What You Don’t Know about (and in) the Secondary Market Can Hurt You
The secondary, pre-IPO market for shares is a rough and wild place with great rewards … and great risks.
The joint-stock company and the stock market were … born within just a few years of each other. No sooner had the first publicly owned corporation come into existence with the first-ever initial public offering of shares, than a secondary market sprang up to allow these shares to be bought and sold. It proved to be a remarkably liquid market. (The Ascent of Money, p. 132)
That’s Niall Ferguson describing the early stages of the first market for shares in one of the first limited-liability companies in the Netherlands in the early 17th century. First came the startup. Interestingly, it was a monopoly created by merging several private firms by government order. Next came the IPO, with shares initially vested for 10 years. After the directors successfully petitioned the government to suspend their obligation to publish the accounts, making shareholders’ claims on the company’s profits unverifiable, the shareholders started selling their stock to third parties.
The genesis of the stock market took a few decades, which is a long time for an investor waiting on returns, but very rapid compared to many other complex social institutions. Similar evolution has been happening to the private-equity/VC market on about the same time scale. The secondary market in startup shares is now flourishing. What does this market look like, and what are the typical blindspots of incoming investors?
The Scope of the Secondary Market
It’s hard to measure the scope and history of the secondary market in Silicon Valley because there is no central exchange. According to one estimate, the first half of 2019 saw a secondary market volume of $55.4 billion, which was projected to rise to $215 billion by 2023. However, since many offers and sales proceed on a need-to-know basis among just a few parties, tracking deals and volume is not straightforward.
Reconstructing the history of Silicon Valley’s secondary market is difficult for the same reason. The flexibility and informality that make the secondary market so attractive also make it more opaque.
Still, the logic of the market allows inferences about who’s playing and how the market is likely to react to other kinds of change. The obvious sellers in the market are startup founders, employees, and early-stage investors who want to liquidate their shares but can’t or don’t want to wait for an exit. Early stage investors can also use the secondary market to participate in late and growth-stage rounds of their portfolio companies without additional risk — they simply sell some of their early preferred shares at the price set by the new round, and then use some of the proceeds to partially reinvest in the same company and secure top liquidation preference with no risk of losing capital. They will have already secured at least some profit.
Not surprisingly, these different groups have different interests. Startups give their employees common stock vested for a few years in the hopes of keeping them loyal and motivated. Early-stage investors tend to receive more valuable preferred stock in order to secure their support and keep them coming back round after round. Founders tend to keep common stock or (in rare cases) hybrid FF preferred stock in order to profit from their genius and hard work. However, investors don’t want anyone selling shares and cashing in on terms that they themselves can’t obtain, so they want — at minimum — to be included in the best deals. Both founders and investors want maximum control over who has how many of their company’s shares and when they’re being sold.
The typical buyers include late-stage VCs, family offices, UHNWIs, and anyone else seeking access to promising stock, but who doesn’t want to wait to buy it at public-market price at an IPO, or wanting to buy the stock before a big anticipated exit. In 2020 and 2021 many of the now-famous tech behemoths — AirBnb, Palantir, Snowflake, DoorDash, Unity, SpaceX, RobinHood — have had tremendous secondary market transaction volume thanks to smaller investment firms and individuals seeking secondary deals instead of chasing underwriters and fighting huge institutional investors for IPO allocation. Prior to COVID, AirBnb was priced at $36B on the secondary market before surging to over $100B after their IPO, Unity went from $6B secondary to $40B public, Palantir $22B to current $40B, and Snowflake jumped from $12B secondary to $80B post-IPO within less than a year.
Since the secondary market is, by definition, private, and many of the pseudo-exchanges, like SharesPost and Forge, either do not have access to best deals, do not accept pre-committed capital, or charge high fees on top of often-inflated share prices, many would-be market entrants lacking the expertise or connections to get started should probably invest through or alongside a late-stage fund.
Knowing the incentives involved also helps to predict the market’s dynamics. The secondary market is a source of liquidity, and it presents an alternative to traditional exits. Other things being equal, the secondary market will gain importance and volume as exits wane. Like many phenomena in business and life, exits fluctuate between upward and downward trends. There have been a host of big exits recently. Taking IPO activity as a rough proxy for all exits, the current volume matches the previous peak of 2014. Their current performance, however, is almost unprecedented.
New entrants are another indicator of a thriving market. Not only have the range and professionalization of intermediaries on the secondary market increased, but entirely new models are emerging as well. Though it sounds like a contradiction in terms, a “private stock exchange” has even appeared, which seems to work like a traditional stock exchange with lower capital and disclosure requirements. Such innovation is the opposite of stagnation.
Implications & Complications of the Secondary Market
The secondary market is less transparent and open than the public market. Less regulation, formality, and oversight makes it more attractive for incoming investors, but it also presents them with different risks.
The first risk is obvious: these are still startups striving to prove themselves. While big public-market incumbents do occasionally tank, they’re generally established companies resting on a proven business. Venture capital, the kind flowing into and through the secondary markets, is daring, taking chances on new and yet-unproven ideas.
The second risk is less obvious: asymmetric information. The public markets are designed to provide all traders with the same information, and to prevent anyone with more or better information from trading. Sure, by investing more time and effort, some investors can gain an informational advantage. But the idea is that they all have the same access to the same basic resources. The system is designed to ensure equal opportunities, if not equal outcomes.
Other things being equal, more participants with more information will make price discovery more effective. The logic resembles regression in statistics: as more data goes into the model, the more the errors across many measurements will cancel each other out. That’s market efficiency.
The secondary market for startup equity is different. There are fewer disclosure requirements — barely any for firms with fewer than 2000 shareholders — so everyone has a different vantage point with differential access to different information of different value.
However, asymmetric information in the secondary market doesn’t mean that insider trading is rife. It just means that “insider trading” doesn’t mean much. An “insider” in the public market is someone who knows more than everyone else and uses that information to their own advantage. An insider on the secondary market is just someone who knows more than you do and uses that information wisely and rationally.
Information asymmetry is one of the main reasons why investment advisors for public equity markets are as useful as rowboats on Mars, but they are essential to those entering private equity markets. The higher volume and higher quality of information that the biggest VC firms acquire through connections and board seats is one of the major reasons for their consistently good results.
The expansion and internal diversification of the secondary market is definitely a good thing for those who know what they’re doing. It provides more liquidity to finance more innovation and more chances to profit from it. But this market remains a risky, opaque, arcane playing field best left to experts. Whether or not poker players ever repeat the advice, investment gurus do regularly: “If you sit in on a poker game and don’t see a sucker, get up. You’re the sucker.”