As companies stay private longer, especially in the red-hot tech sector, there’s a temptation for executives and employees to want to sell stock and begin to cash out before going public.

Numerous exchanges have cropped up in the past few years to facilitate such sales. These include SecondMarket and SharesPost, which have sold employee or early investor stock to accredited investors. More recently, some exchanges such as EquityZen and Equidate, have put a new spin on the transactions, creating derivative contracts linked to share prices, which allow investors to have a stake in the game, without actually owning shares.

But the Securities and Exchange Commission (SEC) is investigating middleman sales of private shares, primarily by hedge funds and other big investors, as well as investigating derivative sales of stock through these online exchanges, according to a recent Wall Street Journal report. And in June the SEC shut down and fined one such exchange, called Sand Hill, $20,000. So, if you or your employees are involved in such sales, proceed with caution, financial and regulatory experts say.

“A shortcut to the public markets, while appearing attractive, could cost the company offering a security, by causing an investigation,” says John Carney, a partner at law firm BakerHostetler, and a former SEC attorney.

Early investors in Facebook famously drove up its share price on SecondMarket, an Inc. 5000 company, in the years leading up to its 2012 IPO on the NASDAQ. 

Today, Uber is the poster child for staying private longer and collecting venture-capital investment. The car share company, founded in 2009, is valued at an estimated $50 billion, making it the most valuable startup in history. It’s taken in roughly $6 billion in 10 investment rounds, and it's anyone's guess when it will go public. Others include Pinterest, the image-based social media site founded in 2010, which is valued at $11 billion, and has taken in $1.3 billion in six venture-capital rounds. And Snapchat, the disappearing message app valued at $20 billion, which has similarly received $1.2 billion in eight rounds.

Venture-backed companies stayed private on average 7.5 years in 2014, nearly twice as long as they did in 2000, according to the National Venture Capital Association, whose data also show that between 2013 and 2014, venture capital dollars to late-stage companies surged 35 percent to $12.2 billion.

The increasing length of time to an exit event has created a big need for liquidity, says Robert Whitelaw, chairman of the finance department at New York University’s Stern School of Business.

“There is demand on the buy side and the sell side, and I don’t think there is a problem with that,” Whitelaw says. The problem is the lack of transparency in the market for private shares, which the SEC has rightly identified, although it’s perhaps incorrectly using the Dodd-Frank financial regulation reform law to attack the problems, Whitelaw adds.

By some estimates, more than $30 billion in private company shares exchanged hands in 2014.

Still, Dodd-Frank’s provision against unregulated derivatives trading was meant to prevent big structural problems such as those that led to the 2008 mortgage crisis and financial sector meltdown. The secondary market for private company shares does not present such a risk, Whitelaw says. (The SEC declined to comment.)

Nevertheless, in the wake of the financial crisis, Congress did amend securities laws in 2010 to require derivatives to be traded only on national exchanges, and subject to SEC registration statements.

As such, exchanges that facilitate swaps or other derivatives tied to private company shares could be operating in a legal gray zone. And certainly big hedge funds that buy private shares or share options and then resell them to other investors, many of whom are eager to get in on fast-growth companies before they go public, could be operating in even more murky and unregulated territory, financial experts said. So you and your employees could be doing serious danger to your company by engaging in such transactions.

If executives are in a hurry to get cash, for example, they may undervalue their companies. Two executives could conceivably sell shares for different prices, Whitelaw says. And a secondary market for company shares could negatively impact the actual share price, once a company goes public.

Just as important, secondary market sales could launch an expensive and time-consuming SEC investigation down the road.

“Allowing cash-strapped executives to…sell their otherwise restricted shares through an unregulated marketplace can create havoc for the executive and their company,” Carney says.

Published on: Jul 6, 2015