2 Professor of Business Law, Tilburg Law School, Visiting Professor, Faculty of Law, Kyushu .... perspective on the oper
The “New” Venture Capital Cycle (part I) The Importance of Private Secondary Market Liquidity
Jose M. Mendoza and Erik P.M. Vermeulen
Topics in Corporate Law & Economics 2011-1 Electronic copy available at: http://ssrn.com/abstract=1829835
Abstract This paper demonstrates that liquidity gaps disrupt the venture capital cycle. How should this problem be addressed? We offer a new perspective on the venture capital cycle and argue that the emergence of more liquidity options can bridge these gaps. Analyzing the development of secondary marketplaces for private shares in non-listed companies in the United States and similar initiatives in Europe, Israel and India, this paper makes the case that the development of a structured pre-IPO segment in stock markets can remedy the disruptions in the venture capital industry.
Keywords: venture capital, innovation, entrepreneurship, venture capital cycle, liquidity, stock markets, secondary markets, SecondMarket, SharesPost, IPO, trade sale JEL Classifications: G15, G18, G24, G28, K22
© 2011 Lex Research Ltd
Electronic copy available at: http://ssrn.com/abstract=1829835
The “New” Venture Capital Cycle (part I): The Importance of Private Secondary Market Liquidity Jose Miguel Mendoza1 and Erik P.M. Vermeulen2
1.
Introduction
The dream of a successful initial public offering (IPO) is still one of the most important drivers for innovative entrepreneurs that start their own companies. The IPO is also crucial for venture capitalists that invest in these entrepreneurs, since it provides them with the opportunity to exit their investments and, at the same time, realize strong positive returns. Arguably, IPOs make the venture capital industry tick. To see this, it is important to understand the venture capital cycle.3 It typically starts with the creation of funds that raise capital from both institutional and private investors that are interested in backing innovative start-up companies. The venture capital (VC) funds select promising firms, which they nurture and support by contributing money and services that these companies need to reach the next stage in their development. Ideally, this continues until the moment that the VC funds decide to exit their portfolio companies and reap the fruits of their investments. A significant part of the returns are then distributed back to the initial investors, enabling the restart of a new VC cycle. !
As illustrated by this sequence of events, IPOs are considered as essential to sustain a
robust venture capital industry. To be sure, several other exit mechanisms are available to achieve exits, including trade sales, secondary sales and buy-backs. However, it is widely accepted that VC funds and entrepreneurs have traditionally preferred IPOs.4 Through this route, venture capitalists usually stand to gain the most from liquidating their successful investments. At the same
1
Visiting lecturer, Tilburg Law School and doctoral candidate at the University of Oxford.
2
Professor of Business Law, Tilburg Law School, Visiting Professor, Faculty of Law, Kyushu University, and VicePresident Corporate Legal Department of Philips International B.V. (Corporate and Financial Law Group), The Netherlands. The authors would like to thank Janke Dittmer, Christoph Van der Elst, Adriaan Hendrikse, Joseph McCahery, Theo Raaijmakers, Francisco Reyes, Steven Seuntjens, William Stevens, Diogo Vasconcelos, Dirk Zetzsche, the participants of the Nordic Venture Forum 2010, Copenhagen, Denmark, November 2010, the participants of the European Financial Market in Transition Seminar, Copenhagen, Denmark, November 2010 and the participants of the European Venture Summit 2010, Düsseldorf, Germany, December 2010. A special thank you to Valentine Snijder and Diogo Pereira Nunes for their research assistance. 3
See Paul Gompers and Josh Lerner, The Venture Capital Cycle, Cambridge: The MIT Press, 1999.
4
See Bernard S. Black and Ronald J. Gilson, Venture capital and the structure of capital markets: Banks versus stock markets, (1998) 47 J FINAN ECON 243.
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time, the founders of high growth companies are able to regain control from the venture capitalist over the firm’s affairs following the completion of an IPO.5 !
However, observers familiar with the inner workings of IPO markets claim that the
significant decline in the number of public offerings over the past few years has disrupted the traditional VC model in two respects: (1) a reduction in the number of profitable exits led to lower overall returns for venture capital fund investors and (2) a decrease in the number of listed technology firms disrupted the steady supply of innovative entrepreneurs.6 With this in mind, it is fair to say that the economic downturn has aggravated the conditions in the VC market worldwide.7 The VC cycle is also considered by some to be irreversibly broken due to the slowdown of IPOs, one of its central components.8 This development has also called into question the primacy of the IPO exit strategy. In fact, it is widely accepted that, in a sluggish IPO market, venture capitalists have been able to successfully employ trade sales as their exit route.9 Trade sales have even become the preferred exit option for many firms due to regulatory reasons. Contrary to IPOs, trade sales offer immediate liquidity without onerous lockup periods, costly disclosure requirements and obligations for venture capitalists to maintain board seats.10 Perhaps most importantly, the dominance of trade sales arguably leads to a more sustainable VC cycle. With only the best performing high growth companies being able to afford a listing, the confidence of investors in the IPOs of VC backed firms will likely be restored. !
Although it could be argued that the depressed IPO market of recent years does have
important implications for the VC industry, it is too early to announce the demise of the VC cycle. In this respect, it is promising to see that after two years of stagnation the IPO market rebounded in 2010 and seems to be gaining momentum.11 Does this mean that the VC cycle, as described above, will again follow its traditional pattern? The answer is no.12 In this paper, we offer a new 5
This has led some commentators to postulate the reduced monitoring hypothesis, whereby IPOs are usually underpriced in order to achieve a degree of ownership dispersion that will allow the firm’s incumbent management to retain control after the firm has gone public. See Scott Smart and Chad Zutter, Control as a motivation for underpricing: A comparison of dual and single-class IPOs, (2003) 69 J FINAN ECON 85, 11. 6
See Miguel Helft, A Kink in Venture Capital’s Gold Chain, THE NEW YORK TIMES, 7 October 2006.
7
See Joern Block and Philipp Sandner, What is the effect of the current financial crisis on venture capital financing? Emprirical evidence from US internet start-ups, MPRA Paper No. 14727, April 2009. 8
See Scott Austin, Majority of VCs in Survey Call Industry ‘Broken’, WALL STREET JOURNAL, 29 June 2009.
9
See Georg Rindermann, Venture-backed IPOs on Europe’s new stock markets: Evidence from France, Germany and the U.K., in Giancarlo Giudici and Peter Roosen Boom (eds.), The Rise and Fall of Europe’s New Stock Markets, Amsterdam: Elsevier, 2004. See also Armin Schwienbacher Venture capital investment practices in Europe and the United States, (2008) 22 FINANCIAL MARKETS AND PORTFOLIO MANAGEMENT 3. 10
See Alexander Haislip, Essentials of Venture Capital, Hoboken: John Wiley & Sons, Inc., 2011.
11
See Ernst & Young, Global IPO trends 2010; See also Brian A. Shactman, IPO Surge: 18 companies will price in next two weeks, CNBC STOCK BLOG, 25 January 2011. 12
See for a somewhat different view Steven N. Kaplan and Josh Lerner, It Ain’t Broke: The Past, Present, and Future of Venture Capital, (2010) 22 JOURNAL OF APPLIED CORPORATE FINANCE 36 (arguing that there is little evidence that the VC model has changed or is broken).
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perspective on the operation of the VC cycle in the wake of the financial crisis.13 We show that profound changes in the VC industry, particularly with regard to the timing of trade sales and IPOs, lead to a “new” VC cycle. Section 2 analyzes these changes, along with the factors that have contributed to an increase in the amount of time that elapses between the inception of a firm, the first involvement of VC funds and their eventual exit. Section 3 seeks to identify the ways in which these recent developments have redefined the traditional process of the VC cycle. We observe two main trends. First, as the time between incorporation and venture capitalists’ involvement has increased, new categories of investors such as super-angels and large multinational corporations have stepped up to fill this “investment” gap in the early stages of the cycle.14 Second, the longer exit horizon for the array of investors in high-growth firms (i.e., angels, super-angels, corporations, venture capital funds, founders and key employees) has opened up a “liquidity” gap in the cycle, making it more difficult to align the interests of these investors, who often wish to pursue different exit strategies. Interestingly, this development created space for the emergence of alternative liquidity providers, which arguably provided the venture capital industry with the opportunity to continue to operate smoothly, but differently. Indeed, we observe that in the “new” VC cycle, preIPO “trading” of shares in private secondary markets, such as SecondMarket and SharesPost, supply venture capital investors with the necessary liquidity - and, in many cases, exit routes. Section 3 examines these alternative liquidity options, which are central to the “new” VC cycle. Although we find evidence that the venture capital market is able to adapt itself to changing circumstances, regulators and market participants seem to be wary of the opportunities for error and abuse opened up by these new developments.15 For instance, there is already talk of a new bubble in the venture capital industry, fueled by the trading of shares of high-growth internet firms in the booming private secondary markets.16 In addition, it has been pointed out that the new exit options largely operate in a regulatory fog, opening the door to conflict of interest situations. Indeed, the lack of disclosure and transparency usually result in rising valuations and opportunistic behaviour.17 The fragmentation of the investor base and disorganization in certain parts of the venture industry can only exacerbate these problems. !
Section 4 thus begins to discuss the imperfections of the VC cycle and possible regulatory
solutions. In theory, when a market lacks transparency, it is appropriate for governments to fix the
13
Cf. Richard Wray, Recessions offer fertile ground for technology startups, The Guardian, 9 November 2009.
14
See Janke Dittmer, Jose Miguel Mendoza and Erik P.M. Vermeulen, The “New” venture Capital Cycle (part II): The Emergence of Alternative Investment Options (forthcoming 2011). See also GO4Venture, Monthly European Technology Venture Capital Bulletin, September 2010; Pui-Wing Tam and Spenser E. Ante, ‘Super Angels’ Alight, WALL STREET JOURNAL, 16 August 2010. 15
See David Gelles, SEC concern at tech stock frauds, FINANCIAL TIMES, 31 December 2010.
16
See Brad Stone, Silicon Valley Cashes Out Selling Private Shares, BLOOMBERG BUSINESSWEEK, 21 April 2011.
17
See, for instance, Kathrin Hille and Lina Saigol, Renren’s valuation for IPO questioned, FINANCIAL TIMES, 29 April 2011.
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problem by introducing more regulation. In practice, however, this approach will most probably disrupt the VC cycle, thereby discouraging entrepreneurship and innovation. Instead of regulation, we offer more nuanced policy recommendations that could potentially align the incentives of the players in the industry and encourage the smooth transition to a resilient and sustainable venture capital ecosystem. We suggest that governments, securities regulators and stock exchanges should work together with the VC industry to develop a marketplace in which the various players in the VC cycle can get more connected and engaged. Such a marketplace, which arguably bridge the gaps in the traditional VC cycle, is crucial to kickstart the venture capital industry and promote entrepreneurial activity. Recent developments in India and Israel seem to support this view. Finally, section 4 assesses whether similar initiatives could eventually lead to a sustainable VC cycle in Europe. Section 5 concludes.
