Exchanges Democratizing Venture Capital

The upstart secondary markets SharesPost Inc. and Xpert Financial Inc. hope to bust into the private placement market in what could be a long shot bid to democratize the VC industry.

A third exchange, SecondMarket Holdings Inc., may join them.

The ambitious moves to let startups sell newly issued shares directly to buyers hold the promise of prying open the clubby world of venture capital, although few are ready to predict an abrupt transformation of traditional funding. More likely these online market places will need considerable time to prove themselves and initially supply a limited amount of late stage capital to delay the need for an IPO or acquisition.

Some experts even claim they will never capture more than a tiny share of funding deals after they launch this quarter. However, should the IPO market remain soft for several more years, all bets are off.

Two of the firms say they see big opportunities and that the time is ripe right now.

“It’s been a while since there has been positive innovation in the financial world,” says Xpert CEO Thomas Foley. “We see this as a financial revolution.”

Their stab at venture comes at a vulnerable time. VCs are feeling the strain of a poor liquidity environment and a weak IPO market, resulting in a corresponding pullback in commitments from financial institutions, such as endowments and pension funds. At the same time, startups are eager for new sources of financing. The prospect of cash from a less active investor base with no board seats and little influence over business strategy is a tradeoff many appear willing to take, even if it means foregoing the operational advice and industry experience a VC provides.

Internet startups, meanwhile, are hot, especially social media companies, and money managers are eager to get a piece of a Facebook, Twitter and Groupon. Many are ramping up internal private company research to chase these growth company investments.

If successful, the initiatives could dramatically shrink the role of VCs in the startup ecosystem, much in the same way that angels have in early stage funding.

But the challenges of putting together private company deals are considerable, and interlopers into venture haven’t always fared well. Hedge funds hoped to make a foray into the business a few years ago, with little success. Institutional money does flow into startups through brokers, investment bankers or when money managers approach founders, but it remains at a trickle. As many as 30% of LPs and fund managers show interest in funding startups, but by some estimates less than 5% of deals contain their money.

The exchanges acknowledge the hurdles. But they insist they have put together safeguards to protect startups worried about distributing business plan details too broadly and to screen out all but accredited investors. They also are aware of the thorny regulatory issues. The Securities and Exchange Commission has a preliminary inquiry of secondary trading underway looking at the key 500-investor threshold, above which private companies need to release protected financial information.

The probe, according to insiders, is focused on such companies as Facebook and whether secondary funds skirt the rule when they raise capital from scores of investors but invest as a single entity. While the probe doesn’t seem likely to bring substantial changes to the market, an unexpected outcome could derail private placement plans.

Despite the challenges, the exchanges are likely to find some early success. SharesPost says it is solely targeting more mature startups with the goal of bringing in money alongside venture funds. Xpert says it is looking to attract early stage companies as well.

We’re complementing what [VCs] do, not replacing what they do.”

David Weir, CEO, SharesPost

Xpert, which counts among its backers the high-profile investor Tim Draper of Draper Fisher Jurvetson, maintains that companies will have two alternatives when floating shares on its exchange. They will be able to use a Dutch auction with a minimum bid or a fixed-price option serving investors on a first-come, first-served basis.

To facilitate trading, startups will be able to pre approve interested investors so transactions can take place the instant buyers and sellers are matched. San Mateo, Calif.-based Xpert also boasts it has an SEC-approved online electronic trading system similar to that of Nasdaq.

Foley says the company will take a fee on transactions and capital raised starting at 2%, or well below the 5% to 7% brokers charge.

The company, f.k.a. XChange, raised almost $3 million from Draper and other angels. Draper, founder and managing director of DFJ, invested in the company outside of the firm. The startup is presently seeking an institutional round of several million dollars.

David Weir, CEO of San Bruno, Calif.-based SharesPost, declined to say what transaction fee he will charge, only that it will be “very competitive.” He says he is seeing a lot of interest from startups.

“At some point, you will see professional money managers raising capital to invest in private companies,” he predicts. “I would expect (primary shares) to be a very big business for us over time.”

