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Is Another Internet Bubble Underway in Social Media? Private Stock Trading in Social Networking Companies

Published onMar 23, 2011
Is Another Internet Bubble Underway in Social Media? Private Stock Trading in Social Networking Companies

Shareholders want to cash out, outsiders want in before an IPO; liquidity pressure on an illiquid unregulated market draws SEC scrutiny.

Social networking has undoubtedly produced a whole new way to interact with the web, and each other.  Connecting with others is the underlying motivation for social networking users.  And connect they do.  Facebook, famously began in 2004 and now has over 500 million members.  Twitter started in 2006 and now has about 200 million member accounts.  LinkedIn started nine years ago, has over 90 million members.  The explosive growth experienced by these companies is reminiscent of the early days of the internet boom.  Other than being young and tech driven, these three companies share another common trait.  They are currently private.  That is, shares in the companies are not traded on public exchanges and the general public may not purchase the stock. (Note:  Most commentators believe Facebook and Twitter are positioning themselves to go public, while LinkedIn recently announced it will go public in 2011.  But all three currently remain private.)

The tech start-up story is pretty familiar, especially since Mark Zuckerberg’s ascension to success was chronicled in an Oscar-winning movie.  But the fact is, many of these companies started in a similar fashion; intelligent computer scientists or students with an idea of using the web in a new manner to connect people invent a web-based computer program.  Then the inventors expand their idea into a business.  Eventually, through use of the program by Internet users the business achieves the capability to turn a profit.  But expansion does not happen magically, investors and venture capitalists in return for an equity stake in the company often fund it.

Here is where the story gets interesting.  Typically, only the inventors, early employees and the early investors, hold shares in these private companies.  Each shareholder hopes for the day when he can turn his stake in the company into cash.  The cash out date that private shareholders look forward to is the IPO; these relatively few shareholders hope to see the stock price explode and thereby profit more than handsomely on their stock.  (The 2004 Google initial public offering turned one thousand of the company’s employees into instant millionaires.)  Without a liquid market to trade in, private shares in these companies are essentially worthless.  Although there are limitations on what current employees may do with their stock and the shares are not highly liquid, trading between former employees or even early investors does take place on private exchanges.  And further, some companies have looked to private investments to provide capital for further expansion.

Movement in the private market has investors clamoring to get into these tech stocks before an initial public offering.  The high demand for these stocks is driving the valuation of these private companies to astronomical levels.  On March 4, CNBC reported that a 0.1% stake being purchased by General Atlantic puts the valuation of Facebook at $65 billion.  Which makes Mark Zuckerberg’s 24% stake worth more than $15 billion.  Zynga, the company responsible for Facebook gaming hits like FarmVille, has been estimated to be worth $10 billion.  Twitter, fueled by a little “tiger blood,” has recently been pushed to $4.5 billion, and LinkedIn has been valued at $2.9 billion.  Meanwhile, Groupon, the daily discount website, has been valued at $15 billion, and turned down a $6 billion takeover offer from Google. The point being, that social media is beginning to look a lot like a bubble.

Though these investments are private placements arranged by investment banks with major institutional investors, smaller trades are taking place on secondary private exchanges like SharesPost and SecondMarket, both ebay-like platforms that connect private-stock buyers and sellers.  A recent DealBook article highlighted a February auction that moved almost $40 million worth of Facebook shares on SecondMarket.   Moreover, at least three firms have considered creating investment pools that aim to buy up shares of emerging technology companies like Facebook, Twitter, and LinkedIn.  GreenCrest CapitalFelix Investments and EB Exchange Funds are calling these pools “Facebook funds” or “Twitter funds.”

But increased scrutiny from the Securities and Exchange Commission has accompanied the enormous valuations and increased trading.  The closer observation is likely related to the evolution of private market, which includes the emergence of online broker services like SharesPost and SecondMarket.  The SEC does not require private companies to disclose financial information or to file financial statements like publicly traded companies.  One of the main rationales underlying the Securities Exchange Act is to provide the investing public more information on the companies of which they own stock.  Therefore, once shares in a company become more widely owned the SEC takes an interest in its financial information.

The Securities Exchange Act section 12(g) requires a company with 500 or more shareholders of record in a given class of stock to publicly disclose certain financial information. (Good analysis of the Facebook situation at DealBook.)  Disclosure does not mean a public offering, but it does mean losing a good deal of protection for the company’s non-public material information.  Usually, a company becomes a reporting company (what happens when it has more than 500 shareholders) shortly before it files for an IPO to avoid this.  Further, the SEC also requires persons dealing on the secondary private exchanges to be accredited investors, on the assumption that accredited investors are sophisticated and can fend for themselves against a lack of financial disclosure.  These issues are brought up by the Goldman Sachs investment in Facebook and the pooling funds created by the investment funds, so it’s not surprising that the SEC has taken notice of private trading.

SEC interest is also affecting the way these companies control the trade of their shares.  In 2010, Facebook banned its employees from selling stock in the private markets in order to keep out of trouble with the SEC.  Further, EB Exchange Funds has recently stopped development of its fund “Facebook funds.”  Of course, companies could always avoid the hassles of remaining private by launching an IPO, and this would certainly make early employees, investors and those lucky enough to have a piece of a hot tech stock very happy.

*Joseph Norman is a second-year law student at Wake Forest University School of Law.  He holds a Bachelor of Science in Management from North Carolina State University and an MBA in Finance from the McColl School of Business at Queens University of Charlotte.  Prior to enrolling in law school, Mr. Norman worked for Wells Fargo Wealth Management in Equity Research.  Upon graduation in May 2012, Mr. Norman intends to practice corporate law.

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