The Difference Between Public and Private Stock Markets

by: Felix Salmon

SecondMarket put on a conference in San Francisco yesterday morning, where I got to talk to chief strategy officer (whatever that means) Jeremy Smith. I asked him about my theory that it's easy to make big acquisitions if you're public, using a hypothetical Facebook-Skype deal as my example.

Jeremy pushed back a bit: anything Facebook could do as a public company, he said, it could do as a private company too. Leverage? Banks would be lining up to lend money to Facebook right now. A big capital raise? Again, there's no shortage of people wanting to invest in Facebook, or of banks willing to give Facebook a bridge to such a raise.

There is however a huge difference if Facebook wanted to pay in stock. For one thing, illiquid stock in a private company is much harder to sell than liquid stock in a public company. And while a VC fund might be willing to accept stock as payment on the understanding that it would sell that stock pretty quickly, it would be impossible to persuade any such fund to accept another form of illiquid equity. They're meant to be making an exit here, not a new investment. If Facebook is buying a small company owned by its founders, they might be willing to take stock in payment. But exiting venture capitalists, not so much. (Unless the exiting fund could then sell that stock to a younger fund run by the same company; I'm not sure whether that would work.)

I learned quite a lot at the conference about the nuts and bolts of listing on what SecondMarket likes to call its "liquidity platform" — it's not nearly as onerous as listing on the NYSE, but it's still not easy, and it does require a fair amount of legal legwork. So far, the smallest company to use it had a valuation of about $150 million; it's designed for companies worth $1 billion or so. That's big money — but still small enough that we're talking about a set of companies which are too small to go public, judging by the size of IPOs in recent years.

In any event, most of these companies won't go public: they're nearly all VC-backed, and 90% of VC exits are via M&A rather than via IPO. And this is where the real value of a SecondMarket listing becomes apparent: in an M&A transaction, the acquirer is always going to feel the need to offer some kind of premium over the latest value that the shares fetched on SecondMarket. Without that price being out there, negotiations can be harder, since the buyer wouldn't be able to see the price that a significant number of buyers with ready cash are willing to pay for equity in their target.*

And one panelist, I forget who, pointed out another clever way that SecondMarket is changing the way that companies and investors interact: historically, secondary offerings, of stock held by existing shareholders, always took place after an IPO. Now, with SecondMarket, they're taking place on a regular basis before an IPO. That removes an important incentive to go public, and will only serve to make the average age of companies at IPO even higher.

Meanwhile, all the signals on Capitol Hill seem to be pointing towards the SEC making life easier for companies like SecondMarket, and embracing the new halfway house between private and public. That would make the government far more responsive to this development than the law world, where Wilson Sonsini's Yokum Taku said that he be "shocked" if the standard provisions in the structure of VC-backed companies, which haven't really changed since about 1974, were changed at all in his lifetime.

The most interesting panel was moderated by Dan Primack, who asked a good question: what happens when the bubble bursts? Right now SecondMarket is riding high because pretty much all the companies using it to trade their stocks are seeing their valuations float effortlessly ever higher. But once those valuations crash, will people still be willing to sell? And who will want to buy? Will there be vulture secondary investors?

My worry is that these markets are a bit like the housing market, where people remember the valuations at the peak of the market, refuse to sell for substantially lower amounts, and the market stops clearing. After all, the primary market in private equity — the capital-raising rounds which are marked as Series A, Series B, and so on — is highly allergic to "down rounds" and does tend to seize up during market downturns. Why should the secondary market be any different?

The public markets, by contrast, go up and down all the time — they have no problems at all with stocks going down. So the open question is whether private secondary markets are more like public secondary markets, or more like private primary markets. We'll find out, I guess, when the current dot-com bubble finally crashes.

*Update: In a classic example of the way that public shareholders get less information than anyone else looking to buy a stake in the company, it's worth noting that this information does not make its way into the IPO prospectus. LinkedIn's (LNKD) S1, for example, says that its shares have been trading on SecondMarket. But it doesn't say for how much.