2.
A new equilibrium in the market for exits
It has been argued that the sudden paucity of VC-backed flotations ushered in a new era of venture capital financing.18 In this altered world, trade sales are the most important and even preferable exit vehicles for venture capitalists (see Figure 1). Even though we can see a revival in the global IPO market starting in 2010, it seems hard to believe that going public will recover its traditional allure. Yet, our basic claim here is that the recent data from the United States seems to indicate that a new equilibrium is emerging in which IPOs are available only to the best performing and most promising companies that have the ability to grow very quickly into world market leaders (see Figure 2).19 Consider the case of Groupon, a rising star that purveys online discounts from local businesses. In November 2010, Google offered to acquire this high-growth company for the astonishing price of US$ 6 billion. But Groupon spurned the deal and set its eyes on an initial public offering, because its founder was not convinced of Google’s ability to develop the company to its full potential.20 Of course, Groupon’s decisions is heralded by stock markets that actively seek to lure listings from high tech and innovative companies. In the aftermath of the economic downturn, NASDAQ already secured listings from Skype, an internet communications company, and Kayak, a travel search engine, whose IPOs are scheduled to take place in 2011.21 The surge in VC-backed IPOs will undoubtedly rekindle the competition among stock exchanges to attract
18
See James Mawson, VCs fear ‘permanent’ change, Global Corporate Venturing (www.globalcorporate venturing.com), 15 October 2010. 19
See David Zax, Facebook, Groupon, LinkedIn, and Zybga: When an IPO is like a Bar Mitzvah, Fast Company, 10 January 2011. 20
See Paul Smalera, Google’s Groupon groping reveals the shift in power in the web world, CNNMoney.com, 4 december 2010. 21
See Spencer E. Ante and Anupreeta Das, Skype IPO to wait until later this year, WALL STREET JOURNAL, 27 January 2011.
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more companies.22 Moreover, it is only expected that in their continuous efforts to create a robust venture capital industry, many jurisdictions will again start discussions to emulate US stock exchanges. This is not a new phenomenon.
!
Over the past two decades, there has been an increase of market venues designed to
facilitate exit by venture capital investors around the world. Under substantial pressure to compete with the United States, these markets initially sought to attract high growth firms in their jurisdictions by mimicking NASDAQ’s model.23 For instance, Eastern Asian countries set up segments such as KOSDAQ (South Korea) and JASDAQ (Japan),24 which were designed to replicate NASDAQ’s success. The pan-European stock exchange, EASDAQ, is yet another
22
See David Gelles, NYSE woos Silicon Valley to catch next wave of listings, FINANCIAL TIMES, 23 January 2011.
23 See John C. Coffee, The future as history: The prospect for global convergence in corporate governance and its implications, (1999) 93 NORTHWESTERN UNIVERSITY LAW REVIEW 641. 24
JASDAQ, initially launched in 1949, was for many years confined to the operation of Japanese the over-the-counter trading market. After its 2004 reorganization as a securities exchange, JASDAQ shifted its focus towards high-growth Japanese firms that intended to raise outside equity. Since that time, JASDAQ has repeatedly surpassed its main competitor -the Tokyo Stock Exchange- by number of yearly initial public offerings. Now controlled by the Osaka Stock Exchange, JASDAQ boasts over 926 listed firms and a large share of the country’s IPO market. See Overview of Jasdaq Securities Exchange Inc., Osaka Stock Exchange Ltd., 24 November 2009. Its upcoming merger with the Hercules and NEO listing venues - also controlled by the Osaka Stock Exchange - will create an organization with over 2,000 listed companies. See Ideal Future for the Integration of JASDAQ and Hercules, Osaka Stock Exchange Ltd., 29 October 2009.
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example of an attempt to transplant NASDAQ’s success.25 EU policymakers reacted to the inauguration of EASDAQ by setting up Euro.NM, a network of local growth markets.26 The introduction of new market venues in Europe created an overcrowded marketplace for exchanges specifically designed for high-growth firms. The fierce competition that ensued and external factors, such as the rupturing of the dot com bubble, paved the way for the ultimate failure of the Euro.NM and EASDAQ.27
!
Surprisingly, venture capital funds in the United States increasingly started to use foreign
listing venues - such as AIM in the United Kingdom - to exit their investments after the US IPO
25
EASDAQ, launched in a joint effort by European and US companies, closely followed NASDAQ’s regulatory model and internal structure. This proximity to NASDAQ may have been determinant in the decision of large US investment banks to invest in EASDAQ in 1999. See StevenWeber and Elliot Posner, Creating a pan-european equity market: The origins of EASDAQ, (2000) 7 REVIEW OF INTERNATIONAL POLITICAL ECONOMY 4. However, the creation of this panregional exchange had a bearing on political sensitivities and nationalistic sentiments in Europe, leading to protectionist responses. 26
New markets were set up in countries such as France (Nouveau Marché), Germany (Neuer Markt) and Italy (Nuovo Mercato). 27
Some of the factors that led to the demise of the new markets include increased competition from domestic European exchanges, the inability of the new venues to attract a critical mass of firms and the dot com crash (see Robert Abbanat, A Pan-European Market for Technology Growth Companies, MIT, September 2004.
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market was compromised by a series of uncoordinated regulatory changes dating back to 1997.28 The migration of US high-growth firms has only gained pace after the promulgation of the Sarbanes-Oxley Act (SOX) in 2002, which imposed stiff legal requirements on publicly-held corporations, particularly with regard to their auditing processes (see Figure 3). A study published
in 2008 included compelling evidence showing that SOX had disproportionately affected small US publicly-held firms.29 Because significant costs were imposed on companies that intended to float their shares on US capital markets, AIM, which is based on self-regulation and principle-based rules that allow firms to tailor listing requirements to their specific business needs, quickly became the preferred IPO venue. The decision by US firms to quote on AIM enhanced the reputation of this
28
Such regulatory changes include the Manning Rule and new Order Handling Rules, the repeal of the Glass-Steagall Act and the 2003 Global Settlement Ruling (see David Weild and Edward Kim, Market Structure is Causing the IPO Crisis, Capital Market Series, Grant Thornton, October 2009). 29
Ehud Kamar, Pinar Karaca-Mandic and Eric L. Talley, Going-Private Decisions and the Sarbanes-Oxley Act of 2002: A Cross-Country Analysis, USC Center in Law (Economics & Organization Research Paper No. C06-5 RAND Working Paper WR-300-1-ICJ, 2006).
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market. This not only led companies from other jurisdictions to seek AIM listings, but also encouraged policymakers around the world to adopt the AIM model. 30 !
However, after a brief period of success, the planned IPOs of Skype and Kayak are
indications that AIM’s market share in the post-crisis exit equilibrium is decreasing.31 This trend is accelerated by more and more companies planning a move to NASDAQ and delisting from AIM.32 The decision of these companies is driven by a NASDAQ listing being more beneficial in terms of (1) attracting additional capital, (2) providing more liquidity to investors and (3) improving the firm’s reputation as a successful high tech company. Naturally, some time before the financial crisis, NASDAQ had already matured into a senior market for companies with a higher market capitalization (see Figure 4), leaving AIM to offer exit opportunities for smaller firms that were unable to access NASDAQ. However, in the new exit market equilibrium, not even AIM’s potential role as a springboard for smaller firms may not hold. First, as discussed above, the global decline in the appetite for stock market products has made the IPO an exclusive exit option for large high growth firms that can afford the high listing costs. Second, the mismatch between AIM’s companies and the venue’s pool of investors, which are generally more interested in profit generation than revenue growth, makes this exit venue less attractive for venture capitalists and high growth companies.33 Finally, the best performing high-growth companies usually prefer to extend their reliance on private investment holdings for as long as possible before making the “irreversible” decision to go public.34 !
What is more, the new equilibrium in the exit market, which is generally characterized by an
increasing time to liquidity (see Figure 5) and a high expected rate of return, has resulted in a decrease in the number of venture capital funds. Institutional and other investors in the United States are pouring money in fewer, higher quality funds, such as Bessemer (which recently closed a $1.6 billion fund), Sequoia’s new $1.3 billion fund and Greylock’s new $1 billion fund. Surprisingly, early-stage funds were able to attract $3.9 billion of the $7.7 billion that was raised in
30
215 firms incorporated in countries other than the UK and the US were listed on AIM as of March 2010. However, according to the London Stock Exchange’s alternative measure, 437 AIM firms generate most of their revenue outside the UK and the US (see London Stock Exchange, AIM statistics, March 2010). Also, AIM’s thriving success and distinctive features inspired the creation of the Irish Enterprise Exchange in April 2005, with Euronext and Deutsche Börse quickly following suit by launching the Alternext market and the Entry Standard segment respectively. 31
Although close to 70 US firms had listed on AIM as of December 2007, this number decreased to 25 in March 2010, after the full force of the financial crisis had hit global markets. However, as of the latter date, 55 AIM firms still generated most of their revenues in the US. This alternative measure (i.e. taking into account the country of operation instead of the place of incorporation) is used by the London Stock Exchange to reflect the fact that many non-UK firms incorporate a UK holding company before seeking an AIM listing (see AIM statistics, March 2010, London Stock Exchange and AIM: Adapting to Change, Capital Markets Guide, 2009, Grant Thornton). 32
See David Blackwell, AIM technology companies look at Nasdaq, 2 February 2011. See also CBaySystems Holdings Limited, Notice of General Meeting (on file with the authors). 33
See PriceWaterhouseCoopers, Securing AIM’s future, 2010.
34
See, for instance, Barry Silbert (SecondMarket) at the “Where is the Money?” panel at the DLD11 conference, 25 January 2011.
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the first quarter of 2011.35 Still, venture capital funds are adopting new investment strategies in order to increase their performance and, more importantly, to improve the returns to their limited partners. Currently, VC funds tend to avoid risky investments in “capital intensive” and “longer-tomaturity” start-up companies.36 Since IPOs have become generally unavailable as an exit strategy for the majority of high-growth firms, VC funds have generally become more conservative and riskaverse. This moved them towards the financing of already profitable later stage companies and companies founded by so-called serial entrepreneurs with considerable track records.37 Furthermore, since trade sales have become the dominant and preferred exit mechanism, VC funds started to realize that they need to prepare most of their portfolio companies for an acquisition by a strategic corporate investor, thereby increasing the probability of a successful exit and attracting the interest of institutional investors. The new strategy pursued by VC funds is
35
See TechCrunch, US Venture Funds Raised $7.7 Billion In First Quarter, Highest Influx in a Decade, 11 April 2011.
36
See PriceWaterhouseCoopers, The exit slowdown and the new venture capital landscape, 2008.
