Dan Primack

The latest on private equity, M&A, deals and movements — from Wall Street to Silicon Valley

4 questions for the secondary markets

May 11, 2011: 9:53 AM ET

Later today I'll be moderating a panel at the Capitalyze conference in San Francisco, which is being organized by SecondMarket. This comes less than 24 hours after rival SharesPost held an its own event in Menlo Park. Some questions after yesterday, and in preparation for today:

1. Incentive to leave: There was lots of talk yesterday about preemptively structuring founder liquidity. For example, letting founders sell 2% or so of their shares on a secondary market once the company hits some sort of financial milestone like cash-flow positive. Maybe make it an annual event. That's all well and good – most interests between entrepreneurs and investors remain aligned – but there is a much larger concern: Are the secondary markets incentivizing lower-level employees to leave? After all, many share restrictions are removed once no longer on a company's payroll – and few companies want to be known as ROFR sticklers (makes it hard to recruit new talent).

2. LP pressure: If I'm a limited partner in VC funds, here would be my question about founder liquidity: "Hey, why don't we get a little too?" Now there obviously are huge differences between a university endowment and a debt-laden 26 year-old hoping to afford a house in the Valley, but that difference is minimized a bit when the entrepreneur is now 30 and has tapped the founder liquidity well more than once. What I'm getting at is the notion that VCs – particularly seed/early-stage VCs – could soon face LP pressure to also liquidate some shares alongside founders.

3. Downside litigation: At some point, the secondary markets are going to produce a large number of lawsuits, possibly class-action ones. Imagine one of the heavily-traded companies goes public at 30% lower than where it traded on the secondary market. And imagine the secondary market sellers were insiders. The buyers may well sue, arguing that the sellers should have known the shares were overvalued (remember, buyers almost never know the actual company financials). I don't think these suits will – or should be – successful (anyone buying without the data should know they're flying blind), but lawyers will line up to bring them. Very rich target, plus some wealthy plaintiffs (by definition)…

4. Setting the bar: When investment banks compete in a bake-off to lead the IPO of a secondary-traded company, are they using the secondary trading values as baselines for what they're promising on the public markets? I can't say, but would imagine they almost have to be. I-bankers are known for blowing smoke on pricing to private company CEOs, and it would be hard to imagine them saying, "I know you're getting $20 billion on the private markets, but I think we can only bring you out at $15 billion."

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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