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Startups Using Secondary Markets: 'It's Almost Like I'm A Mini-Public Company'

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By Deborah L. Cohen

CHICAGO (Reuters) - With IPOs out of fashion for many companies, Scott Painter, the CEO of TrueCar, did the next best thing.

Earlier this year, TrueCar, a seven-year-old web company based in Santa Monica, California, turned to SharesPost, an online secondary market for private company stock sales. TrueCar organized a $245 million private placement sale of its shares and used SharesPost to help attract attention.

For TrueCar, which provides pricing information to consumers shopping for new cars, the benefit was clear: SharesPost connected the company to an extensive network of institutional and high-net worth investors it may not otherwise have reached. Though secondary markets have been criticized for their lack of transparency, TrueCar used SharesPost to selectively boost its disclosure.

The company hosted an online road show, educating potential investors about the business, offered up its financials and, in the process, eliminated the need for management to knock on doors. By opening up its books to investors, TrueCar was able to secure about $20 million in investments through SharesPost in September.

"It's almost like I'm a mini-public company, because we run it like a public company," Painter said. "We publish deep financial data."

Startups are having a much tougher time going public these days, thanks in large part to costly compliance rules enacted under the 2002 Sarbanes-Oxley legislation.

According to Dealogic, the number of IPOs valued at $10 million to $200 million dropped to 36 this year to date from 76 in 2006. As a result, secondary markets like SharesPost and Second Market have stepped in to fill what entrepreneurs have long lamented as a restrictive funding gap.

"We've got a market that works really great for the large companies," said James Angel, an associate professor specializing in financial markets at Georgetown University's McDonough School of Business.

"If you're a tiny little company that nobody ever heard of, you're totally ignored by the market," Angel said.

The dilemma has done much to boost interest in secondary markets for private company stock. Shares in tech titans Facebook and Zynga have provided much of the buzz around secondary markets of late, as sky-high valuations have caught the eye of investors.

The markets work like online trading platforms - for a fee, they match buyers and sellers of private company stock. Disclosing audited financial information is not always a requirement, which has led to criticism over the markets' lack of transparency.

But proponents say secondary markets give entrepreneurs visibility and help create demand for their stock.

"I've got 50 public-company-style investors that are watching every move we make," Painter said.

An evolving market

Wall Street banks have caught on to the buzz around private stock offerings.

Earlier this year Goldman Sachs offered its high-net-worth clients the chance to own stock in Facebook, with a reported minimum investment of $2 million, a transaction said to have valued the social network site at more than $50 billion.

Facebook's reported valuation has greatly fluctuated since that time. Facebook wasn't required to disclose its financials, and critics charged that the Goldman Sachs deal was an end-run around SEC regulations. The agency is reportedly investigating the rules governing private markets.

To be sure, SharesPost and SecondMarket are not public markets.

In accordance with SEC rules, only institutional investors and high-net-worth individuals can participate as buyers.

"What we're trying to do is fill that gap between the venture capital system and the public markets," said David Weir, SharesPost CEO.

"You're not really ready to go public yet, but we can help you kind of cross that chasm to become a big enough, mature enough company so you can become a viable public company if that's what you choose to do," Weir said.

SharesPost charges a commission of 3 percent of the total transaction amount or $5,000, whichever is greater, for buyers and sellers who opt to retain a transaction specialist. Second Market, which handles a variety of illiquid securities, charges commissions of 3 to 5 percent on private company stock transactions. SharesPost has executed more than 1,000 transactions this year, up from "several dozen" in 2010, said Weir, who declines to provide dollar volume figures.

Several companies, including Tesla and LinkedIn, have since gone public, commanding stock valuations priced higher than those in private trading on the site, he added. SecondMarket, which launched its private company stock market in April 2009, has executed more than 800 transactions to date involving about 50 private companies and amounting to roughly $1 billion, according to Jeremy Smith, its chief strategy officer.

A double-edged sword

Secondary market standards are still a work in progress, which has made them murky territory for entrepreneurs.

There are different rules for the time frame for investors to buy shares, the amount of financial disclosure required and the minimum size of investments. SecondMarket, for example, allows companies to dictate the terms of transactions in what Smith called "controlled liquidity" programs.

"They decide who the buyers are that are allowed to be bidding on their stock," Smith said. "They set rules for the sellers - how much can sellers sell. (They) may set different rules for different types of shareholders."

Allowing top employees to sell a portion of their shares on secondary markets can be a boost for morale, Smith added, noting Silicon Valley companies now struggle to attract and retain talent.

Companies often give themselves the right of first refusal to buy back stock when insiders sell. In addition, a good valuation in the secondary markets could be used as a benchmark when entrepreneurs return to the VC and private equity markets for subsequent rounds of financing. But Georgetown professor Angel said secondary markets can be a double-edged sword.

"You may be hot one year, cold the next," Angel said.

"When you go to a VC and try to argue what the valuation should be for this round, they point to that really low number and say, ‘You gotta be kidding.'"

SecondMarket's Smith said companies typically must have an enterprise value of at least $200 million.

"You pretty much have to be a company that's on a trajectory to get a big valuation and a public offering," said J.B. Pritzker, a Chicago-based venture capitalist who heads the technology investment firm New World Ventures.

An eventual IPO is exactly what Painter is aiming for, and he hopes the exposure from SharesPost will help.

"I didn't need help raising $20 million," he said. "It helped me to educate the market."

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