37
See Pui-Wing Tam and Amir Efrati, Web Start-Ups Get Upper Hand Over Investors, VC Firms Drive Up Valuations, Attach Fewer Strings to Deals, WALL STREET JOURNAL, 10 March 2011.
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reflected in Figure 5: By initially focusing on a trade sale, portfolio companies will be ready for an exit scenario earlier than in the event of an IPO, which currently takes close to nine years.38
!
Even though venture capitalists have been able to design strategies that match the new exit
equilibrium, certain gaps have appeared in the traditional VC cycle. First, the low number of venture capital firms and their propensity to move to the mid to later stages of funding creates a gap in the seed and early years of a firm’s development. Second, even if certain investors are willing to pour money in early stage start-ups - solving the investment gap for innovative companies - they meet another obstacle tied to the long exit horizons mentioned earlier: a liquidity gap. Obviously, this gap could discourage early stage investors and entrepreneurs from making the necessary investments in start-ups. In order to ensure a steady flow of entrepreneurs and capital support, new liquidity options are required to support the VC cycle. In the next section, we will first analyze the market based reactions to the investment and liquidity gaps discussed above. As we will see, the VC market appears to have adjusted to these developments, as illustrated by the rise of online private secondary exchanges. Yet, as our analysis shows, there is also an important role to be played by governments and stock exchanges. Rather than directly emulating
38
However, the trade sale exit takes still considerably longer than the exit scenarios of the booming years of venture capital. In 2000, an IPO or trade sale were pursued after 3 years (see Figure 5).
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the NASDAQ (or AIM) formula, they should support, facilitate or even spur these new initiatives to address the problems described here. More direct intervention is only warranted if the market has not already stepped in to fill the gaps. We take a closer look at possible governmental actions in Section 4.
3.
The rise of alternative liquidity options
3.1!
The need for pre-IPO liquidity
Mark G. Heesen, president of the National Venture Capital Association (NVCA) famously observed in 2004 that, for the venture capital industry, ‘liquidity is king’.39 Of course, Mr. Heesen’s remark simply reflects the insights gained during the industry’s decades-long experiment in funding and nurturing start-up companies. For reasons we have discussed, investors place a high value on the liquidity that can be obtained when exiting a firm in their portfolios.40 This holds true for the many different parties that hold stakes in high growth companies, from founders to venture capital fund investors. The availability of a secure exit strategy is of such importance that it can make or break the commitment of prospective investors to contribute human and capital resources to a fledging enterprise. This explains why the liquidity crisis of recent years is seen as a serious threat to the venture capital cycle. !
In addition, it is reasonable to assume that the lack of liquidity can also hamper the interest
of “new” investors in the venture capital industry. Tow examples bear out this point. First, the investment strategy of super angels, the new kids on the block of venture capital financing, hints at the importance of reliable and alternative exit options. Super angels are funds managed by former entrepreneurs who usually contribute a significant amount of capital to start their own fund. These funds employ a “spray and pray” strategy by making a large number of small investments in seed or early stage companies.41 Since super angels prefer to exit their portfolio companies in four years or less, the liquidity gap and the fragmentation among risk capital investors encourages them to sell and divest to large corporations even if the portfolio company is still in its early stage (even before it has been able to develop a market). To be sure, much of the time, start-up companies will eventually be acquired by large corporations with a strategic interest in these firms. Sometimes, however, follow-on investments by VC funds or even corporate venture capitalists may be crucial for start-ups to reach their full potential, particularly if early corporate acquisitions prevent the
39
See Jeanne Metzger and Joshua Radler, Venture-backed M&A valuations rose sharply in Q1-2004, THOMSON VENTURE ECONOMICS - NVCA, 10 May 2004. Mr. Heesen also believes that pre-IPO liquidity is needed: “Given the length of time it takes for a venture-backed company to go public or get acquired, we continue to support proposals that allow private companies to have better access to temporary liquidity as they approach an ultimate exit”. See Venture Industry Cool to Easing Rules on Private Company Stock, WSJ BLOGS, 11 April 2011. 40 41
See Gordon Smith, The exit structure of venture capital, (2005) 53 UCLA L REV 53. See Internet start-ups, Another Bubble?, THE ECONOMIST, 18 December 2010.
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emergence of the next Apple or Google. This would, of course, be preferable from an innovation and economic growth perspective. In this respect, alternative liquidity options can arguably play an important role in enhancing the strategies of super angels strategies in the new venture capital cycle. !
We can sketch a similar picture for corporate venture capital initiatives, which feature in our
second example. The involvement of large corporations in the later stages of the VC cycle is not new. In the booming years of the venture capital industry around the turn of the 21st century, corporate venture capital generally had a strong exploitative focus on generating financial returns through sharing in the profits attached to successful venture capital exits. The dot.com bubble together with the unclear scope and directions of the initiatives expectedly resulted in a short-lived interest in corporate venture capital activities. But corporate venture capital involvement never disappeared completely. Instead, the scope of corporate venture capital investments gradually moved towards a more explorative and strategic engagement with portfolio companies. The surprising fact is that in the aftermath of the financial crisis, corporate venture capital units are increasingly interested in seed and first rounds of investments without the prospect of an exit scenario. The corporations’ early involvement in a start-up can be explained in terms of an increased pressure on their innovation efforts.42 Indeed, an emphasis on “open innovation” encourages multinational corporations to get more creative in attracting and integrating the best outside innovations. Yet, some caution is necessary: corporate venture capital investments, which ex post may lead to the development of non-core technologies, may result in management pulling the plug on corporate venture capital initiatives if exit strategies are not available. !
As mentioned above, however, perhaps the biggest challenge for the VC industry is to
provide the necessary incentives for the potential founders and key employees to engage in new ventures. In the context of venture-capital backed companies, it is not uncommon for the founders and key employees to own a minority equity interest. This commonplace equity picture raises questions about the rights of minority shareholders, For instance, are minority shareholders bound by the actions and decisions of the controlling investors? Are current and former employees who still own shares in the company always entitled to obtain detailed information about the company’s affairs? Or, in the event of a merger under Delaware law, do the minority shareholders have to accept the actions of a shareholders’ representative appointed by the majority owners of the company?43 Under the traditional VC cycle, venture capitalists bargain explicitly for convertible preferred stock with its attached control and information rights to protect their investments against the downside risk.44 The exit through an IPO allowed the investors and the entrepreneurs to enter 42
See Joseph A. McCahery and Erik P.M. Vermeulen, Venture capital beyond the financial crisis: how corporate venturing bootsts new entrepreneurial clusters (and assists governments in their innovation efforts), (2010) 5 CAPITAL MARKETS LAW JOURNAL 452. 43
See C.A. No. 5074-VCL (Del Ch. 20 September 2010) Aveta Inc. v. Cavallieri.
44
See Paul Gompers and Josh Lerner, The Venture Capital Cycle, Cambridge: The MIT Press, 1999.
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into an implicit contract for control. In practice, this entails that besides capital and value-added services, the founders of VC-backed companies acquired a call-option on future control, which could be exercised “simply” by demanding an IPO. The entrepreneurs will thus only be able to regain control if an IPO turned out to be feasible. Clearly, under the operation of the new VC cycle, with its preference for trade sale exits, the implicit contract is not widely available anymore. Of course, entrepreneurs and key employees will usually be able to co-sell their shares in lucrative trade sales - the tech savvy and wealthy acquirers are even inclined to overpay for these start-ups in order to be able to own the Next Big Thing.45 However, the extended exit horizon - and its delayed cash out event - potentially discourages entrepreneurship. The fact that a former Facebook employee approached SecondMarket in 2008, a company that offered a marketplace for classes of stock in public companies and assets of defunct companies that could not be sold on the public market, to assist him in selling his stock options is indicative of the lack of liquidity options (see Figure 6).46
!
Bearing in mind the problems faced by investors, founders and employees of start-up firms,
it is fair to say that the rise of online exchanges for secondary trading in private company stock 45
See Internet start-ups, Another bubble?, THE ECONOMIST, 18 December 2010.
46
See Kevin Kelleher, The SEC’s challenge in the secondary market, CNNMoney.com, 4 January 2011.
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should be heralded as a positive development for the VC industry. The growth of these venues during the most recent financial crisis is a sign that the market has provided a solution to the problem of declining liquidity in the VC cycle. As the time from inception to exit from in high growth firms extended gradually, online exchanges for secondary trading in private company stock emerged to fill the liquidity gap.47 These online marketplaces seek to profit by helping investors to cash out of their illiquid positions in VC-backed firms that could be years away from a trade sale or an IPO.48 Venues of this nature also command significant attention from potential investors, as they offer the supply side of the venture capital market the chance to buy into firms in high demand, such as Facebook, Groupon and Twitter.49 It should be noted, however, that the increasing trading activity channeled through these online platforms has even raised concerns at the Securities and Exchange Commission, who decided to start a formal inquiry into this growing industry in the beginning of 2011.50 !
Of course, it has always been possible to buy shares in unlisted firms through ad hoc
transactions brokered with potential sellers. Interested investors could also buy into stock of private companies by investing in special purpose vehicles created to purchase shares of fast growing high tech companies. Furthermore, it is possible to buy illiquid shares through brokerage firms that operate in over-the-counter (OTC) markets. In the United States, OTC transactions can be carried out through electronic quotation venues such as the Over-the-Counter Bulletin Board (OTCBB) or the ‘Pink Sheets’ system (referring to the color of paper the quotations were printed on).51 However, this OTC market mainly deals in low-grade securities issued by firms in economic distress or ‘microcap’ issues that fail to qualify for a regular listing in a stock exchange.52 Most of the shares traded in these OTC markets are of such low value - ‘penny stock’, shares trading under US $1 each, are common here - that they have become the target of spammers and fraudsters bent on swindling the uninformed public.53 In stark contrast, the new online exchanges we study in this section are mainly focused on VC-backed high-potential firms that, for a variety of
47
See David Marcus, Liquidity now, THE DEAL MAGAZINE, 21 January 2011.
48
The market for shares in private firms was worth $2.4 billion in 2010 and recent forecasts suggest that it might grow by 50% during 2011. See David Gelles, Approval for Xpert to deal in private company shares, FINANCIAL TIMES, 3 January 2011. 49
See Julianne Pepitone, Secondmarket trading doubles in private company stock, CNN MONEY, 22 January 2011.
50
See Dan Primack, Secondmarket has gotten SEC inquiry, FORTUNE, 3 January 2011.
51
See Brian J. Bushee and Christian Leuz, Economic consequences of SEC disclosure regulation: Evidence from the OTC Bulletin Board, (2005) 39 J ACCOUNTING ECON 2. 52
However, OTC markets also quote liquid and highly valuable securities issued by foreign firms that cross-list into the US through an ADR program, who do not want to incur in the costs of accessing venues such as the NYSE or NASDAQ. See Nicolas Bollen and William Christie, Market microstructure of the Pink Sheets, Vanderbilt University Working Paper, 2007. 53
See Laura Frieder and Jonathan Zittrain, Spam works: Evidence from stock trouts and corresponding market activity, Harvard Public Law Working Paper No. 135/2007.