SecondMarket doesn’t yet have plans to sell primary shares. The company—which is based in New York, but also maintains an office in Palo Alto, Calif.—has been looking at the idea, acknowledges Jeff Thomas, vice president, who says: “It is something we are evaluating.”

Entrepreneurs seem intrigued. Steven Goldsmith says he would consider it for his lighting controls system startup, which is presently raising a round of angel funding. A lot depends on the size of the transaction fee and what the investor base looks like, says Goldsmith, president of SwitchGenie Solutions. But “it’s very interesting. It just gives you more possibilities.”

MerchantCircle Chairman Ben Smith IV says he would not jump in without a lot of thought.

“This is basically an unregistered IPO,” says Smith, who adds that it raises possible legal issues about a company’s performance and the perception it is moving too slowly toward broad investor liquidity.

Perhaps the biggest complaint comes from VCs who worry startups will be short-changed.

“VC dollars come with a lot of value added,” says Richard Ferrari, a managing director at De Novo Ventures, early stage health care investors. “I actually think [the exchanges] will never get enough traction.”

Venture investors also worry small companies will have to put up with valuation discounts and that only the Facebooks and Twitters will get the attractive markups. Startups selling shares on an exchange also might be branded with a higher fail rate, since they could be the ones VCs reject. Top name VCs could be motivated in response to place restrictions on term sheets to prevent cheap shares from being sold online.

VC dollars come with a lot of value added. I actually think [the exchanges] will never get enough traction.”

Richard Ferrari, Managing Director, De Novo Ventures

Yet online private placements could be useful tools, says Randy Hawks, a managing director at Claremont Creek Ventures. They could help companies resist takeover attempts or negotiate better prices from acquirers. They also might spark more interest on the Nasdaq for growth companies.

“I’m willing to live in a capitalist market,” Hawks says.

The opportunity is similarly more attractive than secondary trading, says Hans Swildens, managing director of Industry Ventures, a secondary market investor. VCs in the United States invest roughly $20 billion a year, or about 10 times the transaction volume of the secondary market, Swildens says,

Still the exchanges won’t get more than 1% to 3% of that market, or about $200 million to $300 million in transaction volume, he predicts. “I don’t think it will change the market.”

For now, however, that could be how the exchanges like it. Scaling the business will be difficult.

“We’re complementing what [VCs] do, not replacing what they do,” Weir says.

Facebook Casts a Long Shadow as Secondary Markets Prosper

History:

Secondary exchanges emerged 18 months ago to provide liquidity to venture investors, founders, angels and employees, as well as an investment channel for institutions interested in private companies. With startups taking longer to go public, venture investors needed a way to sell holdings to accumulate reserve capital for portfolio companies.

Popularity: Interest in the exchanges grew because of the so-called “Google Effect,” which caused hyper valuations for top name Internet companies. Facebook, for instant, reportedly received a $50 billion valuation in early January when Goldman Sachs put up money for the social network. Employees and investors are eager to profit from the high valuations. Institutions are eager to buy into growth companies.

Growth: Exchanges continue to expand at a good clip. SharesPost now has 37,000 institutional buyers and individuals registered on its site, up sharply from early last year. The transaction volume on SecondMarket rose to $73.5 million in the third quarter of 2010 from trades conducted in nearly a dozen companies.

Concentrated Market: Despite the growth, buying remains concentrated in a small number of names. About 80% of transactions on SharesPost measured by dollar volume take place in about a half a dozen companies, including Facebook, Twitter and Groupon Inc. In the third quarter, Facebook shares accounted for 37% of SecondMarket’s transactions. Next in line were GlobalLogic Inc., 35%; and Bridgelux, 11 percent. The concentration poses a risk. A Facebook IPO would cut deeply into business.

Institutional Interest: Secondary markets are attracting increasing institutional participation. SharesPost says transactions involving institutions—mutual funds, hedge funds and the like—now make up about 40% of the site’s dollar volume as institutions dedicate more resources to understanding private companies. “We’re seeing an increasing amount of demand from institutional investors,” says SharesPost CEO David Weir. “They are looking for high growth opportunities.”