Losing a Goose That Laid the Golden Egg

Not everyone on Wall Street is giddy over Facebook’s initial public offering of stock.

A group of private exchanges has popped up in recent years to accommodate a fast-growing trading market in the private shares of the Internet companies like Twitter and LinkedIn. Facebook has driven much of this growth, emerging as the most actively traded private company by a wide margin.

At SecondMarket, one of the largest of such exchanges, the trading of Facebook shares accounted for about a third of the firm’s total revenue last year.

Now, with Facebook on the verge of listing on either the New York Stock Exchange or the Nasdaq, the secondary market is faced with the prospect of losing its golden goose. Not to mention that Zynga, Groupon and LinkedIn, all of which were actively traded on private exchanges, have recently gone public.

The transformation of these once-private Internet darlings into publicly traded companies may well spell the end for these private market exchanges. Yet the leading players insist that their business has room to grow.

“We certainly expect a reduction in revenue, but we also expect some companies like DropBox to step in,” said Gregg Brogger, the president and founder of SharesPost. “Venture capitalists always have another generation of new start-ups, and our market will as well.”

SecondMarket and SharesPost are two of a handful of exchanges that have facilitated trades in Facebook and other private company shares. Although SecondMarket was founded in 2004 — the same year Mark Zuckerberg pushed his Facebook Web site live — many of its rivals are less than four years old. Its closest competitor, SharesPost, started in 2009. Meanwhile, in recent years, a smattering of investment firms have created their own pooled vehicles to buy shares in fast-growing, private Internet companies.

The market’s growth was fed by several factors. A sluggish stock market slowed the demand for initial public offerings. At the same time, the valuations of an elite group of social-networking companies soared.

As the market values of Facebook, Twitter, and Zynga skyrocketed, some of their employees and early backers sought to cash out their holdings. At the same time, buyers — many of whom were users of these sites — wanted to own pieces of these companies before they listed on public exchanges. Facebook was the hottest of the bunch.

“Facebook was quite unusual. It attracted a lot of buyers,” said Steven Kaplan, a business professor at the University of Chicago. “A company with a 50- to 100-billion-dollar market capitalization that hasn’t gone public yet is not an everyday occurrence. It’s an every five to 10 years occurrence.”

In three years, the trading volume of the private exchanges has been tremendous. In 2009, SecondMarket completed $100 million worth of transactions in private shares. Last year, its volume was nearly six times that amount, with Facebook trades making up the bulk. Its rival SharesPost logged $625 million in transactions last year, more than double its total from 2010.

The frenzied activity has drawn scrutiny from regulators. About a year ago, the Securities and Exchange Commission asked several of the leading private exchanges for details about trading in Facebook, Twitter, Zynga and LinkedIn. The commission’s investigation is exploring the transparency of these markets and proper disclosures by companies.

“These markets are used car markets where buyers aren’t allowed to check what’s under the hood,” said Jay R. Ritter, a finance professor at the University of Florida.

In its initial public offering filing on Wednesday, Facebook disclosed that it had been cooperating with an S.E.C. inquiry into secondary trades involving the private sale of its stock. It said it thought it had complied with the federal securities laws governing those transactions.

The S.E.C. is also considering changing a rule that would benefit SecondMarket and its rival exchanges. Under current rules, private companies with 500 or more shareholders must provide increased financial disclosure to the regulators. The commission has said it is considering raising that number, a change that would help companies stay private for a longer period of time.

Yet some companies are reluctant to participate in the secondary market. As the market has grown, Facebook and others have grown circumspect over who owns their shares and have tried to exert control over their employees’ ability to trade them. Many are adding restrictions to new shares, giving the companies more control, Barry Silbert, the chief executive of SecondMarket, said. This threatens to damp the trading volume on these exchanges.

From the perspective of Mr. Silbert and his peers, Facebook’s success in trading on those exchanges represents a new era in capital formation, where companies will stay private longer and shareholders will not wait for an I.P.O. to take money off the table. While no private Internet company can fill the hole Facebook will soon leave, the exchanges hope a deluge of smaller companies will eventually fill the gap.

Mr. Silbert has also moved to transform SecondMarket — which also facilitates trading in other assets like bankruptcy claims — into a more mature exchange. It recently required companies that wanted to sell shares to submit financial information, including audited financial information and capitalization tables, for prospective investors. Mr. Silbert said the extra layer of transparency would be a great standard for the post-Facebook era, since it would help buyers feel more confident in their trades. The company says it has conducted transactions for 45 companies and is qualifying 200 additional companies.

SharesPost has also been busy. In 2011, it added about 40 companies to its menu. It has revamped its platform, adding features that cater to companies seeking more control. Through an online dashboard, a company, for instance, can decide what type of buyers it prefers and how many shares can be sold for a period of time.

“This Facebook moment is bittersweet,” Mr. Silbert said. “Facebook was our first foray into the private market and proved that secondary market trading could be great for a company.”