14
reasons, have not yet decided to undergo an IPO or a trade sale,54 but needed “public” liquidity.55 In fact, close to 95% of the firms whose shares are traded in SecondMarket, possibly the largest of the online exchanges, are based in Silicon Valley.56 !
By matching sellers of shares in VC-backed firms with multiple potential buyers, these
exchanges have created a space for trading in an asset class that would otherwise be highly illiquid. Before turning to this issue, however, we must note that online exchanges are not the only solution to the liquidity gap faced by investors in VC-backed firms. For instance, an increasing number of entrepreneurs are in fact making use of “venture capital equity exchange funds” to obtain some liquidity before a firm reaches the exit stage of the VC cycle. The Founders Club, which operates these funds, allows the founders and CEOs of promising start-ups to swap a portion of their future firm-related payouts for immediate liquidity. These individuals pledge a percentage of the cash flows they will receive after an IPO or a trade sale and, in return, become limited partners in a fund operated by the Founders Club.57 After an exit event has taken place, the moneys paid into the fund will be immediately distributed among its investors.58 !
The Founders Club takes up cash flow pledges in firms that are at different growth stages,
which is meant to ensure a uniform degree of distributions over a fund’s lifetime. In this way, the individuals that invest in one of these funds may be better able to meet their specific liquidity demands. This also allows them to achieve a measure of portfolio diversification, as their payout will be tied to the future prospects of several enterprises operating in different industries, instead of just one firm in a single sector.59 However, gaining admittance to the Founders Club is not an easy task. The invitation-only admission process is conducted by a committee of prominent venture capitalists from around the world.60 Moreover, only an exclusive set of investors are allowed to participate in the creation of a fund. 61 This means, of course, that key employees and small investors may not, for the time being, use the Club’s funds in order to satisfy their liquidity needs. 54
See Sarah Lacy, Back off SEC: Let’s put the ‘risk’ of secondary markets in perspective’, TECHCRUNCH, 29 December 2010. 55
See Brad Stone, Silicon Valley Cashes Out Selling Private Shares, BLOOMBERG BUSINESSWEEK, 21 April 2011.
56
See SecondMarket, Private Company Report, Q4 2010, available at http://www.secondmarket.com/pdf/documents/ secondmarket-q4-2010-pcm-report.pdf 57
See The Founders Club, The Founders Club opens its doors to VC backed entrepreneurs in France, Press Release, 19 January 2010. 58
See Maija Palmer, Entrepreneurs launch fund, FINANCIAL TIMES, 10 December 2009.
59
Each of the fund’s operated by the Founders Club is made up of ‘20-30 high potential venture backed portfolio companies’. See Meritage Funds, The Founders Club launches in the US with participation by Meritage Funds partners, Press Release, 25 October 2010. 60
See James Hurley, Equity ‘swap shop’ spreads risk for venture-backed firms, The Daily Telegraph, 10 September 2010. 61
The funds are usually open for ‘serial entrepreneurs, renowned CEOs, VCs and fund of fund VCs and pension fund bosses in the US, UK, France, Germany and Switzerland’. See The Founders Club, The Founders Club completes angel funding for equity exchange fund, Press Release, 1 september 2010.
15
Still, the Founders Club is an elegant solution to the problem of liquidity for the individuals that have access to it. Since these funds rely on cash flow pledges instead of share transfers, many of the problems associated with secondary trading in online exchanges disappear. Perhaps more importantly, the Founders Club provides access to a multinational network of industry professionals, which may foster a useful exchange of ideas and investment opportunities.62 In this respect, this initiative tries to solve liquidity and fragmentation issues faced by the players in the venture capital ecosystem, a goal that is also sought after by the online private secondary exchanges that are discussed in the next section.
3.2!
The online private secondary exchanges
In general, the online markets for secondary trading in the shares of non-listed, high technology companies may be seen as an essential ingredient of the new venture capital cycle. Without sufficiently clear options to exit from portfolio firms, it would be difficult to align the interests of the entrepreneurs and those who invest in a company during the different stages of its development. Although IPOs and trade sales - even with their recently extended time horizons - often provide a suitable exit for late stage investors, players who entered at a previous phase may prefer to have more liquidity options earlier in the cycle. as we have seen, this is mostly the case of seed investors, key employees and, in some cases, the firm’s founders. Also, early stage venture capital funds and strategic corporate investors may desire to pursue an early exit from a portfolio firm in order to comply with their own strategic or financial targets.63 It follows that online exchanges of the kind described here, which cater to the liquidity needs of these different “investors”, fulfill a crucial role in supporting the venture capital cycle.64 For this reason, we briefly look below at the main participants in this expanding industry.
62
See GrowthBusiness, Dealmakers club together, 10 February 2010.
63
Venture Capital funds with Series A shares have been known to use these secondary markets to gain some liquidity before an exit event. See Russell Garland, Secondary marketplaces showing signs of finding their niche, FIRSTMARK CAPITAL, 12 May 2010. 64
It should be noted that, as these private secondary markets are relevant mostly to certain players in the venture capital market, their operation can be quite different to that of regular stock exchanges. Commentators have in fact pointed out that liquidity volumes are not significant within these private markets (see John C. Coffee’s Jr’s remarks in R Teitelbaum, Facebook Drives SecondMarket Broking $1Billion Private Shares, Bloomberg Markets Magazine, 27 April 2011). Although it is certainly true that trading volumes in private secondary markets are much lower than in traditional public exchanges, the level of trading can still be adequately matched to the specific function that these private markets perform in the venture capital cycle by supplying some pre-IPO liquidity for the investors, founders and employees of high-growth firms.
16
3.2.1! SecondMarket Perhaps the most well-known online exchange for shares in private firms is the New York-based SecondMarket,65 which rose to prominence after becoming the main platform for trading shares in Facebook.66 The sellers of shares traded in SecondMarket are mainly the former and current employees of firms, with founders also unloading their stock from time to time (see Figure 7).67
Most of these transactions involve the sale of partial positions held by these individuals, which allows them to obtain a measure of liquidity without losing the chance to participate in a future IPO or a sale to a corporate acquirer. 68 On the opposite side, demand is driven mainly by venture
65
Although SecondMarket’s marketplace for shares in private firms was only set up in 2009, the firm has been trading illiquid assets since 2004. Its ‘Private Company Stock’ division has already enabled transactions worth more than US $500 million. See SecondMarket, Private Company Report, Q4 2010, available at http://www.secondmarket.com/pdf/ documents/secondmarket-q4-2010-pcm-report.pdf 66
In the last quarter of 2010, Facebook deals accounted for 39% of SecondMarket’s share-trading business. See Garett Sloane, Facebook makes SecondMarket first rate, NEW YORK POST, 21 January 2011. 67
It is also relevant to note that transactions carried out through SecondMarket must be valued at a minimum of US $25.000, for which the exchange charges a fee that ranges from 3% 5%, depending of the amount of the deal. See David Marcus, Liquidity Now, THE DEAL MAGAZINE, 21 January 2011. 68
See Ryan Kim, The secondary market is hot, hot, hot, GIGAOM, 21 January 2011.
17
capital funds, who execute almost half of the trades, as well as by accredited individuals, institutional investors and hedge funds (see Figure 8).
!
SecondMarket deals in transactions that are not subject to registration with the Securities
and Exchange Commission (SEC) under an exemption inferred from the provisions of the Securities Act of 1933 known as Section 4(1-1/2).69 In order to make use of this exemption, SecondMarket ensures that (1) the prospective buyer is sophisticated and able to bear any economic loss related to the investment and (2) the purchaser understands and acknowledges the resale restrictions that must be respected in order to fall under the registration exemption. The operation of SecondMarket is also conducted under the safe harbor provided by Rules 144 and 144A of the Securities Act, which relate to the resale of restricted or control securities.70 Under Rule 144A, resales of these securities will not require SEC registration if the purchaser is considered to be a “qualified institutional buyer” or “QIB”, which is an institution that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of non69
“Section 4 1 1/2” is a legal construction based on Sections 4(1) and 4(2) and Rule 144 (and 144A) of the Securities Act of 1933, which exempts from SEC registration those private share placements in which the seller is not the firm that issued the securities. 70
For a detailed explanation of what constitutes a restricted or contorl security, see Section 144 (3) of the Securities Act of 1933. The SEC adopted Rule 144 to clarify the exemption conditions under Sections 4(1) and (2) of the Securities Act of 1933. See Jim Bartos, United States Securities Law: A Practical Guide, Kluwer Law International, 2006.
18
affiliated entities.71 Rule 144 allows the resale of restricted and control securities under certain conditions, including a one year holding period. This requirement usually does not create any barriers, since there is a tendency for the demand side of SecondMarket to be composed mostly of later stage investors that intend to hold on to the acquired shares until the traditional IPO or trade sale exit.72 !
In addition to these regulatory issues, SecondMarket or their affiliated broker-dealer checks
and verifies whether there are any contractual restrictions on the transfer of the shares. For instance, venture capitalists usually avail themselves of rights of first refusal, which entitle them to purchase new shares or acquire stock owned by the selling shareholders. In order to close a secondary sale transaction with a third party, these rights of first refusal should be waived or given the time to expire. Another contractual barrier is formed by the co-sale agreements giving other shareholders the right to sell their shares alongside the initial seller to the acquirer. As time is an important factor for buyers and sellers of shares in SecondMarket, the venue’s legal and compliance team must quickly and diligently screen and analyze the contractual restrictions, which also facilitates the disclosure of existing restrictions to potential buyers. Finally, SecondMarket has procedures in place to process the actual transactions, i.e., the signing and execution of the share purchase and other agreements. The process is depicted in Figure 9.
3.2.2! SharesPost In the context of processing the transactions in online private secondary markets, SharesPost, a competitor of SecondMarket, simply offers its members templates of purchase agreements for use on its online bulletin board marketplace. This California-based venue already matches buyers and sellers of stock in over 100 VC-backed private firms.73 In close resemblance to SecondMarket, SharesPost started operations in 2009 with the specific aim of dealing with “the lack of market liquidity for private company shares”.74 Even though the exchange does not disclose much information about its performance, it appears to have taken over a considerable share of the market for shares in private companies.75 The company’s online bulletin board service has over 50,000 registered users, who have access to reports prepared on the finances and operations of the high growth firms whose stock is traded on SharesPost.76 It should be emphasized, however, 71
To post a bid for shares offers through SecondMarket, potential buyers must qualify as either Accredited Investors (Cfr. Rule 501 of Regulation of the Securities Act of 1933), Qualified Purchasers (Cfr. Section 2(a)(51)(A) of the Investment Company Act of 1940 or Qualified Institutional Buyers (Cfr. Rule 144A of the Securities Act 1933). 72
See Darian M. Ibrahim, The New Exit in Venture Capital, University of Wisconsin Law School, Legal Studies Research paper Series Paper No. 1137, 2010. 73
See http://www.sharespost.com
74
See Adam Piore, Tech bubble grows fast on Sharespost, INSIDE INVESTOR RELATIONS, 13 January 2011.
