Fred Wilson had this to say on his blog today:
In the past week, I’ve had two different discussions with readers of this blog who wanted in on one of our deals. One reader wanted to invest in Twitter, the other in Boxee. I told them both it wasn’t possible. There are all sorts of reasons why it’s not possible, but let’s start with the qualified investor rule. To invest in the sorts of deals we invest in, you need to be a “qualified investor” in the eyes of the SEC.A VC, Nov 2008
His post interests me because over the past ten years we have been heading toward a situation where there is considerable overlap between ostensibly public companies and mature (or at least large and profitable) private companies.
I don’t have the statistics handy right now, (I will find them and put them up in a future post), but suffice to say that the majority of publicly traded companies today (i) have no research coverage, (ii) have market caps that make them of no interest to institutional investors and (iii) have average daily volume of next to nothing whether in terms of shares or in terms of dollar value of shares traded.
At the same time, you have a small but growing contingent of private companies that have reached the size where previously they would have been realistic candidates for an IPO or takeover bait. The IPO is not an option because (i) no deals can get done and (ii) savvy management teams realize that, regardless of what your VCs and bankers are telling them, there is no point in being a public company unless your post-deal market cap will be at least $1 billion. Given that everybody’s stock is in the crapper and hoarding cash is the default posture, acquisitions are few and far between too.
So, we have orphan public companies and orphan private companies. I will save my thoughts on orphan public companies for another time.
Although he spares us the mind-numbing complexities of Reg D and Rule 144 and “Accredited” and “Qualified Institutional” buyers, Fred is correct that the securities regulatory scheme in this country is not conducive to a secondary market for private equity securities. Still, I do not agree with Fred that regulation is the right place to start. My guess is that Fred could have sold those readers some stock if he wanted without running afoul of the law.
Normally, a purchaser in a private transaction with an issuer — such as a venture fund buying stock directly from a private company — must stipulate that they do not plan to re-sell the securities they are purchasing. If a purchaser buys shares from an issuer with the intent to then sell those shares to someone else, the purchaser becomes a “statutory underwriter” and must perform due diligence on the issuer or be liable for any losses that the next purchasers suffer. This is why investment bankers’ fees on IPOs (when they happen) are still 7%. The bankers are underwriting the deal (buying with an intent to re-sell) and have a due diligence obligation if they want to have a defense against being liable for the losses of subsequent purchasers.
As with any barely comprehensible regulation, there have to be exceptions. Rule 144a says that a purchaser can re-sell the securities it purchased without being considered an underwriter if it sells them to a Qulified Instituional Buyer (”QIB”, pronounced “quib”), basically someone who has a $100 million in investable assets or is a bank or an insurance company. This is the way most bond issuances (back when companies could issue bonds) get done.
When he talks about a “qualified” buyer, Fred is alluding to Rule 144a. If I am reading him right, Fred is saying that in order to sell to the readers that approached him, he would have to rely on 144a (in other words the readers would each have had to have $100 million in their brokerage account). However, just because you don’t have an intent to re-sell the shares when you purchase them from the issuer, that does not mean that you can never re-sell them later in a private transaction. You simply must not intend to re-sell the shares at the time of purchase.
Absent other constraints, if Fred wanted to sell some shares of Twitter to me, he probably could. So what are these other potential constraints?
First of all, Fred may have entered into an agreement where if he receives an offer for his stock that he would like to accept, he must first give the other existing shareholders an opportunity to buy his stock on those same terms. This “Right of First Refusal,” while not universal, is very common in private company deals. Needless to say, I am much less likely to make Fred an offer for his stock if all I am doing is establishing a third party value for others to step in front of me and snap the stock up. Second, investing in private companies requires that you do considerable diligence (there are no “underwriters” doing it for you). While it might be true that the people approaching Fred about Twitter and Boxee are smart, sophisticated people, that doesn’t mean that they really know what they are getting. They might just want to buy some stock in what they perceive to be “hot” companies that have the sponsorship of someone like Fred. Furthermore, they may have no opportunity to perform the due diligence even if that is what they want to do. Fred probably has “Information Rights” where he is entitled to receive monthly financial statements, budgets and other critical information from the issuer, but he is also probably obligated to keep that information confidential. How am I going to know that Twitter is anything other than a company with a lot of buzz if I can’t see how much cash they have in the bank and how much they are spending along the way?
I could go on, but my point is not to bust on Fred. He even says there are lots of reasons why he can’t sell to these readers. Doubtless one of those reasons is that he thinks these investments will make him a lot of money one day, which is great.
It is true that securities regulations in the United States make it more difficult to sell a security in a private company than in a public one (this is intentional, I might add). Still, until investors like Fred start giving up all of their rights of first refusal, information, co-sale, pro-rata purchase, anti-dilution, etc. ad infinitum, a meaningful secondary market in individual private equity securities just is not going to develop. This is one area where blaming the government is barking up the wrong tree.
Darren Rowse is the man behind