April 27 (Bloomberg) -- Barry Silbert was born to trade.
By age 10, he was swapping baseball cards at collectors conventions. At 15, he plowed his savings into shares of Chromatics Color Sciences International Inc. -- a penny stock that lost him $2,000. And as a 25-year-old banker for the creditors of Enron Corp., Silbert traveled the globe after the firm’s 2001 bankruptcy, flogging Enron assets, including fiber-optic cable and Bolivian pipelines.
He’s been a registered broker since he was 17, Bloomberg Markets magazine reports in its June issue.
Today, Silbert, 34, is the best-known player in a sizzling market: the trading of shares of private, venture-backed social-media companies such as Facebook Inc., LinkedIn Corp. and Twitter Inc. As chief executive officer of New York-based SecondMarket Holdings Inc., he is building the go-to forum for trading these boldfaced shares, some of whose prices more than doubled in the 12 months ended in mid-April.
Those rising stock valuations are turbocharging SecondMarket -- and making Silbert rich. SecondMarket says it’s the world’s biggest broker of venture-backed private-company stock by the value of shares traded. The firm’s private-company transactions, which totaled $100 million in 2009, quadrupled by 2010 to $400 million.
Based on first-quarter results, SecondMarket could broker $1 billion in private-company shares in 2011, taking fees of from 3 to 5 percent on each trade.
Last year, prominent Asian investors bought a 10 percent stake in the firm for $15 million, valuing Silbert’s 35 percent stake at $52.5 million.
Changing the World
Silbert wears his sandy-blond hair brushed forward -- and looks 10 years younger than his age. Like a lot of tech-driven entrepreneurs, he is certain his venture is changing the world.
“The money that we are freeing up is being reinvested in other venture-backed startups -- and creating jobs,” Silbert says. “This market we’re building is critical to the whole capital-formation process.”
The shares of private companies have become a hot market -- and a hot topic. The value of all private-share transactions was $4.6 billion in 2010, up from $2.4 billion in 2009, according to Rye Brook, New York-based broker-dealer and research firm Nyppex Holdings LLC. The volume, the firm says, could climb to almost $7 billion this year. Silbert says much of that is coming SecondMarket’s way.
“We’ve heard expressions of interest from holders of stocks in thousands of private companies,” he says.
Investors are eager to get their hands on the private stock of such companies as Facebook and Twitter in anticipation of big profits when they go public, and investment banks are scrambling to offer their clients the chance to buy in. Yet, the shares trade in a sometimes opaque market that is open only to a relatively privileged class.
In January, Goldman Sachs Group Inc. withdrew the U.S. portion of an offer to sell $1 billion in Facebook shares to clients because the media attention surrounding the offering “might not be consistent” with securities laws. Goldman, which had itself invested in the company, then sold the $1 billion Facebook stake to non-U.S. clients, giving the company an implied valuation of $50 billion.
Some Securities and Exchange Commission strictures may ease soon. On April 6, SEC Chairman Mary Schapiro, in a 26-page letter responding to an inquiry from California Representative Darrell Issa, said she was considering raising from 499 the number of shareholders a private company can have without making financial disclosures to the commission. Such a change could increase the market for private shares by broadening the pool of potential investors in any one company.
The SEC also sent a letter of inquiry to private-share brokers, including SecondMarket, regarding pooled investment funds that sink money into private-company shares, SecondMarket spokesman Mark Murphy says. David Weir, CEO of SecondMarket rival SharesPost Inc., says his company also received a request for documents. Although Silbert personally owns stakes in a half-dozen Internet startups, none trade on SecondMarket, he says.
The regulators have yet to address what some analysts see as the fundamental issue: allowing private-company shares to trade in quasi-public markets without full disclosure. John Coffee, a professor of securities law at Columbia University, says participants in the private-share market face what he calls “informational asymmetries” -- meaning that insiders in private companies are likely to have far more knowledge of corporate performance than outsiders buying in.
Silbert says his clients know they are taking chances.
“Institutional investors are sophisticated and understand the risks,” he says.
Second-Market’s most serious competitor is San Bruno, California-based SharesPost. Other rivals include Gate Technologies LLC in New York and Xpert Financial Inc. of San Mateo, California. Investment banks also buy and sell private-company shares for their clients, sometimes via SecondMarket. Venture-capital firms that want to buy or sell shares often use SecondMarket or its competitors, or trade informally among themselves and with employees or former employees of private venture-backed companies.
How much financial information do companies whose shares trade on SecondMarket have to disclose? As much or as little as they want. SecondMarket provides its customers only the financial data that firms are willing to provide.