75
See Sarah Morgan, The other stock market: Trading private shares, SMARTMONEY, 13 January 2011.
76
See SharesPost to post first report on Groupon’s estimated valuation, BUSINESSWIRE, 2 February 2011.
19
that this information is mainly gathered from third party sources. Clearly, since the participants that engage in the secondary sales process, i.e., the seller, the buyer and the company, are usually loath to disclose financial and strategic information of private and confidential nature, trading may be prone to error and misrepresentation. It is not surprising therefore that the online marketplaces admit that they would benefit from more disclosure and transparency. SharesPost addressed these concerns by launching and developing the “Venture-Backed Index” that seeks to provide investors, advisors and companies with a benchmark for the appraisal of high tech companies. It is a modified market capitalization weighted index to provide investors a single reference point from multiple sources of information that have an impact on the value of a company. The SharesPost Venture-Backed Index is the average valuation of a company based on recent - less than 120 days old - information about (1) the transactions in the company’s shares, (2) the posted interest for future transactions, (3) the valuations as reflected in research reports and (4) pre-money valuations in venture capital financing rounds.
!
The Venture-Backed Index can be an important tool for the different parties that deal in
SharesPost and other private secondary markets. Consider the case of Facebook. Initially traded on SecondMarket at an implied valuation of $14 billion in January 2010, Facebook’s value had reached $56 billion by December 2010, as per transactions carried out on SharesPost (see Figure 20
10). The latest SecondMarket trades were executed at an implied valuation of $67.5 billion, an almost 5X increase in value in little more than a year. Although it is still too early to conclude that
Facebook is overvalued, tools such as SharesPost’s Venture-Backed Index provides a means to determine a more accurate value of Facebook.77 For instance, a recent transaction involving Facebook shares on SharesPost implied a valuation of $76.3 billion. However, according to (1) posted indications of interest for future transactions and (2) other research reports, the value was $73.1 billion and $13.6 billion respectively in April 2011. The different valuations resulted in a
77
See Alexei Oreskovic, Facebook ignites Bubble 2.0 chatter, REUTERS, 6 January 2011.
21
SharesPost Venture-Backed Index Value of $54.3 billion, which brought the valuation much closer to Goldman Sachs valuation of $50 billion in January 2011.78
3.2.3! Myths and facts about private secondary exchanges It follows from the above discussion that the use of online exchanges as an outlet for trading shares in closely-held firms is not free from controversy. As we have seen, concerns have been raised about the lack of sufficient information regarding the companies whose stock is negotiated through these venues. As private firms have no obligation to make public disclosures under US law, many doubt the accuracy of the valuations used to determine the price of transactions in SecondMarket and SharesPost.79 The introduction of SharesPost’s Index or the virtual data rooms set up by these exchanges to disseminate information have not been enough to quell the unrest,80 as rumors of an expanding tech bubble continue to spread.81 Recall, however, that the buyers of shares on these private secondary marketplaces are not ordinary retail investors, but rather sophisticated players with prior and detailed knowledge of firms’ activities. These senior investors can arguably protect themselves from abuse without any assistance from mandatory disclosure rules or governmental supervision. Still, the SEC’s inquiry into SecondMarket, launched early in 2011, suggests that policymakers and regulators struggle with the potential consequences of an increasing number of transactions being channeled through these markets.82 This inquiry could lead to either more relaxed and modernized regulations - if the SEC believes that initiatives like
78
The increasing attention given to private secondary exchanges is also exemplified by Xpert Financial, a more recent entrant to the market. Xpert Financial was the first exchange to obtain authorization from the SEC to operate as an alternative trading system. See Michael J. McFarlin, Private stock goes electronic, FUTURES MAGAZINE, 1 February 2011. This exchange seeks to capture a portion of the growing market for private shares by offering automated trading through its electronic platform. See David Gelles, Approval for Xpert to deal in private company shares, FINANCIAL TIMES, 3 January 2011. Gate Technologies is also seeking to compete in this market by setting up an electronic platform for secondary trading in shares. While SecondMarket and Sharespost rely on ‘privately managed auctions, brokerages and trading specialists’ Gate and Xpert are betting on ‘end-to-end electronic trading platforms’. See Ben Popper, Gate Technologies expands, challenges SecondMarket’s model, THE OBSERVER, 9 February 2011. Another interesting development concerns the recent formation of NeXt BDC Capital Corp, a closed-end fund that will invest in the shares of private firms through exchanges such as SecondMarket, SharesPost and Xpert Financial. As described in its registration statement before the SEC, NeXT’s primary business strategy is to ‘utilize such private secondary markets as a principal means to acquire equity investments in privately-held companies that meet our investment criteria and that we believe are attractive candidates for investment’. See Form N-2, filed on 7 January 2011, available at http://www.sec.gov/ edgar.shtml. NeXt BDC intends to carry out an IPO which, if successful, will expand the number of investors with indirect access to equity stakes in high growth firms. See Nadia Damouni, IPO filed for secondary market investment fund, REUTERS, 10 January 2011. 79
See Ari Levy and Brian Womack, Facebook, Twitter valuations fuel trading surge to $7 billion, BLOOMBERG, 2 February 2011. 80
For example, SecondMarket allows firms to determine who can buy or sell their shares. In return, firms agree to disclose relevant information that is passed on to SecondMarket’s investors through its virtual data rooms. See Kevin Kelleher, The SEC’s challenge in the secondary market, FORTUNE, 4 January 2011. 81
See Dean Takahashi, Can there be a tech bubble without an IPO frenzy?, VENTURE BEAT, 25 January 2011.
82
Industry experts have in fact indicated that ‘the SEC may consider secondary markets too risky even for the accredited and sophisticated buyers who are allowed to purchase private stock’. See Robin M. Bergen and Shawn J. Chen Regulating secondary markets in the Facebook era, WESTLAW NEWS & INSIGHT, 28 January 2011. See also Dan Primack, Secondmarket has gotten SEC inquiry, FORTUNE, 3 January 2011
22
SecondMarket and SharesPost fill the gap created by the changing IPO market83 - or the introduction of stricter rules and an extended enforcement policy. The rules and enforcement approach will arguably take precedence if the relatively slow trading process and dearth of available stock appears to unjustifiably build up hype and expectations about the high tech companies, which may fuel bubbles in the shares of these firms.84 Because non-listed high tech companies can become unusually large before an IPO or a trade sale takes place, hedge funds, private equity funds and investment banks increasingly look for opportunities on SecondMarket and SharesPost.85
These investors, however, may not fully understand the operation and
development of fast growing start-ups. Consequently, the privately owned stock may very well be overvalued at the time of a “traditional” exit through an IPO or a trade sale. This could arguably have a negative impact on retail investors, who may inadvertently buy into an overvalued company at the time of its IPO. !
The increasing popularity of venues such as SecondMarket and SharesPost has also
generated some unease among firms ‘listed’ on these exchanges. Under US securities regulation, once a firm has surpassed a threshold of $10 million assets and 500 shareholders of record, it must register with the SEC and produce periodic disclosure reports.86 As the issuers of the securities traded on these markets are attracting new investors, they might at some point go over the 500 shareholder threshold. The most salient example of this problem is perhaps the recently proposed $1.5 billion investment in Facebook by Goldman Sachs. The latter firm sought to gather funds from its clients through a special purpose vehicle, which would then be used to purchase an equity stake in the social networking company. This was seen by some as an attempt to circumvent the 500 shareholder threshold for registration before the SEC.87 After overwhelming media attention and rumors of a possible intervention by the SEC, Goldman Sachs was forced to restrict access to the transaction, making it available only to non-US investors.88 Although firms that reach the threshold need not go public,89 the costs of disseminating private information about
83
See, for instance, Jean Eaglesham and Jessica Holzer, SEC Boots Up for Internet Age, WALL STREET JOURNAL, 9 April 2011. 84
See Robin M. Bergen and Shawn J. Chen Regulating secondary markets in the Facebook era, WESTLAW NEWS & INSIGHT, 28 January 2011. 85
See John Gapper, Wall Street goes west for investment opportunity, FINANCIAL TIMES Business Blog, 11 April 2011.
86
See Section 12(g) of the Securities Exchange Act of 1934, as amended and complemented.
87
See Steven M. Davidoff, Facebook and the 500-person threshold, DEALBOOK, 3 January 2011.
88
Foreign investors are subject to certain exemptions that would allow the Goldman-Facebook transaction to go through unencumbered. See Dominic Rushe, Goldman Sachs suffers Facebook fiasco, THE GUARDIAN, 17 January 2011. 89
Even if firms can remain private after surpassing this threshold, it has been suggested that companies might be inclined to undertake an IPO once they are forced to provide period reports to the SEC, as illustrated by the case of Google. See Steven M. Davidoff, Facebook and the 500-person threshold, DEALBOOK, 3 January 2011.
23
their activities can be potentially high.90 Preparing quarterly and annual reports requires the assistance of accountants, external auditors and other professionals, whose services fees will have to be borne by the company. Perhaps more importantly, revealing strategic information about the firm’s activities might also benefit competitors or increase transaction costs in the context of the company’s relations with third parties.91 !
Finally, trading in secondary markets may generate several other problems for young, fast-
growing firms. For instance, there might be an issue with the potential misalignment of incentives between the company, its founders and key employees if members of these last two groups sell a significant part of their shares: a lower equity stake in a VC-backed company often results in founders and key employees exerting less efforts towards the firm’s success. 92 In general, the demotivation factor already appears to kick in when the founders and key employees start to monetize their ownership positions.93 In this respect, it may be argued that high valuations have a detrimental effect on the growth and development of a company. This may even be exacerbated if higher valuations lead to an increasing grant price of stock options, which negatively affects a company’s ability to attract new top talent.94 Changes in the ownership structure of a high tech company’s may also get a lukewarm reception by the company itself, in that secondary marketplaces inherently attract competitors seeking to gain information about the firm’s activities and operations by exercising their information rights after having acquired an equity stake. !
