SecondMarket Attempts to Sell Startups on the Value of Letting Employees Trade Their Stock

8/18/11Follow @wroush

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reward employees and feeding the avarice of both sellers and buyers of private stock. This is partly for reasons of SecondMarket’s own making. For the first couple of years after it started facilitating private trades in 2008, it worked directly with shareholders—mainly ex-Facebookers at first, then others—without necessarily getting approval from the companies that issued the shares. The idea of losing control over who owns their shares doesn’t sit well with most startups, so some companies, such as Zynga, began blocking sales on SecondMarket. (Most options grants give the issuer the right of first refusal or ROFR when an employee wants to sell shares; companies can also deter sales by imposing big fees.)

But lately, SecondMarket has changed its approach. Despite increasing demand from both sellers and buyers—the company completed $100 million in private company stock transactions in 2009 and $400 million in 2010—SecondMarket now says it thinks of stock issuers, the startups themselves, as its core clients. It says it wants to help them set up systems that let employees cash in pre-IPO shares in an orderly way. It calls these systems “controlled liquidity programs.”

“If there is one thing that people don’t understand about SecondMarket, it’s this transition from working on behalf of shareholders to working on behalf of companies,” says Jeff Thomas, a senior vice president who leads business development for SecondMarket’s Private Company Market division in San Francisco. “It’s a strategic decision we’ve made, that for our long-term business model to work we need to work with the issuers to solve a couple of different problems.”

To understand those problems and the solutions SecondMarket is offering, it helps to look first at the history of the company, which started out under the name Restricted Stock Partners. Barry Silbert founded the firm in 2004 after working in the restructuring practice at investment bank Houlihan Lokey, where he had helped to sell off the assets of bankrupt or distressed companies like Enron and US Airways. “Through that experience he decided he wanted to create an online exchange for all of the world’s illiquid assets—anything that wasn’t already traded on an exchange,” says Thomas. “The concept was to match buyers and sellers by running auctions, setting a price, and handling settlements, but in an automated and scalable way.”

The company started off selling restricted stock in public companies (hence its name) and did well enough to attract venture funding from firms like New York’s FirstMark Capital. But its first big break came during the financial downturn in 2008. The company realized it could use its technology to facilitate trades of collateralized debt obligations, or CDOs—the notorious asset class, made of rolled-up mortgages, student loans, and other fixed-income instruments, whose collapse fueled much of the banking crisis. Little information was available about exactly which assets were rolled into most CDOs, so owners were having trouble unloading them. “We stepped into the market to match buyers and sellers,” says Thomas. “A lot of the assets were high quality, but the owners needed liquidity, so they were willing to take a discount. We got a ton of press for that in 2008 and 2009. We were the only financial services company growing through the downturn. That success really allowed us to launch all of our other markets.” The company, which changed its name to SecondMarket in 2008, now trades nine different asset classes including bankruptcy claims, limited-partner interest in private equity funds, and private company stock.

But it wasn’t SecondMarket’s idea to start trading in private company stock. That chain of events started in 2007, when Microsoft invested $240 million in Facebook in a deal that valued the social networking company at $7.5 billion. The deal got some ex-Facebookers thinking more concretely about the value of their own stock, and some of them approached Silbert’s firm. “They said, ‘We see you make a market in restricted stock in public companies. We hold some restricted stock in a private company. Can you help?’” says Thomas. “That motivated us to … Next Page »

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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