‘Dearth of Information’
“There’s a real dearth of information about these companies,” says Larry Tabb, CEO of Tabb Group Inc., a capital-markets research firm. “Are investors trading blind? With illiquid securities, you almost have to be.”
SecondMarket is booming partly because fast-growth tech companies are shying away from initial public offerings. According to the National Venture Capital Association Yearbook 2011, there were 72 venture-backed IPOs in 2010, compared with 271 in 1999. The median interval between when such a company is founded and when it goes public rose to nine years in 2010 from just four years in 1999.
Two reasons are the onerous financial disclosure and additional accounting required under the Sarbanes-Oxley Act, passed after the accounting scandals of 2000 to 2002, says Alan Patricof, founder of venture firm Greycroft LLC. In addition, many of the smaller investment banks that used to underwrite tech IPOs have been bought by larger institutions. Analyst coverage of newly public startups has fallen, making investors wary, Patricof says.
Accredited Investors Only
The Securities Act of 1933 restricts purchases of private-company stock to what it defines as “accredited” investors. In the case of individuals, that means people with a net worth of at least $1 million or $200,000 in annual income. In Coffee’s view, inflation has made the standards less meaningful.
“It allows the middle class to enter into a dangerous world of limited information and fluctuating liquidity,” he says.
Silbert characterizes SecondMarket as an EBay for illiquid assets. Companies may opt for open trading in their shares or for quarterly or annual offerings. Most trading is initiated via phone or the firm’s website. The sellers are usually former employees and early-stage venture capitalists. The buyers are hedge funds, wealthy investors and other VCs.
Sellers can post their offering price and the number of shares they are selling. Buyers either agree to that price, make lower bids or use the site to set up meetings to negotiate offline. Companies publish whatever financial information they’re willing to disclose on a secure section of the website to which only participants in a transaction have access.
Silbert wants to move beyond the EBay model by adding social-networking functions. Participants can now list their holdings, post strategies and create watch lists of those companies they’re most interested in. In the future, they will also be able to swap messages, Silbert says.
Coffee says markets like Silbert’s look better than they work.
“These private secondary markets give the illusion, but not the reality, of liquidity,” he says. “They are matching systems, and the broker does not function as a dealer committing its own capital. In a period of market distress, liquidity will vanish.”
Even today, days or weeks can go by without shares of even big private-company stocks changing hands.
A look at Facebook trades published by SecondMarket competitor SharesPost shows that private shares are a market of which buyers should beware. In January, investors agreed to trade a small lot of Facebook stock for $60 a share, more than twice the price that other investors agreed to pay the very same day. SharesPost CEO Weir says his company’s brokers now review price postings before they go live.
SecondMarket doesn’t disclose the price at which shares are bought and sold on its network.
Silbert trades more than just the shares of startups. The broker-dealer has staked out a slew of other tough-to-trade asset classes in which it matches buyers and sellers, among them bankruptcy claims, mortgage-backed securities and limited partnerships in hedge funds.
One new customer is Pacific Investment Management Co., a subsidiary of Munich-based Allianz SE, with $1.24 trillion in assets under management as of December. Pimco shares can be traded only by employees of the Newport Beach, California-based firm, which uses shares as performance-based compensation. SecondMarket is also targeting the private shares of big companies such as Cargill Inc. and Levi Strauss & Co.
“We’re scratching the surface of what we can do,” Silbert says.
In late 2007, a former Facebook employee approached the firm and asked whether it could help unload some shares. A separate private-company desk was created in April 2009. As of March, Facebook shares, which trade at weekly auctions, accounted for more than 40 percent of SecondMarket’s private-company transactions. In March, its Web-based network for traders of all of its asset classes had 53,000 registered participants, up from 35,000 in 2010, 6,500 in 2009 and 2,500 in 2008.
Facebook spokesman Jonathan Thaw says the company, co-founded and run by Mark Zuckerberg, effectively bans current employees from trading its stock.
“We implemented an insider-trading policy last year to better comply with insider-trading laws and to protect the interests of the company and its employees,” he says.
Private gaming company Zynga Inc. also forbids its employees from selling, except during designated trading windows.
Insider Trading Concern
“This policy is in place because employees have information about the company that’s not publicly available and might expose them to the risk of insider trading,” says Karyn Smith, Zynga’s deputy general counsel.
Silbert swiped a page or two from Facebook’s game plan in March, when SecondMarket vastly expanded its website. While investors could trade in just 50 stocks as of mid-April, SecondMarket also profiles on its website thousands of other private companies whose shares might trade in the future. That number is now 12,500, up from 550.