To prevent these problems, firms could rely on the share transfer restrictions that are
included in their by-laws, investment term sheets or employment contracts. In fact, information gathered from SharesPost shows that close to 90% of the transactions channeled through the exchange are subject to transfer restrictions.95 As we have seen, the rights of first refusal allow a firm’s investors to acquire the shares offered by a stockholder in need of liquidity before third parties can purchase them. Still, confusion about the actual scope of certain provisions has led some firms to consider a strengthening of the general restrictions that govern the transfer of stock by shareholders. 96 In this respect, employees who could decide to sell based on inside information
90
See Henry Butler and Larry Ribstein, The Sarbanes-Oxley debacle: What we’ve learned; how to fix it, The AEI Press, Washington DC, 2006. 91
Anat Admati and Paul Pfleiderer, Forcing firms to talk: Financial disclosure regulation and externalities, (2000) 13 REV FINAN STU 479. 92
This effect, which is linked to the theory of agency, is clearly described in a slightly different context by Eugene Fama and Michael Jensen in Separation of Ownership and Control, (1983) 26 J LAW ECON 301. 93
The employee de-motivation factor was explained during a SecondMarket Webinar on Dispelling Myths Around the Private Company Stock Market early 2011. 94
See Lou Kerner, Lots of obstacles remain for secondary market, SECONDSHARES, 20 May 2010.
95
See Julianne Pepitone, SecondMarket trading doubles in private company stock, CNN MONEY, 22 January 2011.
96
See David Marcus, Liquidity now, THE DEAL MAGAZINE, 21 January 2011.
24
are sometimes prohibited to trade their shares.97 These measures, however, would deprive employees and early stage investors of the needed liquidity, which might have adverse consequences for the venture capital cycle and the high growth firms it supports.98 !
In the absence of a more structured and clear marketplace, the private secondary markets
may not reach their full potential. As illustrated by the SEC’s inquiry into SecondMarket, there is still a regulatory fog surrounding the operation of these exchanges. In fact, even if secondary venues like SecondMarket and SharesPost employ licensed broker dealers, many questions remain about their operations. This uncertainty is increased by the mismatch between the rules that govern secondary trading and the transactions that are being structured around high growth firms. The problems described here could potentially reduce the amount of trading that is channeled through private secondary markets, which could widen the liquidity gap and adversely impact the venture capital industry. For these reasons, a certain amount of intervention by regulators may be necessary. Of course, the nature and degree of this intervention requires some analysis to ensure that it is designed to properly support the further development of these markets. An examination of the rules and regulations designed by the Tel Aviv Stock Exchange (TASE) to cater to the needs of early stage research and development companies suggests a way in which private secondary exchanges can be better integrated into the venture capital ecosystem. The TASE example particularly throws some light on the advantages of a segmented exit structure, in which each tier could be viewed as a stepping stone for the next, more regulated and reputed exit segment.
3.3!
TASE: Special listing rules for R&D companies
The Tel Aviv Stock Exchange created a special regime in 2006 to facilitate market access for companies in the field of research and development.99 This initiative was launched to meet the funding needs of innovative companies, which require access to large amounts of capital to advance to the later stages of their life cycle. 100 The special rules of the TASE set a low entry threshold for ‘R&D firms’ that plan to undertake an IPO. To qualify under the R&D category, a company must show that it has invested a minimum amount of resources (NIS 3 million or close to US $900,000, which may include investments received from the office of the Chief Scientist at the Israel Ministry of Industry and Trade) on research and development. In addition, candidate firms
97
See Telis Demos, Valuations of social media groups soar in the first quarter, THE FINANCIAL TIMES, 15 April 2011.
98
See supra, pg [...].
99
Yuval Horn, Funding and Opportunities of Life Science Companies: The Israeli Experience, WHO’SWHO LEGAL (February 2011). 100
See Listing Rules, Tel Aviv Stock Exchange, available at http://www.tase.co.il/TASEEng/Listings/IPO/ ResearchandDevelopmentCompanies/
25
must certify that their activities involve ‘research and development, or the production and marketing of products resulting from its own research and development’. Once these few requirements have been met, firms can launch an IPO on the TASE under a simplified regime. Companies that qualify under the R&D regime are exempted from bringing evidence of a track record, a requirement that is often compulsory in traditional listing venues. Another important trait of the simplified regime involves a variable rate for the minimum public float in an IPO. For issuances in which the value of the public float ranges between NIS 16 million (about US $4.5 million, which is also the low threshold for raised capital) and NIS 50 million (about US $14million), firms must issue at least 10% of their share capital. Beyond the NIS 16 million threshold, the minimum public float rate goes down to 7.5%. This system of variable floats, which allows IPOs to take place without significantly diluting the equity of a firm’s incumbent shareholders, is meant to encourage the access of innovative firm to the TASE. Finally, R&D companies can also benefit from general listing provisions that apply to all firms such as the Dual Listing Rule, which allows Israeli listed firms that have cross-listed into the United States or the United Kingdom to use the accounting rules of these jurisdictions when preparing their reports to national Israeli authorities.101 !
The timing of the TASE in launching the special R&D regime was almost perfect. As the VC
cycle underwent the changes described earlier and funding for high-tech firms became scarce, the Israeli exchange provided a solution to meet the financing needs of domestic companies. It should be stressed here that the “early R&D listing” can serve as a substitute for traditional venture capital financing. The new rules paved the way for 17 IPOs by high tech companies - mostly engaged in the biotechnology industry in 2006. In the following year, another 20 R&D companies seeking additional capital floated their shares on the TASE. Naturally, an R&D listing also increases the liquidity options for existing shareholders in the company provided that the sale of shares complies with the lock-up rules promulgated by the TASE. What is more important, since the TASE listing is considered as a springboard for subsequent public offerings in the United States of the United Kingdom, listed R&D companies are well-prepared for a real exit event in the near future. This arguably explains the TASE’s IPO boom and its success in attracting firms from Europe and the United States. 102 The growing interest in the TASE’s initiative even appears to lure in international financial institutions, which are essential to further support the expansion of the high tech industry in Israel. 103 !
The example of TASE illustrates the potential of a segmented stock market in successfully
accommodating firms at different stages in the venture capital cycle. Indeed, Israeli high tech companies have the option of an array of exit segments as depicted in Table 1. Interestingly, the
101
See The Dual Listing Law: An Important Step Towards Globalization of the Israeli Capital Market, Tel Aviv Stock Exchange. 102
Sarah Toth Stub, Israeli Life Sciences Boom, WALL STREET JOURNAL (31 March 2011).
103
Adrian Filut, Barclays launches financial R&D center in Israel, THE GLOBE (14 March 2011).
26
founders of SecondMarket decided in October 2010 to extend its private company stock market to Israel, facilitating secondary liquidity for the shareholders of early stage high tech companies.104 This pre-IPO segment could be followed by an R&D listing to access more capital before considering a dual listing at the prestigious NASDAQ. By April 2011, two Israeli companies had already “listed” on SecondMarket.
Table 1: Segmented Stock Market - the Israel Example Segments
“IPO” Segments preferred by Israeli High Tech Companies NASDAQ Global Select Market
IPO
NASDAQ/TASE Dual listing rule
NASDAQ Global Market NASDAQ Capital Market
!
IPO entry level
TASE (R&D)
Pre-IPO segment
SecondMarket (Israel Office)
In the next section, we turn to examine a framework that can accommodate a more
complete venture capital ecosystem. We consider the extent to which a segmented stock market could contribute to the performance and success of the venture capital industry. By focusing on three parties - (1) government regulators, (2) stock exchanges, and (3) investors - we suggest that collaborative action seems to be a critical factor in encouraging entrepreneurs and investors to engage in more innovative and creative ventures, while offering them not only new investment opportunities, but also a balanced liquidity infrastructure.
4.
A segmented stock market to bridge the liquidity gap
Governments all over the world have tried to create their own venture capital ecosystem modeled on Silicon Valley, but they never seem to succeed.105 After making this statement, David Cameron, the current Prime Minister of the United Kingdom, went on to explain how government support could potentially assist in turning the Silicon Roundabout - a high-tech business hub in East London - into a global hotspot for innovation.106 The proposals were aimed at improving the legal environment (i.e., relaxing visa requirements for qualified personnel, overhauling intellectual property rules, etc), enhancing funding opportunities (i.e., governmental co-investment with large
104
See Shmulik Shelah, SecondMArket launches Israel activities, GLOBES (25 October 2010).
105 See
David Cameron, East End tech city speech (transcript), 4 November 2010, available at http:// www.number10.gov.uk 106
See Silicon Roundabout: London’s high-tech start-ups, ECONOMIST, 25 November 2010.
27
private firms in startups) and luring big players from high-tech industries into the area (i.e., Google and Intel were invited to open up facilities in the Roundabout).107 This attempt to create an ‘East London Tech City’ is just one of the initiatives promoted by European governments to replicate the success of Silicon Valley. 108 Similar efforts have been deployed in almost every other continent across the globe.109 While the reasons for which Silicon Valley commands the attention of policymakers are abundantly clear, there is still no certainty as to how governments can assist in replicating its success in their own jurisdictions.110 !
Governmental schemes to develop a robust venture capital industry have taken many
forms. For instance, policymakers often seek to set up investor-friendly environments in which the fundraising process by startup firms and VC funds can run smoothly.111 This goal is usually pursued by adjusting key measures in a legal system, lowering tax barriers and enacting liberal bankruptcy statutes. 112 Moreover, governments have sought to foster the development of “clusters” - made up of closely located high-tech firms - where geographical proximity and focused investor attention could combine to stimulate innovation.113 Public initiatives to nurture local venture capital industries also tend to involve governmental investment in startup firms. Initiatives of the kind described above have not always been successful. An illustrative example concerns the efforts of policymakers to stimulate the development of high-tech clusters. 114 To achieve this elusive goal, governments have allocated funds to science parks and research centers, attempted to improve
107
See Tim Bradshaw, East London market to rival Silicon Valley, FINANCIAL TIMES, 28 January 2011.
108
See Erick Schonfeld, Europe is searching for its Silicon Valley, TECH CRUNCH, 5 April 2008. See also Des Dearlove, The cluster effect: Can Europe clone Silicon Valley?, STRATEGY + BUSINESS, 1 July 2001. 109
See, inter alia, Ambika Patni, Silicon Valley of the East, Harvard International Review, 22 September 1999; Cristina Molina, Jalisco: Latin America’s Silicon Valley, BUSINESS NEWS AMERICAS, 20 June 2008; Banji Oyelaran-Oyeyinka, Learning hi-tech and knowledge in local systems: The Otigba computer hardware cluster in Nigeria, United Nations University Working Paper Series, January 2006; Simon Benson, Silicon Valley to create job boom, THE AUSTRALIAN, 18 February 2009. 110
See Josh Lerner, Boulevard of Broken Dreams, Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed 0 and What to Do About It, Princeton University Press, 2009; Joseph A. McCahery and Erik P.M. Vermeulen, Venture capital beyond the financial crisis: how corporate venturing bootsts new entrepreneurial clusters (and assists governments in their innovation efforts), (2010) 5 CAPITAL MARKETS LAW JOURNAL 452. 111
See Jeanne Metzger, Recent tax change makes Canada increasingly venture investor friendly, NVCACCESS, 12 March 2010. 112
See John Armour and Douglas Cumming, The legislative road to Silicon Valley, (2006) 58 OXF ECON PAP 596.
