For decades the venture capital economy of Silicon Valley has been the epitome of technological and business model innovation. Yet some of even the most forward-thinking VCs have bristled at the emergence of market-driven secondary investment exchanges (secondary markets). Before Facebook went public, sales of the company’s shares on the secondary markets brought unprecedented visibility to these new private equity exchanges. Post-Facebook’s IPO, the debate as to what role secondary markets play in the venture economy has only continued to heat up.
As one of the leading secondary investment exchanges for privately held companies, SharesPost Financial Corporation naturally believes that the venture capital ecosystem has ample room for these markets. And, in fact, given the “new norm” of private companies’ lengthy maturation periods pre-IPO, we believe these markets can actually provide the kind of liquidity and control necessary to keep the engine of innovation on track.
But is this really true, and to what degree is this true? To better understand the environment that gave rise to secondary markets, and to better forecast how relationships between secondary markets and other private market influencers can evolve in a mutually beneficial way, SharesPost recently supported a study by Jerome S. Engel of the University of California, Berkeley. Engel’s work has been published in a whitepaper entitled “Financing Innovation: Why Emerging Secondary Markets are Good for the Venture Capital Economy,” which is available on SharesPost’s website.
In his report, Engel presents a 30,000-foot view, examining capital choke-points and external events that have stalled the VC innovation engine. He describes the current VC marketplace as a barbell, with vast amounts of funding available at either end—at the creation of new ventures and at exits or liquidity events. In the narrow middle of the barbell, where expansion stage capital is necessary to maintain valuations and support growth, “Series B” funding is hard to come by. With the number of IPOs bottoming out in recent years, portfolio company time-to-liquidity has increased significantly. This in turn has dampened VC returns and made employee stock option compensation less effective, while demotivating founders and employees and encouraging premature mergers.
Additionally, the past 10-20 years have witnessed the disappearance of specialist investment banking which had played a major role in the majority of venture-backed technology IPOs prior to the dot-com bubble. These specialist firms historically bridged the gap between venture capital financing and IPO, but having been mostly acquired by large investment and commercial banks, this gap looms larger than ever. Against this backdrop, unintended consequences of regulations such as the Manning Rule, Regulation Fair Disclosure, decimalization and Sarbanes Oxley have reshaped the IPO marketplace, drawing out timelines and further stifling access.
As Engel points out, this shrinking of the IPO window has generated a backlog of trapped value in venture capital investments, undermining long-term prospects for the venture economy. He describes a “damaged incentive structure” that can encourage founders and investors, starved for liquidity, to prioritize nearer term but sub-optimal exits over the building of long-term value. Lastly, stock option incentives, the heart and soul of the Silicon Valley compensation model, lose much of their effectiveness for recruitment and retention if they are illiquid for 10 years or more.
Private secondary markets such as SharesPost and SecondMarket represent an immediate response to the problem. Secondary markets help release trapped value back into the economy by providing early stage investors a way to harvest their gains and reinvest them in the next generation of innovators. Later-stage investors benefit by gaining access to the kinds of growth that are rarely seen these days on the public markets. The ability to exercise stock options and sell the underlying shares sold on the private markets in a controlled fashion would again be a great motivator for employees.
As private companies mature, their lack of liquidity may create significant pressure to go public before they are ready or seek to sell the company before it has achieved its full potential. For these companies, secondary markets can act as a liquidity “release valve” giving management more flexibility and control over the timing of their IPO.
A healthy venture economy is a key driver of global innovation, employment, economic growth and investment returns. But it will be difficult for this economy to flourish over the long-term if the narrow middle of the “barbell” remains neglected and a lack of liquidity perpetually hampers the effectiveness of angels, venture capitalists and entrepreneurs. The new private capital markets have arisen in response to these problems and, as they evolve, may well represent a part of the solution.
