raise $175 million in an IPO. That followed filings last year from Kayak Software Corp., Zipcar Inc. and Responsys Inc.
“There will be a little bit of a breakout in 2011 and that may take a little pressure off some of those companies,” said Michael Fitzgerald, managing general partner of Commonwealth Capital Ventures in Waltham, Massachusetts.
While more private companies will jump into share trading, the secondary market may take four or five years to develop, said Naval Ravikant, founder of AngelList in San Francisco, which connects entrepreneurs and angel investors. He finds too much risk in buying stakes in smaller companies, which don’t share sensitive financial information out of concern that competitors will see their data.
“I don’t see there being a liquid market for those kinds of companies,” said Ravikant, who has also invested in Twitter.
That means firms like SecondMarket, SharesPost, Xpert and Gate have to count on a continuous pipeline of companies that are growing fast enough to attract outside investors and willing to divulge their revenue and profit.
“This is really the embryonic stage of a new market,” said Gate’s Molinari. “Once you have demand you have to figure out how you’re going to do it in the most compliant fashion possible.”