Information issues on Wall Street 2.0.

AuthorPollman, Elizabeth
PositionIntroduction through III. Information Issues in the Secondary Markets for Private Company Stock, p. 179-221

Billions of dollars have f10oded new online marketplaces for trading private company stock. These marketplaces stand poised to become important, lasting features of the private company world as they provide a central meeting place for buyers and sellers and potentially increase the liquidity of private company stock. Increased liquidity is particularly important to investors in start-up companies, as these companies have faced 10nger periods of time before going public or being acquired. The new marketplaces also raise significant information issues, however, that threaten their legitimacy and efficiency. This Article is the first to examine these information issues--lack of information, asymmetric information, conflicts of interest, and insider trading--as well as possible solutions that would al10w the markets to continue to evolve while promoting their integrity and investor protection goals. Specifically, the Article proposes establishing a minimum information requirement for secondary trading in private company stock and reexamining the thresholds for accredited investor status in order to ensure that market participants can fend for themselves without additional protections. The Article also examines potential responses to insider trading in these markets, arguing that a case exists for the SEC to take action in the private market context, since harm may be cognizable and the arguments for regulating insider trading are as strong in the private market arena as in the public.

INTRODUCTION I. SECONDARY MARKETS FOR PRIVATE COMPANY STOCK A. Background 1. Venture Capital Cycle and Liquidity Environment 2. Securities Law Framework B. The Rise of the Secondary Markets and How They Work 1. SecondMarket 2. SharesPost II. POTENTIAL BENEFICIAL ROLE OF SECONDARY MARKETS FOR PRIVATE COMPANY STOCK III. INFORMATION ISSUES IN THE SECONDARY MARKETS FOR PRIVATE COMPANY STOCK A. Lack of Information, Asymmetric Information, and Conflicts of Interest B. Insider Trading IV. POSSIBLE RESPONSES TO INFORMATION ISSUES IN THE SECONDARY MARKETS FOR PRIVATE COMPANY STOCK A. Lack of Information, Asymmetric Information, and Conflicts of Interest B. Insider Trading V. THE TENSION BETWEEN PRIVATE AND PUBLIC MARKETS CONCLUSION INTRODUCTION

A new generation of securities markets is emerging. Shares in private companies, previously regarded as an illiquid, out-of-reach asset class, are being traded on websites resembling stock markets. Hot demand for private shares of Facebook and other techno10gy and social media companies has fueled the recent meteoric rise of these online markets. Their future may turn, however, on how policymakers and market participants deal with information issues in these markets, which to date have been largely unregulated. This Article is the first to examine these information issues and potential responses to them.

The new online marketplaces for trading private company stock have arisen in the context of changing market patterns. Over the past decade, the number of start-up companies entering the capital markets through an initial public offering (IPO) has significantly dropped relative to historical norms. (1) Whereas from 1991 to 2000, nearly 2000 venture-backed companies went public, fewer than 500 did so from 2001 to 2010. (2) In addition, the median age of companies at the time of their IPOs has increased. (3) Partially in response to the decline in IPOs, Congress recently enacted the Jumpstart Our Business Startups Act (JOBS Act). (4) Among other things, the JOBS Act created an "on-ramp" that reduces burdens on newly public companies, but these regulatory changes are recent and their effects remain to be seen. (5)

With fewer companies going public, and with those that do staying private 10nger than before, early start-up emp10yees and venture capital firms (VCs) have experienced significantly 10nger waiting periods before gaining liquidity in private company stock. VCs are "institutional managers of risk capital" that support the growth of innovative companies. (6) When a VC invests in a start-up company, the investment is essentially illiquid and of uncertain value until the company matures and reaches a liquidity event. (7) The liquidity event, typically achieved by the company's acquisition or through an IPO, marks the payoff for the VC and its fund investors. (8) Likewise, emp10yees and former emp10yees in start-up companies have depended on the company reaching a liquidity event in order to cash in on stock earned as equity compensation. (9)

Meanwhile, during this period of decline in the IPO market and increasing liquidity concerns, outside interest in buying private company stock has surged. (10) Certain high-profile private companies have grown quickly and have offered the allure of potentially huge rewards when the company finally has an IPO.

