Last week, we wrote about private shares fraud and how we think there may be significant litigation and/or arbitration in the future in this space. Today's NY Times has a very good Dealbook piece (below) by the "Deal Professor" about the lack of disclosure in the private shares markets of SharesPost and SecondMarket. The most important sentence: "The lack of information combined with this illiquidity contributes to the volatility and mispricing of shares." That's spot on. We're talking about large investments in unregistered shares within an unregulated market. Major exposure to potential fraud. Major.
November 22, 2011, 4:37 pm
Private Markets Offer Valuable Service but Little Disclosure
By STEVEN M. DAVIDOFF
Information is the lifeblood of capital markets. In the movie “Wall Street,” Gordon Gekko demanded confidential information from a young would-be Master of the Universe, Bud Fox, played by Charlie Sheen. The value of stocks is based on information, which is why securities laws are intended to ensure that all investors have at least minimum amounts of information.
Private, closed markets like SharesPost and SecondMarket aid in the cause of market transparency, providing platforms to trade shares of companies that have yet to go public. At the same time, the limited amount of information available to investors in these markets raises some questions. Regulators, which have been looking at these markets, may be right to be concerned.
Both SharesPost and SecondMarket, to be sure, are aimed at sophisticated investors, who can buy shares in up-and-coming companies, mainly Internet start-ups, before their initial public offerings. The two markets have cut their teeth on connecting buyers and sellers in hot pre-I.P.O. tech companies like Facebook and Groupon.
Yet gaining entry to both markets is simple. Before trading or being allowed full access to the market’s platforms, a user must first register and attest to being an accredited investor under the securities laws. This generally means that the user must have an individual income greater than $200,000 a year or a net worth of more than a million dollars. Lying on the Internet is easy, though, as anyone who has ever been on a dating site knows.
Both SharesPost and SecondMarket review the potential buyer’s declaration to ensure that these standards are met, including requiring government identification, but neither appears to ask for tax returns or require independent verification of a person’s salary and net worth. After being certified, an investor can bid to buy shares of these companies.
The problem is that potential buyers sometimes have little information on which to base their purchase. Public companies are required to make copious disclosures to the Securities and Exchange Commission, including audited financials that are reviewed by the S.E.C. The agency recently prompted Groupon and Zynga to revise their accounting disclosures before their I.P.O.’s.
SecondMarket changed its business model in 2010 to require companies to provide two years of audited financials and other information to potential bidders. The exception is Facebook, the most actively traded stock on SecondMarket. For Facebook, there is no information requirement. Shareholders fly blind, relying on anything they can glean from almost anywhere but the companies themselves.
SharesPost does not appear to provide the information that SecondMarket requires. SharesPost strives to fill this gap by arranging to have privately prepared research reports posted on its site. But without full information, the research providers cannot do any better than buyers in accurately pricing stocks. The result is volatility.
Facebook’s value on SharesPost has fluctuated wildly. In January, Facebook shares traded at a price that gave it an implied market value of more than $141 billion . Less than one month later, Facebook shares traded at an implied value of about $71 billion. Four days later it was at about $87 billion. Since that time, Facebook shares have traded in a range that values the company at $73 billion to $87 billion.
This summer, Groupon was reportedly trading on the private markets at an implied market valuation of about $20 billion. Groupon is now trading at a value of about $13 billion.
The problem is not just overvaluation. In January, Bloomberg News reported that shares of LinkedIn were trading on the private markets at $30 apiece, valuing the Internet company at $2.51 billion. LinkedIn is now public and trading at a market valuation of about $6.7 billion.
SharesPost appears to provide more market information than SecondMarket. It posts all of the prices of its trades and has enlisted research providers to assist investors.
One of the largest research providers on SharesPost traditionally was Global Silicon Valley Partners.
Brad Flynt, a law student at the University of Georgia School of Law, has written an unpublished paper questioning the independence of Global Silicon Valley Partners.
The research provider is affiliated with the Global Silicon Valley Corporation, a publicly traded company that is active in purchasing shares on the private markets. G.S.V.C. is headed by Michael Moe, who is also a director of SharesPost.
Last spring, Global Silicon Valley Partners published a research note that estimated Facebook shares at $22.24 to $22.57 apiece, valuing Facebook at $52.3 billion to $53.1 billion. About this time G.S.V.C. purchased 225,000 shares of Facebook at $29.28, valuing Facebook at roughly $68 billion.
This raises conflict-of-interest issues because Global Silicon Valley Partners set a low valuation target at the same time its affiliates, Mr. Moe and G.S.V.C., were buying shares at a higher one.
In an interview, Mr. Moe said that Global Silicon Valley Partners was now defunct and that, though this was not disclosed in the research reports, Global Silicon Valley Partner’s research was always independently prepared by Candlestick Advisers, a consulting and advisory firm based in India.
Mr. Moe said that there was no economic relationship between Candlestick and G.S.V.C. but rather a personal one between himself and Candlestick’s owners. According to Mr. Moe, Candlestick is compensated by SharesPost for its research reports but neither he nor G.S.V.C. received money from Candlestick. SharesPost declined to comment on the relationship between Mr. Moe, G.S.V.C. and its research providers, instead referring me back to Mr. Moe. Candlestick Advisers did not reply to a request for comment.
It all raises questions about what exactly shareholders know and how they know it on these markets.
SharesPost appears to be trying to do the right thing by putting more information out there. Given the lack of information on the companies itself, however, this is a roll of the dice. And there needs to be more disclosure about these research providers that would explain their motivations and compensation.
This is also an illiquid market. Except for trades in Facebook, shares of other private companies appear to be infrequently bought and sold. Twitter and Zynga do not appear to be available for purchase on SecondMarket. The last trade in Zynga on SharesPost was on Sept. 9. Twitter appears to have traded only once this year on SharesPost. The lack of information combined with this illiquidity contributes to the volatility and mispricing of shares.
The S.E.C. thus faces a quandary. These private markets offer an increasingly desirable service by providing an outlet to sell shares in companies that do not want to subject themselves to the increased regulation and scrutiny that comes with being public.
But it is too often all or nothing in terms of information. Congress is considering a number of bills intended to make trading in these markets easier, and the S.E.C. is also reviewing its rules governing private markets. Congress may also want to consider enacting requirements for companies with shares actively trading on these markets to disclose sufficient information to allow informed trading. SecondMarket has already taken a step in the right direction but could do more and provide data on purchases and sales.
Investors will otherwise remain in the dark, gambling without information.
Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.