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Private Secondary Markets: Contrast With Listed Company Regulation

(The following post originally appeared on ONSecurities, a top Minnesota legal blog founded by Martin Rosenbaum to address securities, governance and compensation issues facing public companies.)

April 2, 2013

In the emergence of secondary markets for private company stock, the latest development is Nasdaq’s sponsorship of a private secondary market. These markets allow privately held companies (sometimes with hundreds of stockholders) to have the benefits of a liquid market in their securities without subjecting themselves to the restrictions of an exchange listing. At the same time, Nasdaq and the other stock exchanges have been imposing even more governance requirements and restrictions on listed public companies.

Secondary markets for private company stock are not new. SharesPost, Inc. and SecondMarket have been operating online secondary markets that trade in private shares for a few years. Each works with private companies that choose to list on their platforms and want to provide employees, venture backers and other existing shareholders with liquidity opportunities by privately placing their shares with qualified investors. Private resale markets gained popularity with the rise of richly-valued Silicon Valley-based technology companies. Shares of Facebook and LinkedIn were highly sought-after prior to their IPOs and were available in the private secondary market. Currently, eharmony, foursquare, Pinterest, Spotify and tumbler are among the many private companies currently listed on SharesPost’s website and SecondMarket’s website. Start-ups have had much more difficultly going public in recent years. This is a result of a variety of factors, a discussion of which is beyond the scope of this post, but the cost of Sarbanes-Oxley compliance, a recessionary economy and decimalization are often cited. Companies that do go public take more time to do so, which means that private company shareholders (including employees who receive equity as a meaningful portion of their compensation) hold illiquid stakes in companies for a longer period of time. The resulting pent up demand for liquidity presents an opportunity for the private secondary markets.

Most recently, Nasdaq has announced that it is joining forces with SharesPost, Inc. to establish The Nasdaq Private Market, a marketplace for the resale of private stock. According to the press release, the venture “combines NASDAQ OMX's market and operating expertise as well as resources with SharesPost's leading web-based platform.”

Adding to the attractiveness of private secondary markets is the recent easing of registration requirements under The JOBS Act. Prior to its adoption in mid-2012, companies with at least $10 million in assets were required to register under Section12(g) of the Exchange Act if their number of record shareholders expanded beyond 499. This subjected them to the burdensome reporting obligations applicable to public companies, including obligations to file detailed annual and quarterly reports with the SEC. By participating in the private secondary market and expanding their shareholder ranks, companies risked having to register with the SEC before they were ready. Facebook, an active participant in the secondary markets prior to its IPO, fell prey to 500 shareholder rule and was forced to go public in 2012. The JOBS Act increased the shareholder threshold to 2,000 as long as no more than 499 are non-accredited (shareholders who received shares under a company's equity compensation plans and investors who purchased securities pursuant to the crowdfunding exemptions are excluded altogether). Because participants in the private secondary market are accredited investors, there is less risk of over-expanding a company’s shareholder base through trading in the secondary market.

Another reason for companies to stay private for longer is the increasingly more stringent regulation by the SEC (Sarbanes-Oxley) and the national securities exchanges. An example is Nasdaq’s recent proposed new listing standard that will require all companies listed on Nasdaq to establish and maintain an internal audit function. The proposal permits outsourcing of the function to any third party service provider other than the company's independent auditor and charges the audit committee with sole responsibility to oversee the internal audit function. Although many Nasdaq listed companies already have a separate internal audit function, this will certainly add burden and expense to smaller public companies that may not. Yes, the NYSE already has a comparable listing standard in place, however the NYSE is generally considered to be the market for well-established companies that are more likely to have separate internal audit functions in place.

Comment. As it proposes increased regulation of its public securities exchanges, Nasdaq is also recognizing that the securities environment in general (including as a result of its own actions) may be ripe for a rise secondary trading of private company stock. In fact, Nasdaq bet on it when it established the Nasdaq Private Market with SharesPost, as described above. It will be interesting to monitor the progress and success of the joint venture. Is Nasdaq trying to get the best of both worlds? 


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