What You Don’t Know About The Secondary Market Can Hurt You
“The joint-stock company and the stock market were … born within just a few years of each other. No sooner had the first publicly owned corporation come into existence with the first-ever initial public offering of shares, than a secondary market sprang up to allow these shares to be bought and sold. It proved to be a remarkably liquid market.”
That’s Niall Ferguson describing emergent trading in one of the first limited-liability companies in 1612 in his book “The Ascent of Money.” Interestingly, the startup was a monopoly created by government-mandated mergers, with shares initially vested for 10 years. After the directors successfully dodged their reporting obligations, rendering shareholders’ claims on the company’s profits unverifiable, the shareholders started selling their stock to third parties. And the secondary market was born.
The Scope Of The Secondary Market
Silicon Valley’s secondary market in startup equity is already a few decades old, and it’s flourishing. What does this market look like, and how can incoming investors navigate it?
The scope and history of the secondary market are obscure because there is no central exchange. According to one estimate, the first six months of 2019 saw a volume of $55.4 billion, which was projected to reach $215 billion by 2023. However, since many offers and sales are not publicized, tracking deals and volume is complicated. The flexibility and informality that make the secondary market attractive also make it opaque.
Still, market logic allows inferences about who’s playing and how the market reacts to change. Sellers include founders, employees and early-stage investors who want to liquidate their equity without waiting for an exit. This allows early-stage investors to participate in later rounds of their portfolio companies without additional risk — sell some of their preferred shares at the new round’s price and use the proceeds to reinvest in the same company with no downside risk. Some profit and extra liquidation preferences are already secure.
Different groups have different interests. Startups give employees vested common stock to promote loyalty. Early-stage investors bargain for preferred stock, which keeps them coming back round after round. Founders keep common stock to profit from their genius and hard work. However, investors don’t want anyone selling shares on better terms than they themselves can obtain, so they seek to be included in the best deals. Employees want flexibility, which means the freedom to sell at will. Founders want control over who owns their company’s equity and when it’s sold.
Typical buyers include late-stage VCs, family offices, ultra-high-net-worth individuals (UHNWIs) — anyone seeking stock without the patience for an uncertain exit or who wants to buy stock before a big anticipated exit. Since the secondary market is private and many pseudo-exchanges, like SharesPost and Forge, have no access to best deals or offer it overpriced to small investors, market entrants lacking capital or connections should probably invest through or alongside a late-stage fund.
The incentive structure also hints at the market’s dynamics. The secondary market is a source of liquidity — it’s an alternative to exit. Other things being equal, the secondary market expands as exits wane. Taking IPO activity as a proxy for exit activity, the current volume matches the previous peak of 2014. Their current performance, however, is almost unprecedented.
Implications And Complications Of The Secondary Market
New entrants are another indicator of market vigor. Secondary-market intermediaries become more diverse and professional, and new models are emerging. Though it sounds like a contradiction, a “private-stock exchange“ has emerged. It works like a traditional stock exchange with lower capital and disclosure requirements. Such innovation is the opposite of stagnation.
The secondary market is less transparent and open than the public market. Looser regulation, formality and oversight attract incoming investors, but flexibility comes with certain risks.
The first risk is obvious: These are startups striving to prove themselves. While big public-market incumbents do occasionally tank, they’re generally established companies with a proven business. Venture capital, the kind flowing into and through secondary markets, takes chances on new and yet-unproven ideas.
The second risk is less obvious: asymmetric information. The public markets are designed to provide all traders with the same information. Sure, with time and effort, some investors can gain an informational advantage. But in theory, they all have equal access to the same basic resources. The system is designed to ensure equal opportunities, if not equal outcomes.
Other things being equal, more participants with more information will make price discovery more effective. It’s like regression in statistics: As more data goes into the model, the more inevitable errors across many measurements will cancel each other out. That’s market efficiency.
The secondary market for startup equity is different. There are fewer disclosure requirements — barely any for firms with fewer than 2000 shareholders — so everyone has differential access to different information of different value.
However, asymmetric information doesn’t mean that insider trading is rife; it just means that insider trading doesn’t really apply. An “insider” in the public market is someone with privileged information and who uses it to their advantage. An insider in the secondary market is just someone who knows more than you do and uses that information wisely and rationally.
Information asymmetry is one of the main reasons why investment advisors are useless for public-equity markets, but they are essential to those entering private-equity markets. The higher volume and higher quality of information that the biggest VC firms acquire through connections and board seats is one of the major reasons for their consistently impressive results.
The expansion and internal diversification of the secondary market are definitely good for VCs. It provides more liquidity to finance more innovation and more opportunities to profit from it. But this market remains a risky, opaque, arcane game best left to professionals. Whether or not poker players ever repeat the advice, investment gurus do regularly: “If you sit in on a poker game and don’t see a sucker, get up. You’re the sucker.”
Originally published at https://www.forbes.com.