113
For a relevant study on clusters, see Robert Plant, An Empirical analysis: Venture capital clusters and firm migration, (2007) 12 J DEVELOPMENTAL ENTREPRENEURSHIP 2. 114
On the importance of these clusters, see Timothy Bresnahan and Alfonso Gambardella (eds), Building high-tech clusters: Silicon Valley and beyond, (2004) Cambridge University Press.
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interactions between firms and universities and provided incentives for regional high-tech initiatives.115 For the most part, these efforts have been unsuccessful in Europe and elsewhere.116 !
As discussed, one of the more salient priorities in the agendas of policymakers has been
the development of stock markets that would support exits by investors in high-growth firms. In Europe, these efforts have mainly focused on nurturing ‘growth markets’ with low entry barriers and few ongoing requirements for listed firms.117 After witnessing the success of London’s Alternative Investment Market (AIM), European policymakers were convinced that exchanges with a light regulatory touch could act as incubators for small, high-growth firms. AIM’s model indeed provides a low-cost option for firms that seek a public listing, through a process in which firms tailor the venue’s principles-based rules to their specific business needs. The success of AIM in the years before the recent financial crisis prompted policymakers to take action, primarily by working with national regulators and stock exchanges to improve the conditions for trading on these growth markets.118 In 2007, as the number of US firms listed on AIM peaked, it seemed as if Europe had found a way to provide a workable exit strategy for investors in high-growth companies.These hopes rapidly disappeared, however, as the AIM proved to be an unwelcome venue for many firms, for reasons we have already discussed. !
This example suggests that governments may have to reconsider some of the policies
designed to foster the venture capital industry. Although this paper does not intend to cover the full spectrum of channels through which governments can accomplish this goal, we can draw several lessons from the developments analyzed in the previous Sections. These lessons may be of particular relevance in the European Union. European policymakers have long been committed to create an environment in which high-potential growth companies are able to flourish into large, world-leading companies in a relatively short period of time.119
Seeing the importance of
developing a full venture capital ecosystem where innovative firms can prosper, efforts in the EU should arguably be geared towards supporting the market-based initiatives that have already emerged to cover the ‘gaps’ in the venture capital cycle. As this paper deals mainly with the so-
115
See, for instance, Luigi Orsenigo, The (failed) development of a biotechnology cluster: The case of Lombardy, (2001) 17 SMALL BUSINESS ECONOMICS 77. 116
See Vivek Wadhwa, Okinawa’s doomed innovation experiment, BUSINESSWEEK, 18 October 2010 and Schumpeter, Fish out of water, ECONOMIST, 29 October 2009. 117
European Commission, Reports on Enterprise and Industry: More Risk Capital, available at http://ec.europa.eu/ enterprise/policies/finance/risk-capital/index_en.htm. 118
European Commission, Reports on Enterprise and Industry: Initial Public Offerings and Growth Stock Markets, available at http://ec.europa.eu/enterprise/policies/finance/risk-capital/initial-public-offerings/index_en.htm. 119
See Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, Europe 2020 Flagship Initiative, Innovation Union, COM (2010) 546 final, Brussels, June 10, 2010. The Innovation Union is one of the seven flagship initiatives defined by the European Commission in its Europe 2020 Strategy. There are seven flagship initiatives: (1) Innovation Union, (2) Youth on the move, (3) A digital agenda for Europe, (4) Resource efficient Europe, (5) An industrial policy for the globalization era, (6) An agenda for new skills and jobs, and (7) European platform against poverty.
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called ‘liquidity gap’, our focus here will be on the liquidity providers that have created novel means of exit for investors in VC-backed firms.120 !
As explained in the previous section, pre-IPO segments have emerged to satisfy the
liquidity needs of investors in VC-backed firms in the United States and Israel. The list of new players, which still continues to grow, includes online ‘facilitators’ and platforms (i.e., SecondMarket and SharesPost) for secondary trading in the shares of VC-backed firms. These initiatives have made it easier for employees and early-stage investors in US VC-backed firms to partially wind up their positions in order to obtain some liquidity. It should come as no surprise that these developments have not gone unnoticed in other parts of the world, where the market is also starting to provide solutions for the liquidity gap explained in this paper. Aside from the successful experience of equity exchange funds such as the Founders Club, exchanges for secondary trading in the shares of private firms have emerged in Europe (i.e., the Nederlandsche Participatie Exchange or NPEX in the Netherlands and IlliquidX in the United Kingdom) and India (i.e., the launch of the India Venture Board). This arguably poses a challenge for government regulators, who may soon have to face public pressures to address the regulatory void that appears to surround these new liquidity segments.121 Focusing on the European Union, we believe that policymakers should embrace the development of these new liquidity providers, which may become essential for the proper operation of the venture capital cycle. To achieve this goal, we call for swift action on the following fronts:
1. Support the emergence of ‘private’ secondary trading venues. As illustrated by the US experiment with exchanges for secondary trading in the shares of VC-backed firms, the emergence of these venues can raise alarms among regulators and market participants. Recall, for instance, that the SEC has started an inquiry into SecondMarket or, also, that there are many doubts about the valuations used to trade shares on private secondary exchanges.122 This uncertainty or ‘regulatory fog’ can reduce the market’s confidence in the services offered by these new liquidity providers, with dire consequences for the VC cycle. Although this problem has already been addressed to some extent in the United States, the situation in Europe may call for immediate attention. We already mentioned the introduction of NPEX in the Netherlands. Inspired by the success of SecondMarket, NPEX opened its trading platform in 2009, allowing investors to
120
In another paper (Janke Dittmer, Jose Miguel Mendoza and Erik P.M. Vermeulen, The “New” Venture Capital Cycle (part II): The Emergence of alternative investment options, forthcoming 2011), we look into the role of government in solving the funding and investment gaps in the VC cycle. 121
European policymakers faced similar pressures to regulate the hedge fund industry after a series of high profile interventions by hedge funds in European firms. See Matthew Dalton and Charles Forelle, EU Parliament backs new hedge fund rules, WALL STREET JOURNAL, 18 May 2010. 122
See Shira Ovide, Another sign of a tech bubble?, WALL STREET JOURNAL, 6 January 2011.
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buy shares in non-listed companies.123 Contrary to its counterparts in the United States, buyers on NPEX are not limited to professional investors (or qualified institutional investors). In general, companies that request a listing on NPEX are obliged to submit a prospectus and regularly disclose financial statements. NPEX is comparable to eBay, in that shares are sold and bought through an auction-style bidding process. The seller determines the share price, collects bids for a fixed length of time and sells to the highest bidder. So far, NPEX has established itself as a market for interests in real estate partnerships.124 Since an “eBay” system could arguably lead to an effective determination of the value of the real estate interests (a market that usually lacks transparency and is therefore prone to fraud and misrepresentations), it is not surprising that NPEX has obtained clearance form the Dutch Authority for the Financial Markets (AFM) to offer investment services and operate as an exchange for shares of non-listed companies. The valuation issues at private secondary markets in the United States show, however, that the eBay approach adopted by NPEX will be far from sufficient to determine the “proper” value for the shares of high tech companies. !
It is therefore not yet clear whether the new liquidity providers for non-listed stock will be
able to carry on their activities without facing a high level of regulatory scrutiny. 125 Recent examples of financial market innovations (i.e., hedge funds, dark pools, high-frequency trading) suggest that as the media attention surrounding these new players grows, European regulators will be more tempted to intervene with heavy-handed regulation.126 More importantly, the legal framework contained in the Markets in Financial Instruments Directive (MiFID) may be insufficient to accommodate these new market venues.127 Still, if this growing industry does not find the space to develop, Europe may be left with a defective and incomplete venture capital cycle. For these reasons, we believe that European policymakers should start designing a light regulatory framework to support the growth and encourage the formation of new liquidity providers. The main purpose of this framework would be to provide a measure of legal certainty for market participants that deal in the shares of non-listed VC-backed firms. This could be accomplished through a simple registration procedure for secondary trading venues, designed to distinguish them from other market participants such as Regulated Markets or Multilateral Trading Facilities, both of which are subject to more stringent rules under MiFID than the ones required for the liquidity providers 123
See www.npex.nl.
124
See Matthijs Schiffers, Handel in aandeel Facebook prikkelt fantasie NPEX, HET FINANCIEELE DAGBLAD (15 September 2011). 125
See, for instance, the discussion that followed on an article published by the Dutch Investors’ Association on 29 March 2011 (Platform voor niet-beursgenoteerde effecten biedt beleggers kansen). 126
See Louise Armistead, European regulators to investigate high-frequency trading, DAILY TELEGRAPH, 1 April 2010; European regulators may take swift action on ‘Dark Pools’, DEALBOOK, 18 November 2009. 127
In fact, it is not clear whether a liquidity provider of the kind described here would be able to operate as a Multilateral Trading Facility or a Systematic Internaliser, due to the highly specific requirements set up in MiFID for these entities (see, for instance, Articles 14 and 27 of MiFID).
31
discussed here. A simple registration process could give ground to the creation of new trading segments, a development that would be much welcome in Europe.128! !
Although this “regulation lite” approach offers some benefits, we do not expect that this
measure alone will produce a burgeoning trading community. The lukewarm reception that the venture capital industry has given to NPEX despite its AFM license suggests that much more is needed to solve the liquidity problem and unlock the full innovation potential of the VC market. This raises an important question: What would attract entrepreneurs, angel investors, venture capitalists and alike to start trading on the online private secondary markets in Europe?
2. Use “public-private” partnerships to create a structured and segmented trading platform. By most accounts, speculative bubbles are a trademark feature of free-market capitalism.129 Early examples include the notorious Mississippi and South Sea companies, which came to prominence in the eighteenth century. The stories behind these old scandals are well known. Misinformation and investor enthusiasm following the award of monopolies to these firms led to a harmful speculative bubble that was quick to inflate and burst, which gave way to massive losses for the unwary investors of the Mississippi and South Sea companies.130 Two centuries later a new bubble formed in the vibrant US stock market of the 1920’s as a result of speculation and market manipulation.131 This bubble ruptured in 1929, with dire consequences for the U.S. economy.132 During the 1990’s, high-tech startups operating in the internet industry caught the public’s imagination. Subsequently, a bubble formed in a new round of market euphoria or, as a commentator labelled it at the time, irrational exuberance.133 After it became obvious that most of these startups were grossly overvalued, the ‘dot com’ bubble burst in 2000.134 Less than a decade after this happened, another speculative bubble inflated and burst in the housing market, which set the scene for the most recent financial crisis.135 128
The proposed changes to MiFID (MiFID II) include the creation of Organized Trading Facilities, which will most probably capture the private secondary market echanges. Under MiFID II these exchanges should indeed register with the national regulators and the European Securities and Markets Authority (ESMA). 129
See Robert Shiller, Irrational exuberance, (2005) Princeton University Press.
