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Disappearing IPOs and trading Unicorns: a tale of market and governance danger

The rise in secondary market trading for private companies could have serious consequences for the public markets, transparency and investor governance.

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You could be forgiven for thinking that Uber had already floated as a public company.
What do I mean?
Well, take a look at Fidelity, one of the biggest mutual funds. It owns around $529m worth of preferred stock in Uber Technologies, Inc. Series D, 8.00%, according to one of its latest quarterly holdings reports.
And that’s just the preferred stock held in one fund, FTAWX, without even looking into the hundreds of other funds where it might also have holdings in Uber, bought, of course, via private placement. But it’s not just large mutual funds that are investing in private companies.
It seems like the SEC, through small but potent and unrelated rule changes, is undermining the market for IPOs by creating a secondary market for private company share transactions. Ironically, that would answer SEC chair Jay Clayton, and commissioner Michael Piwowar who have been bemoaning the lack of IPOs in the US. Importantly, it could also have serious consequences for the volume of IPOs, stock market transparency and investor governance. According to some estimates, there was around $1 trillion in market cap trading in so-called ‘private transactions’ in ‘unicorn’ and other private companies last year. ‘Unicorn’ is Silicon Valley-speak for high-valued start-ups like Airbnb, Uber and Lyft.
Phil Brown, Chief Strategy Officer of the SEC compliance intelligence company Intelligize first put me on to what he dubbed the ‘Underground IPO market’: “They’ve allowed unicorns to resell on the secondary market,” says Brown, “and, technically,some of these companies are skirting the rules of the ‘34 Act [Securities Exchange Act of 1934] and the ‘33 Act [Securities Act of 1933] because they have more than 500 shareholders.” Private companies are required to have fewer than 500 shareholders, according to the Acts. This was one of the rules that forced Facebook to go public. The Jumpstart Our Business Startups (JOBS) Act increased that threshold to 2,000 for companies with $10 million or more in assets, lifting many unicorns out of that danger zone. “Compared to 10 years ago, we had more IPOs, but the SEC is failing to look around and ask where the money has gone,” he says. Clearly a chunk of the money is in the secondary market of private transactions. Brown’s comments alerted me to something I had seen in Spotify’s SEC filings. Spotify just listed without an IPO. Why? Because it didn’t need the additional funding that an IPO would bring? Or is it because it was able to raise money on the secondary market? Part of the answer appears to be in Spotify’s F1 filing, which says: “Prior to the initial listing, no public market existed for our ordinary shares. However, our ordinary shares have a history of trading in private transactions.” Since June 2017 some 15.6m Spotify shares were sold in private transactions. At an average stock price of $100, that’s more than $1.56bn worth of transactions in the secondary market. I ask Brown about this phenomenon. “A direct listing would be stage two,” he replies. “You can buy indirect shares in Uber today.”
He points to companies such as SharesPost and ShareBid that actually advertise the buying of shares in companies that aren’t listed,” says Brown, with some bemusement in his voice. He adds: “That used to be illegal. You couldn’t do it. Now, you just have to go through a registration process. SharesPost says that filling out its ‘brief’ questionnaire enables them
to accredit clients under securities laws and understand their investment objectives. But Brown is concerned about the rigour of the process: “I actually did it to see what was involved. You tick a bunch of boxes, say you’re rich, and ‘qualify’ what that means. But there is a very low requirement for proof. I couldn’t see a regimented process to prove that you are who you say you are and have the required financial acumen.” In late 2017, SharesPost said it had completed $2.3bn worth of secondary market transactions since 2009. It claims that volume is growing 50% to 60% every quarter. The secondary market allows employees, founders and early investors at unicorns like Uber, Lyft and Airbnb, to cash in some of their paper wealth. It also allows institutional investors in on the game. Says Brown: “All the institutional shareholders care about is whether they can get on board with a $500 million offering that has less cost of capital than, for example, the amount Facebook has to pay now. When Uber raises a dollar it costs a lot less for them to do it than Facebook. They can go to a significantly smaller consortium than the public markets to raise capital with a lot less regulatory burden; they show them their audited financials and the money is in.” And as Brown also points out, the SEC is encouraging the secondary market by increasing the amounts that can be sold to, and bought by, individual private investors.
Firstly, the JOBS Act increased the amounts that could be bought by private investors. “Another thing that the SEC did was lower the rules to get more people into the process,” says Brown. I ask if he means by lowering the level of what your net worth has to be in order to invest in certain transactions? “Correct,” he answers.
The SEC has also expanded the amount a private institution can raise without going public. He notes: “That was rule 504, 505 and 506 of Regulation D where they actually have allowed the dollar amount to expand and this is pulling apart the idea of a public offering.”Brown’s theory is that the IPO market hasn’t gone away, it’s just gone underground: “They (the SEC) are doing comparisons with 1996 and that’s not the right base. Back then, I was at a company that had $5 million in revenue and our nearest competitor had the same and they went public with a $400 million market cap. That’s crazy. Everybody would want to go public. But then people started to realize that there’s no way that $5 million in revenue gets to a $400 million value.” Brown’s contention is that they’re not comparing a normal situation with today. “I would say you have to compare pre-1993 to now. And you also have to compare the costs of being a public company then and now. It’s got to be at least double. The documents are substantially larger, although more substantive certainly. If you picked up a prospectus for a public company back in the early 90s when I worked in the public reference room it would be maybe 50 pages. Now, it’s a hundred.” Whether you compare the number of IPOs and companies now to the numbers in the frenzied days of 1996 or pre-1993, the big difference, he says, is that there was no secondary market then: “If you had a company that was growing and you needed money you had to go to the public markets. You don’t need to do that anymore. You can go to Fidelity, Vanguard and Kleiner Perkins and they’ll put together $3bn for you and you don’t have any disclosure. You have to talk to 20 investors in a room, but that beats the hell out of thousands of shareholders, and CNN and MSNBC talking about your stock price going down an eighth of a percentage point on day number 46 out from the IPO.”
So, Mr Clayton, that’s where your IPO market went….
And the SEC and Congress let it happen, partly, though not wholly, with the JOBS (Jumpstart Our Business Startups) Act, enacted in 2012. Let’s stop blaming regulations which, as Brown reminds me, have protected investors from many a fraudster. Instead, let’s start thinking about how to make it worthwhile for the likes of Uber to sell and Fidelity to buy in the primary markets.

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