These factors have set the stage for a liquidity revolution in private company stock, ignited by new online platforms such as SecondMarket and SharesPost. These platforms act as intermediaries to facilitate private company stock trading, creating centralized meeting places for potential buyers and sellers and 10wering transaction costs. (11) Estimates of the size of this secondary market measure the total transaction volume in the billions. (12) The rapid growth of these markets suggests a potential solution to the liquidity issues in private company stock. (13)

But these new secondary markets also pose significant information issues that have not yet been exp10red in the legal literature. (14) As this Article explains, these issues include a lack of information about the private companies whose stock is being traded, information asymmetry between buyers and sellers, and undisc10sed conflicts of interest among market participants. These information issues raise concerns about the accuracy of the stocks' valuations and whether secondary investors in these markets can truly fend for themselves without additional securities laws protections. Further, concerns about insider trading hang over the community, as many of the selling shareholders are employees or former employees, and much of the material information about the companies is nonpublic.

This Article makes two main contributions to the literature. First, it identifies and analyzes the information issues in the new online secondary markets. Such issues constitute some of the most critical concerns about these markets today. Second, the Article exp10res potential responses to these information issues. Specifically, the Article proposes establishing a minimum information requirement for trading in private company stock and reexamining accredited investor thresholds to ensure that market participants can fend for themselves without additional protections. The Article also examines potential responses to insider trading in these markets, arguing that a case for the Securities and Exchange Commission (SEC) taking action exists, as harm may be cogn10able and the arguments for regulating insider trading are as strong in the private market realm as in the public. Finally, the Article situates these contributions in a broader context by examining the underlying tension between these private secondary markets and public markets.

The Article proceeds as fol10ws. Part I provides background on the venture capital cycle and the IPO market, as well as the securities law framework in which the secondary marketplaces have grown. In addition, it details the rise of the secondary markets and their mechanics. Against that background, Part II discusses the potential benefits these markets offer. Part III analyzes the information issues in the secondary markets, including lack of information, asymmetric information, conflicts of interest, and insider trading. Part IV exp10res potential responses to these issues, with the aim of sparking a wider conversation. Finally, Part V deepens and contextualizes the analysis and potential responses to it by engaging with policy concerns about the public-private divide.

  1. SECONDARY MARKETS FOR PRIVATE COMPANY STOCK

    1. Background

      The secondary markets for private company stock have deve10ped in the context of a changing venture capital and liquidity environment, and in a regulatory framework that was largely established 10ng before regulators could have imagined the existence of online marketplaces. This Section briefly describes the venture capital cycle and the IPO market, as well as the securities law context in which the secondary marketplaces have grown. This background helps explain the business opportunity that the secondary marketplaces have seized and lays the groundwork for understanding the information issues in these markets that this Article exp10res.

      1. Venture Capital Cycle and Liquidity Environment

        The venture capital life cycle starts with the creation of funds that raise capital from institutional and private investors interested in start-up companies. (15) A venture capital fund is typically organized as a limited partnership with the VC as the general partner and the investors as the limited partners. (16) The VC selects the portfolio companies for the fund, and nurtures and supports them by contributing money and often services or advice that the companies need in order to deve10p. (17)

        Venture capital funds generally have a defined period of existence, or "term," and detailed rules about how investors in these funds can liquidate their assets in the funds at the end of that period. (18) The goal is for the startup companies to achieve successful "exits" that make a significant return on investment for the venture capital fund. Indeed, venture capital fund liquidity depends on start-ups' exits. (19) The primary exit mechanisms for start-ups are going public and being acquired in a merger transaction (sometimes referred to as an "M&A exit"). (20) While M&A exits are more common, industry insiders have 10ng viewed IPOs as essential for sustaining a robust...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT