Personal Trading of Shares by VCs on Secondary Exchanges Raises Concerns of Conflicts of Interest

The trading of private company shares in the personal accounts of venture capitalists is raising concerns over potential conflicts of interest for firms as the influence of secondary market exchanges continues to grow.

Numerous venture firms permit employees’ trading in secondary market shares with some limitations, including Lightspeed Venture Partners, Bessemer Venture Partners, YCombinator, Matrix Partners, Founder Collective, Blackberry Partners Fund, Volition Capital and Rho Ventures, according to a peHUB investigation into the practice.

Others — which appear far fewer in number — such as Flybridge Capital Partners, block the practice with policies demanding general partners hold no secondary securities. Many more VC firms refused to comment at all, when peHUB contacted senior partners.

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Sources at firms willing to acknowledge they prohibit GPs from making secondary market investments cited conflict of interest concerns when asked by peHUB.com.

With little in terms of guidelines or industry standards in place, it is unsurprising the issue is not yet one with high visibility among the venture community. More attention is given to the Securities and Exchange Commission’s emerging probe over secondary trades, such as Goldman Sachs’ recent purchase of $1.5 billion in Facebook stock, and whether these transactions push private company shareholder tallies past the 500-person mark, which would require greater financial disclosures.

In any event, the purchases by individual VCs pose a potential minefield for firms raising new funds.

“It will be an issue,” says one high level executive in the secondary business who asked to remain nameless. “It’s a problem with perception.”

That perception could cloud a firm’s good intentions when a GP purchases shares on a secondary exchange of a company that is in the portfolio of a rival firm. The trading also calls into question the goal of VC firms providing maximum returns to LPs when a partner’s personal holding is the acquisition target of a portfolio company.

“There is a lot of potential for misbehavior,” says Katherine Litvak, a law professor at Northwestern University Law School, specializing in private equity, venture capital and finance law. “LPs should be talking to their lawyers about this.”

Some experts expect secondary trading policies to be forced upon firms when they raise new money and sign new LP agreements. These restrictions may require future GP investments to be reviewed by an LP advisory board or by a firm’s investment committee. Many firms that raised funds in the past two years have broad-brush policies in their LP agreements limiting how large an investment can be, or requiring a management committee be informed. However, multiple experts and legal sources confirmed, should VCs’ secondary market activity be challenged formally by limited partners, discussions would unfold privately and a resolution would be non-public.

Currently, the practice of trading in personal accounts appears limited. Most activity appears to be coming from partners at firms in transition: those not raising new funds or raising smaller funds that will push some partners to the sidelines.

But buying is by no means insignificant. One West Coast GP contacted by peHUB acknowledged buying “the usual suspects, such as Facebook, LinkedIn and Zynga in the secondary market for over a year.” He asked not to be identified.

Another senior VC source, who asked to remain anonymous, said concerns about private share buying forced his firm to draft a rule prohibiting secondary stakes in personal accounts. “It’s an obvious potential conflict issue and we stay as far away from any conflicts as we can,” he says.

Executives of the secondary marketplaces say they see no sign the SEC is interested in the personal trading issue. However, firms will want to stay ahead of the issue.

Len Rand, managing director of Granite Ventures, says his firm carefully scrutinizes requests by partners to buy or sell secondary shares when they arise. The aim is to avoid a conflict of interest, he says.

Mark Boslet contributed to this report