Participants flag those companies they want to keep tabs on, giving SecondMarket a crowd-sourced barometer of the interest in each firm. Site registrants can also state their willingness to buy shares -- giving SecondMarket a tool with which to persuade companies to allow their stock to trade on its network.
In April, Facebook had 3,030 “watchers”; Twitter, 1,772; and Groupon, 1,617. Facebook had just 18 “holders” listed; Twitter, zero; and Groupon, 3.
It’s a seller’s market.
Silbert’s growing customer base has tracked the soaring price of Facebook stock. Buyers and sellers signed off on a trade of $10 a share in April 2010, implying a valuation of $22.7 billion, according to SharesPost. By mid-April of this year, the price had risen to $32.50 a share, or $73.7 billion -- more than the real-world market capitalization of EBay Inc. or 3M Co.
By that measure, the overseas Goldman clients who paid $1 billion for Facebook shares in January earned a 47 percent paper return in three months.
Lou Kerner, an analyst at Los Angeles-based investment bank Wedbush Inc., estimates that Facebook’s earnings before interest, taxes, depreciation and amortization were $1 billion in 2010 on revenue of $2 billion. Using a higher implied valuation than SharesPost, he concludes its stock was trading at 78 times Ebitda in mid-April.
Bloomberg data showed Google Inc. and EBay trading for about 14 times Ebitda.
“People aren’t buying Facebook for its revenues in 2010,” Kerner says. “They’re buying it for what it’s going to be doing in 2015. We believe if it were public, it would be worth in excess of $100 billion.”
Other social media companies whose shares SecondMarket trades are also ablaze. SharesPost says prospective buyers and sellers of preferred shares of Twitter settled on a per-share price of $30 in March, up from $11.67 in April 2010.
In December, Chicago-based Groupon turned down a $6 billion buyout offer from Google, the Mountain View, California-based search engine giant. Groupon, which sells coupons for goods and services after negotiating big discounts from merchants, is considering a public offering that values the company at as much as $25 billion, two people familiar with the matter said in March.
Leap of Faith
Investors using SecondMarket and SharesPost to load up on venture-backed private-company shares are taking a leap of faith, says Stephen Grant, a private-equity banker at Internet Securities Inc. in Oakland, California.
“From a fundamental standpoint, it’s ridiculous: There are no fundamentals, just a couple of P&L figures,” Grant says. Still, he says there’s a logic to the clamor to buy Facebook shares. “What people are buying is Facebook’s 600 million active users,” Grant says. “They are heading toward a billion, and that’s one-seventh of the world’s population as your customer base.”
Silbert says his role isn’t to judge whether social-networking stocks are a bubble -- though he points out that plenty trade for far lower valuations than Facebook.
“It’s not up to us to determine what the fair market value is,” he says.
His mission, instead, is to get private companies comfortable with the idea of trading their shares.
“We work with issuers to arrive at a solution that works for them,” Silbert says in his 12th-floor office in Manhattan overlooking Bowling Green. “Companies are growing to realize that this kind of trading is empowering. It’s great for the employees and the company.”
Silbert lets each listing company decide how often its stock can trade, whether current employees can buy or sell and whether institutions such as hedge funds are allowed to buy. His 3 to 5 percent fee is split evenly between buyer and seller.
A SecondMarket registered broker called a market specialist vets the buyer to make sure he or she is accredited and meets with the approval of the issuer, which almost always has a right of first refusal on share transfers. A separate operations specialist ensures compliance with anti-fraud and money-laundering regulations. The broker shepherds everyone through the legal and accounting paperwork, ultimately overseeing the settlement of the transaction.
“SecondMarket has been the leader in standardizing the process -- the vetting, the lawyering,” says William Martin, founder of Raging Capital Management LLC, a $125 million hedge fund that has used SecondMarket to buy social media stock, including Facebook. “They’ve succeeded in attracting the buyers and the sellers.”
Signs of prosperity abound at SecondMarket’s offices, whose walls are painted in bright colors of green, blue and orange. Last winter, the firm increased its office space from 19,000 square feet (1,770 square meters) to 26,000 square feet. It includes a game room where Silbert plays foosball with some of his 135 employees. He can also be found on Friday afternoons knocking back Stella Artoises at SecondMarket’s end-of-week parties.
Silbert has reeled in a diverse cast of enthusiasts, including college friend Jeremy Smith, 35, head of strategy for SecondMarket, and Adam Oliveri, 27, who joined in 2005 just after graduating from the University of Rhode Island and heads the private-company marketplace. Former Google product manager Dominic Preuss, 33, is SecondMarket’s technology chief.
