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Why the SEC is taking aim at direct secondaries

The need for founder and employee liquidity in small, pre-IPO companies has fuelled specialist secondaries activity since the dotcom-days. But as the market shifts towards employee liquidity programmes, regulators are keen to establish a ‘fair, liquid and transparent’ market.

Some say buying out shareholders in venture-backed companies used to be the ‘Wild West’ within the secondaries market – whether transactions were taking place in person or online.

A handful of specialist firms typically built up positions in (often internet or tech) companies via a series of ‘onesies’ – one-off deals with company’s early employees or founders. There have also been a number of electronic trading platforms founded over the years and aimed towards single asset trades by employees of private companies – SecondMarket, SharesPost and Secondcap among them – but most have failed to gain real market traction, according to a recent SEI poll.

Over the past decade, more formal, company-sanctioned ‘employee liquidity programmes’ with preferred buyers have instead been gaining ground and stirring greater buyside competition, according to recent interviews with direct secondaries veterans like W Capital founder David Wacther and Industry Ventures founder Hans Swildens. These programmes effectively allow a company to give employees a cash option while controlling the process; the company sets its own policies and manages the interface with employees, while limiting expansion of its investor base and letting a secondaries firm do the heavy lifting in the background.

Today company programmes are more common than the ‘Wild West-style’ trading on which most firms got their start, James Hutchinson, a partner at Goodwin Procter, told me. “About six of the employee-sourced secondary sales we transacted in the fourth quarter involved programmes.”

But insiders note the market’s not just at a pivotal point because of deal structure evolution – it’s also attracting regulatory scrutiny. Last week, Securities and Exchange Commissioner Luis Aguilar said a “fair, liquid and transparent” secondary market still failed to exist to accommodate trading of private company shares.

The SEC Advisory Committee on Small and Emerging Companies convened specifically to discuss secondary market liquidity. Commissioner Daniel Gallagher opened his statement by recognising the issue of employee liquidity at pre-IPO companies wasn’t new, but one he’d “been pounding the table on for years”.

Aguilar said the lack of a clear secondary market for private company shares was largely down to poorly structured venture exchanges that instilled a ‘Wild West’ culture (he mentioned the Emerging Company Marketplace in particular) and the need to reform the JOBS Act’s “piggyback exception”. The current rule allows for broker-dealers to publish share quotes that are dated or belong to another broker-dealer, meaning they aren’t obligated to confirm new quotations. “It’s a poor way to instill trust in this market,” Aguilar said.

Ad hoc trading has also been highly disruptive for some private companies, which in some cases stopped issuing consent for private transfers – and has given further rise to private employee liquidity programmes, sources say.

Aguilar has proposed eliminating the “piggyback” exception, requiring broker-dealers to publish and review quotations annually and enhancing investor access to the information. It’s unclear when a final ruling is expected, but venture exchanges will be raised again at the June SEC Advisory Committee on Small and Emerging Companies meeting.

Insiders say when that happens, it’s likely to trigger more confidence in exchanges and participating broker-dealers. But will it really change investor behavior?