130
See Joseph A. McCahery and Erik P.M. Vermeulen, Corporate Governance of Non-Listed Companies, Oxford University Press, 2008.See also Frank Partnoy, Why Markets Crash and What Can Law Do About It? (2000) available at http://ssrn.com/abstract=183473. 131
See J Bradford De Long and Andrei Shleifer, The Bubble of 1929: Evidence from closed-end funds, (1990), Berkeley Working Paper. 132
See Charles P. Kindleberger, Manias, panics and crashes: A history of financial crises, (2005), John Wiley & Sons.
133
See Remarks by Chairman Alan Greenspan at the American Enterprise Institute, Washington D.C., 5 December 1996, available at http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm 134
See Alexander Ljungqvist and William Wilhelm, IPO pricing in the dot-com bubble, (2003) 58 JOURNAL OF FINANCE
2. 135
See John B. Taylor, The financial crisis and policy responses: An empirical analysis of what went wrong, (2008), Stanford University Working Paper.
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!
These ominous precedents may explain why some observers seem so alarmed about the
growth of secondary trading markets for shares in VC-backed firms.136 For some time now, rumors of a new tech bubble have been pouring out of media outlets worldwide.137 These reports have been fueled by the renewed interest that venture capital funds, strategic corporate investors and investment firms are showing in high-tech firms. For instance, two funds recently formed by Kleiner Perkins Caufield & Byers will allocate almost $1 billion for investment in IT firms.138 Remember also Google’s $6 billion offer to acquire control of Groupon, which was rejected by the latter firm’s founders in 2010 and the proposed investment in Facebook by Goldman Sachs.139 Another example concerns the interest shown by prominent players in the VC industry to participate in the new funding round conducted by the Swedish firm Spotify.140 As more big players seek to buy into the IT and social media market, investors have become increasingly exuberant, which is having a noticeable effect on the valuations of high-tech startups.141 Figure 11 shows the increase in the implied enterprise value of several of these firms over a 5 month period. Now compare the growth rate of the most rapidly developing firms (Groupon, Twitter and Facebook) with the increases in the share price of more established companies (Apple, Google and Microsoft), as shown in Figure 12. !
As we have seen, the soaring valuations of new startups have cast some doubt on the use
of venues for secondary trading in the shares of VC-backed firms. Let us briefly summarize the reasons for this. First, there seems to be a mismatch between the supply and demand sides for the shares of certain firms in the private secondary market places. Although the auctions conducted by these venues tend to attract sufficient interest of potential buyers, shares are in very limited supply.142 This arguably creates upward price pressures that inflate the valuations of the IT firms ‘listed’ on these exchanges. Second, there is often little information available about the operation of these firms, as they have no obligations to make public disclosures. Traders in markets for shares in non-listed VC-backed companies must rely on pre-money valuations and any other available source of information to determine the price at which they will buy or sell shares. However, as explained earlier, most of the parties that transact in these markets are sophisticated players with sufficient information about a firm’s activities. Still, it is unlikely that every trader in these markets has enough data to make sufficiently informed investment decisions. Due to the lack of homogenous and standardized information, these markets are prone to error, which may give 136
See Shira Ovide, Another sign of a tech bubble? WALL STREET JOURNAL, 6 January 2011.
137
See Heidi N. Moore, As technology deals boom, talk turns to bubbles, DEALBOOK, 19 November 2010.
138
See Dan Primack, Kleiner Perkins goes big: Firm raising more than $1 billion, FORTUNE, 27 october 2010 (80% of the cash contributed to the new funds will be used for IT investments). 139
See Douglas MacMillan and Joseph Galante, Google’s Groupon bid said rejected, BLOOMBERG, 4 December 2010.
140
See Josh Halliday, Spotify swept up in dotcom bubble with $1bn valuation, GUARDIAN, 22 February 2011.
141
See Laurie Segall, As valuations soar, tech field starts feeling bubbly, CNN MONEY, 20 December 2010.
142
See Erick Schonfeld, Facebook’s market cap on SecondMarket now $25 billion, TECHCRUNCH, 4 June 2010.
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ground to speculation and market euphoria. As a replacement for solid facts about a firm’s future prospects, investors may in fact give in to the hype that surrounds certain companies.
!
The possibility that private secondary exchanges could exacerbate bubbles in the shares of
startup firms should not be ignored. For this reason, SecondMarket and SharesPost introduced several means to prevent the rise of speculative bubbles.143 Recall, for instance, SharesPost’s Venture-Backed Private Company Index that tries to prevent overvaluations of stock and SecondMarket’s virtual data rooms where authorized users can gather information about “listed” firms. But a closer look at the these online trading platforms seems to indicate that there is a “market for reputation” that plays an important role in bridging some of the information asymmetries between the issuer companies, the buyers and the sellers in these venues. For instance, 95% of the companies “listed” on SecondMarket are located in California. The fact that buyers, which are predominantly “local” venture capital funds, invest in companies that are geographically close to each other, appears to make it possible to facilitate the emergence and maintenance of a reputation market.144 Of course, as the trading community is growing and 143
For a thorough analysis of remedies to counteract speculative bubbles, see Robert Shiller, Irrational exuberance, (2005) Princeton University Press. 144
See Erik P.M. Vermeulen, The Evolution of Legal Business Forms in Europe and the United States, Venture Capital, Joint Venture and Partnership Structures, Kluwer Law International, 2003.
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becomes more global, the access to and the performance of the reputation market decreases, which in turn forms the basis for more and more calls for regulatory intervention.145
!
This holds important lessons for government regulators and policymakers that are on the
brink of taking important steps to remove barriers for the creation of a robust venture capital industry. As the time that elapses from the inception of a start-up company to an exit event (particularly an IPO) hit a historic high in 2010, high tech companies are looking for alternative investment options and secondary liquidity sales to incentivize early stage investors and employees. This presupposes that a vibrant venture capital industry needs access to a pre-IPO marketplace where the fragmented and disorganized stakeholders of the venture capital ecosystem, such as entrepreneurs, venture capital funds and angel investors, could connect and exchange (co-)investment and exit opportunities. Surprisingly, the blueprint for such an initiative has already been laid out by the India Venture Board (IVB).146
145
The operation of the stock markets in Amsterdam and Antwerp in the 17th century also relied more on credible commitments than rules and regulations. Cf. Dirk Zetzsche, An Ethical THeory of Corporate Governance History, Center for Business and Corporate Law Research Paper Series (CBC-RPS) 6, February 2007. Interestingly, SecondMarket introduced Trusted Networks, allowing investors to create a network of trusted investors (see www.secondmarket.com). 146
See www.indiaventureboard.com
35
!
The IVB is an online marketplace/platform with some interesting features.147 First, the IVB
provides investors with a “Deal Corner” where they can post investments interests and initiate transactions. Second, the IVB gives entrepreneurs the possibility to make investment pitches. Third, companies and investors can upload information about important developments, investments and deals to the IVB Announcement Board. Finally, and perhaps most importantly, the IVB intends to offer liquidity by facilitating secondary transactions, similar to SecondMarket and SharesPost. Yet, there are some salient differences between the developments in the United States and India. In order to build an accessible market for reputation, the IVB introduced an invitation policy to its investment community. Initially, the group of invitees consists of 100 investors and 12 intermediaries, but the expectation is that the community will increase its investor base rapidly. Yet, given the importance of reputation and credibility, the market will maintain its structured and closed organization. The companies and entrepreneurs seeking investments need not to be invited to participate in the IVB, provided that they are endorsed by the Indian Private Equity & Venture Capital Association (IVCA) or one of the top angel networks (the Indian Angel Network or Mumbai Angels). This is not surprising since these networks belong to the founders of IVB. Interestingly, the National Stock Exchange of India (NSE) and the state-owned Small Industries Development Bank of India (SIDBI) are the other two founding institutions of IVB, potentially making it the first “pre-IPO” segment of the NSE. The public-private partnership element arguably adds to the credibility and reputation of the board. !
So the question remains: could we foresee the emergence of such a collaborative initiative
in Europe? To answer this, we end this section as we started it, with a statement by British Prime Minister David Cameron: Governments (and other regulatory bodies, such as stock exchanges) should go with the grain of what is already there and should not interfere so much that they smother.148
If we consider the developments in India along with the pressures for an
entrepreneurial ecosystem in Europe, the advantages of a pre-IPO segment that covers the European Union seem obvious. The most important ingredients are already available: (1) the European Venture Capital Association, (2) the launch of the European Venture Club in February 2011 to encourage the development of a European-wide venture capital ecosystem,149 and (3) the existence of online private secondary marketplaces, such as NPEX and IlliquidX. Given the importance of bridging the liquidity gap in Europe’s venture capital cycle, perhaps the best way to accomplish this goal would be for policymakers to encourage the integration of these secondary
147
See Deepti Chaudhary, Online Market For Venture Capital in the Works, WALL STREET JOURNAL, 10 March 2011.
148
See The Government’s New Guru: Bring me Sunshine, ECONOMIST (11 November 2010).
149
See www.europeanventureclub.com
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trading venues into existing stock exchanges.150 This could have multiple benefits for all parties involved by bringing about convergence of the various players in the still fragmented VC ecosystem.
5.!
Conclusion
We have made three major claims in this paper. The first is that, if left unchecked, the recent changes in the exit phase of the venture capital cycle may have detrimental effects on the VC industry. The ability to exit an investment plays a crucial role in the operation of other parts of the VC cycle such as fundraising and investing by venture capitalists. Investment liquidity is also necessary to encourage start-ups and attract the top talent necessary to grow these ventures. This brings us to the second claim: There is a growing need to develop private secondary exchanges that can facilitate pre-IPO trading in the shares of VC-backed firms. We argue that these trading platforms are fast becoming a critical component of the venture capital ecosystem, as they can bridge the liquidity gap in the VC cycle and reduce the fragmentation of the VC industry. As illustrated by the examples of Israel and India, a marketplace of this nature will probably be most effective when it forms part of a segmented exchange with multiple tiers, preferably as a springboard for ‘higher’ segments. The final claim made in this paper is that government involvement in the creation of pre-IPO marketplaces can provide important support for the VC cycle. Properly structured public-private partnerships that build on the ingredients that are already available in financial markets are probably the strongest tool to develop a sustainable VC industry.
150
Stock exchanges that integrate private secondary trading venues into their existing platforms may gain an edge in the increasingly fierce competition to dominate the market for IPOs of high-growth firms. In fact, a segmented venue of this nature would allow stock exchanges to create bonds with these firms early on in their life cycles. This may make it more likely for firms with high growth potential to undergo their IPOs in the same venue that supplied their investors with preIPO liquidity, rather than in competing exchanges.
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