Silbert’s success at matching buyers and sellers has made SecondMarket’s own private shares valuable. In February 2010, Singapore’s sovereign-wealth fund Temasek Holding Pte and Hong Kong-based Li Ka-shing Foundation Ltd., which helped bankroll Facebook, together bought a combined 10 percent stake in SecondMarket for $15 million, valuing the company at $150 million.
“SecondMarket fits into our theme of investing in emerging champions,” Temasek Managing Director Ang Pen Huat says.
Trading private-company shares remains a relatively small business. SecondMarket produced revenue of $16 million on the $400 million of private-company transactions it handled in 2010. Even if the transaction value surges to $1 billion, private-company trades would generate only $40 million in revenues.
“This is not a big asset class,” says managing director Hans Swildens of Industry Ventures LLC, a San Francisco-based investment firm. “It has been a niche business and will continue to be a niche business.”
Silbert says there is plenty of room for growth.
“Three-thousand companies are funded by VCs every year,” he says.
Silbert, who grew up in Gaithersburg, Maryland, was an entrepreneur from an early age.
“I was the kid mowing lawns; I was the kid shoveling driveways,” he recalls. Silbert would turn a profit trading baseball cards with grown-ups 10 years older at hobbyist conventions. “That was my first illiquid asset,” he says.
In 1986, Silbert’s father, a government auditor, died from an aneurysm of the main artery of the heart, and Silbert pursued his odd jobs with even more determination, says his mother, Andrea Epstein. He worked in a liquor store and sold greeting cards.
“It was us against the world,” she says.
In 1994, when Silbert was 17, he got a job filing at a mutual fund near his home. His boss, Michael Byrum, now chief investment officer at Rydex SGI, a New York-based asset manager, persuaded him to take the Series 7 examination, the test now administered by the Financial Industry Regulatory Authority for aspiring brokers. Silbert passed.
He went on to earn a degree from the Goizueta School of Business at Emory University in Atlanta. During his junior year, he got a call from Bear Stearns Cos. Chairman Alan “Ace” Greenberg. An acquaintance had forwarded his resume.
“I almost asked him what he did at Bear Stearns,” Silbert says.
Silbert spent the summer working in Bear Stearns’s international stock loan department, hunting down hard-to-find shares for hedge-fund clients to short. Yet, when Silbert graduated, he chose to work for a much smaller firm, Los Angeles-based investment bank Houlihan Lokey Inc.
“They were on a bit of a mission,” he says. “They were building a company.”
Houlihan Lokey specialized in corporate restructurings, and it pulled in lots of new business after the global panic that followed the 1998 Russian bond default and the meltdown of hedge fund Long-Term Capital Management. Silbert, working out of Houlihan’s Park Avenue offices in New York, was assigned to some serious corporate train wrecks: the 2001 bankruptcies of speech recognition company Lernout & Hauspie Speech Products NV and Saul Steinberg’s Reliance Group Holdings Inc.
“He was a young eager beaver with an entrepreneurial spirit,” says Jeff Werbalowsky, his boss at the time and co-CEO of Houlihan Lokey.
Silbert’s biggest challenge was helping to sell off the tangled assets of Enron, the Houston-based commodities and energy-trading company that went bankrupt in 2001 amid charges of massive accounting fraud. The company had subsidiaries all over the world, many of them co-owned by minority investors. Ultimately, Houlihan Lokey packaged most of the assets into a holding company and distributed shares to creditors.
“Perhaps if there had been a SecondMarket then, things would have been different,” Silbert says.
Silbert’s experience restructuring bankrupt companies gave him the idea that there was a business in finding buyers for hard-to-trade assets. Werbalowsky says he was skeptical, telling Silbert he would be tripped up by, for example, state and federal securities regulations.
“We can work it out,” Silbert would insist.
Silbert drafted a business plan for his company in 2004, calling it Private Company Stock Exchange. He laid out $2,000 for the Web URL PCSE.com, dubbing the company “the EBay of private-company stock.” A lawyer soon pointed out that he couldn’t call his operation an exchange unless he registered as one.
“I flushed $2,000 down the drain,” Silbert says.
Silbert tried again, launching a business with the help of a $300,000 investment from a former brokerage executive he declines to name on the record. The investor suggested it would be easier to trade restricted stock of public companies than private-company shares because holders are registered and prospective buyers such as mutual funds are easy to find, as they are required to disclose their holdings to the SEC.
Trading Restricted Stock
Such stock is awarded to executives as compensation and often can’t be sold for a period of years.
