Would a secondary market for startup stock be a blessing or a curse?

Posted 24 April 2009 09:30am by Patricio Robles with 1 comment

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The current state of the financial markets has made it very difficult for startups to go public. Even startups with significant revenue and bright futures have no guarantee that they'll be able to go public anytime soon.

The dismal IPO market is taking its toll on venture capitalists, who invest in companies that they expect, if successful, will be liquid within some years.

Needless to say, this has many in the VC community worried, since there's no end in sight to the current conditions. To gain liquidity, some companies are permitting their stock to trade hands between shareholders and private institutional buyers. Facebook is one.

Unfortunately these secondary markets are far less efficient than their public counterparts. But that soon could be changing. A New York-based company called Second Market is going to be launching a marketplace for the trading of shares in private companies. It already operates other markets for illiquid assets. If successful in this market, this could open a new path to liquidity for startup founders/employees and their investors.

Fred Wilson, a VC at Union Square Ventures, likes the sound of this. He calls it a "really good idea" and says "it's a third choice that we need".

But is it?

On one hand, it's hard to argue that good startups haven't been affected by the craziness in the public markets. While nobody is suggesting that we go back to 1999 and let every startup with a great story go public, it is a shame that so many good companies are forced to sit on the IPO sidelines, which could potentially put them in tough positions financially down the road as they need more capital to grow. A healthy IPO market is in the interests of lots of people.

On the other hand, Wilson admits that an efficient secondary market will create problems for startups. Companies may find themselves with a hodgepodge of shareholders and founders and employees might have the ability to cash out before 'the real job is done'.

One person who left a comment on Wilson's blog also pointed out the regulatory implications:

Investors getting sold securities without any disclosure and accountability - this is exactly what the SEC was set up to prevent, right? like unregistered schemes with promises of impossible returns? (irony alert)

Publicly trading 'private' securities is kind of an oxymoron - in what sense are they 'private', except that the rules for being sold to the public have been circumvented?

It's a fair point, especially in light of all the financial fraud and shenanigans that have come to light recently.

Time will tell whether Second Market takes off and creates a wholesale path to liquidity for startups kept out of the public markets or whether it flops. Not all VCs are convinced of its usefulness.

But I do want to voice my disagreement with Wilson's statement that "Entrepreneurs won’t start companies and investors won’t invest in them if there is no path to liquidity on the company stock". While it's true that investors are looking for liquidity, the idea that entrepreneurs won't start companies because of a lack of liquidity events is not true.

There are plenty of companies that were never started with plans to provide the type of liquidity that comes from an IPO (or acquisition). Chances are you run one or work for one! From the countless number of one-man websites that earn their owners a comfortable living to the small digital consultancies that provide top notch service to blue chip clients, most 'startups' are just regular small businesses that pay the bills and compensate founders and employees through revenue/profit/cash flow.

Raising VC and going public or getting acquired is a great thing and kudos to those entrepreneurs who can do it. But let's not forget that the average entrepreneur is really a small business owner and he or she is going to start a company regardless of the IPO market or M&A activity because the goal isn't to achieve 'liquidity', it's to build a great business.

There's a famous saying, "Give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime". While I think something like Second Market may have a place in feeding startup entrepreneurs and investors, if there's any lesson from the recession, it's that having enough customers and clients to pay the bills and turn a profit is the best liquidity around, even if it doesn't offer an ocean full of money.

Photo credit: davidcrow via Flickr.