Investing in Secondary Markets

This article published with permission from InvestmentU.com.

As Facebook joins the roughly 5,100 public companies trading on major exchanges in the United States, only a week ago shares were swapping hands on a completely different market — the secondary market.

And, for a growing number of investors and institutions, this alternative marketplace is quickly becoming a hot spot to potentially cash in on a number of firms before they go public.

In fact, you might even be eligible to participate… and not even know it.

The truth about secondary markets

According to aonetwork.com, secondary market exchanges serve to facilitate the purchase and sale of illiquid, restricted and alternative assets, such as private company stock and restricted public equity.

Facebook, Zynga (Nasdaq: ZNGA) and LinkedIn (NYSE: LNKD) all sold on secondary market exchanges before they filed to go public.

Today, well-known firms such as Twitter, Bloom Energy, e-Harmony and Foursquare can all be found on these exchanges, as well.

And many other companies, tech start-ups especially, are finding secondary markets as nice alternatives to IPOs.

LinkedIn Chief Executive Officer Jeff Weiner explains, “Historically when companies had established a certain level of performance and maturity, the IPO was a natural next step. The reason for that was to generate liquidity… to get access to currency… capital… and [for] credibility. The secondary market can help check the box for a few of those objectives.”

So, could secondary markets ever replace the IPO?

Not a chance. Private companies aren’t required to disclose their financial information to investors like publicly traded firms. That’s one of the major risks in this market.

But as Reuters points out, “While the amount of information that would-be investors have is surely lower than if there were a formal SEC-registered prospectus, the rise of the internet has made it much easier to do reasonably good due diligence on how much a company might be worth.”

That’s a big reason the amount of capital flowing in the private-share trading business has more than doubled in value, to $7 billion, in just the past two years.

Even more, Congress is looking to pass laws that could push even more liquidity to this market by doubling the amount of shareholders, to 1,000, that private companies are allowed before needing to publicly disclose their finances.

This is very promising news for companies, like SecondMarket and SharesPost, involved in the secondary market…

Introducing SecondMarket and SharesPost

Founded in 2004, SecondMarket offers a number of asset-backed investments — including auction-rate securities, bankruptcy claims, private company stocks and fixed income products. Meanwhile, SharesPost specializes only in the selling of private company stock.

All of the companies mentioned above (Twitter, Bloom Energy, etc.) either trade on SharesPost, SecondMarket or both. These two companies currently dominate the secondary market space.

The main purpose of these firms is to connect buyers and sellers to trade the various assets they offer. In a way, they are sort of like e-Harmony or LinkedIn, but for investors and institutions.

For example, SecondMarket uses a proprietary matching algorithm to search through its 75,000-member customer base and find good matches between buyers with sellers. After a trade is complete, the companies then take a cut of the total transaction, roughly 3%. This business model has made SecondMarket worth about $200 million, according to The Wall Street Journal.

And now a slew of new competitors are catching on…

For example, Crain’s New York Business reports financial services firm Knight Capital Group (NYSE: KCG) just established its own private-share trading business in December. And LiquidNet, an institutional brokerage firm, also entered this space last year.

As I alluded to earlier, not all investors are eligible to enter this market. It’s only open to financial institutions and accredited investors. In other words, you need to be a hedge fund, investment bank or have a net worth of $1 million and an annual income of $200,000 ($300,000 for couples) to start investing.

Plus, it’s worth mentioning many of these firms have minimum transaction requirements. For instance, SecondMarket has a minimum transaction amount of $100,000. So you need to have a good amount of cash to get involved.

The bottom line

Of course, before entering any investment, it’s important to do your homework first and know what you’re getting into. The secondary markets are certainly not for everyone, but it is a very interesting development and is helping reshape the way companies prepare for their IPO

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Mike Kapsch is part of the research team at InvestmentU.com. See more articles by Mike here.