In late 2004, Silbert’s firm became Restricted Securities Trading Network, which he says made a profit in its first year, 2005, and every year since.
By late 2006, RSTN was e-mailing lists of restricted stock to potential buyers. Silbert soon set up a password-encoded bulletin board allowing sellers to post their holdings. Revenues hit $2.5 million.
In 2007, Silbert learned that Goldman Sachs was building its own system for buying and selling illiquid securities. Silbert decided he might need more money.
“I never wanted to look back and say, ‘If we had had that money, Goldman Sachs wouldn’t have crushed us,’” he says.
By mid-2007, the early stages of the collapse of the market for securities backed by subprime housing loans was under way, setting in motion the crisis that would eventually spread to the larger economy. Lawrence Lenihan, CEO of FirstMark Capital LLC, saw Silbert’s company, by then called Restricted Stock Partners, as a play on the emerging crisis.
“We were looking for businesses that would benefit in an economic meltdown,” Lenihan says. “We knew there would be a lot of illiquid assets.”
FirstMark invested $3.8 million for a 25 percent stake.
Beginning in early 2008, the firm moved into the nearly frozen markets for auction-rate securities, typically bonds sold by municipalities whose interest rates were designed to reset periodically through bank-orchestrated auctions. In February, banks balked and the auctions failed. SecondMarket announced it would match buyers and sellers of auction-rate securities; it oversaw deals that had them trading for as little as 50 cents on the dollar. Still, bondholders rejoiced.
“We were getting flowers and chocolates,” Silbert says.
Bankruptcy Claim Market
Companies began running out of money, and in July 2008 the company started trading bankruptcy claims. It changed its name to SecondMarket in September.
In late 2008 and early 2009, hedge funds such as D.E. Shaw & Co. and Citadel LLC threw up so-called gates to keep investors from withdrawing capital. In January 2009, Second-Market set up a desk for investors to trade hedge-fund limited-partnership “interests.” Now, SecondMarket offers hedge funds the opportunity to monitor and manage the trading of their own partnership interests themselves.
“Honestly, there’s no one else who does what we do,” Silbert says.
In April 2009, SecondMarket started a desk for mortgage-backed securities and collateralized debt obligations -- bundles of debt sliced into tranches with different yields and prepayment streams and sold by banks to investors. All told, SecondMarket has completed more than $14 billion of sales of structured products.
Silbert and his colleagues say there are categories of illiquid assets they have yet to tap. Kevin O’Connor, co-head of structured products at SecondMarket and a former head of JPMorgan Chase & Co.’s auction-rate securities trading, says there’s enormous room for expansion.
‘Wood to Chop’
“There is plenty of wood to chop,” O’Connor, 44, says. “Our job is to find other areas that are underserved.”
The firm is now exploring markets in private real-estate investment trusts and shares of community banks.
Bigger volumes will come from bigger game: shares of large private companies such as Mars Inc., Bechtel Group Inc. and Koch Industries Inc., Silbert says.
“We’re talking potential markets in the trillions, not billions, of dollars,” he says.
SecondMarket’s most serious rival for trading venture-capital-backed company stock is SharesPost. Weir, 51, its CEO, is a former JPMorgan Chase investment banker and ex-CEO of OffRoad Capital Corp., a firm specializing in online private placements. Weir’s site has more registered participants than SecondMarket -- 65,000 compared with 53,000 -- and does less dollar volume. The average trade on SharesPost is about $200,000 with a $25,000 minimum, the company says, versus the average of $1 million to $2 million that SecondMarket claims.
Weir needles his East Coast rival.
“We come out of a Silicon Valley mind frame, using technology to solve the problems,” he says. “They are brokers with phones.”
SharesPost does its deals almost entirely online.
Silbert defends SecondMarket.
“Our model combines innovative technology with human support,” he says.
SharesPost deals exclusively in private-company shares -- not any of the other illiquid assets that SecondMarket has cultivated.
“We are 100 percent dedicated to private-company stock,” Weir says.
SharesPost wants to raise money directly for venture-backed companies in the so-called primary market, instead of just chaperoning trades of existing shares.
Silbert, meanwhile, is seeding some startups himself as an angel investor. He’s invested about $500,000 to help bankroll half a dozen new companies, including New York-based RealDirect Inc., an online real-estate brokerage; Los Angeles-based ProFounder Financial Inc., which hosts a website that allows entrepreneurs to raise funds from their communities; and New York-based Send the Trend Inc., an online customized fashion accessory company. Silbert says what these companies have in common is that the people behind them all want to solve problems for their customers while upending the status quo in the process -- something Silbert has been doing since he launched his new enterprise six years ago.
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