By Susan Pulliam and Telis Demos
Hedge-fund manager Jonathan Sands gushed in a January email that
shareholders of Uber Technologies Inc. could quadruple their money
in two to four years. "The numbers behind Uber are astounding," he
wrote.
The email was a sales pitch for an investment fund with $100
million of stock in the privately owned, smartphone-based car
service, which Mr. Sands said he was getting "directly" from Uber
to sell to other investors, minus a management fee and cut of the
profits for himself.
He didn't actually have any Uber shares to sell. But in a
bustling intersection of Silicon Valley and Wall Street, Mr. Sands
and other financial middlemen like him are creating a murky, ad hoc
market where the red-hot stocks of closely held technology
companies trade largely out of sight of regulators, other investors
and the companies themselves.
Because up-and-comers like Uber, disappearing-message provider
Snapchat Inc. and home-rental service Airbnb Inc. haven't gone
public, almost all of their stock is owned by venture-capital
investors and employees, who face tight limits on selling their
shares.
But some early investors are eager to cash in now. To help them
outmaneuver company restrictions on stock sales, middlemen are
designing derivatives that deliver payments to employees based on a
stock's perceived value. Some financial firms let employees pledge
their shares as collateral for a loan.
Buyers sometimes form investment pools to flip slices of private
stock to other investors who are hungry to get in on the action
long before an initial public offering.
Prices used in transactions can be based on little more than a
guess, since private companies keep almost all their financial
information secret.
Mr. Sands, who runs Artist Capital Inc., based in New York,
asked investment bank Aldwych Capital Partners to help him raise
money for the Uber fund. Aldwych, also of New York, turned to
Raymond James Financial Inc., a large brokerage firm in St.
Petersburg, Fla.
"We are exclusive on a raise for an UBER SPV - the shares are
coming straight from top management at the last valuation (40
bln)," one Aldwych employee told a Raymond James employee in an
email. "Moving fast."
In late February, Uber lawyers told Mr. Sands to back off, and
he did. A Raymond James spokesman declines to comment. An Aldwych
spokeswoman says the bank was "happy to make a few enquiries" when
asked by Mr. Sands to "gauge investor interest in their Uber Fund.
In the end, nothing was raised."
Mr. Sands concedes that he didn't own Uber stock but decided to
abandon the idea anyway, partly because he lacked the financial
data needed to support a large valuation for the car service. "I
didn't do anything wrong," he says.
Uber declines to comment on Mr. Sands directly, but a
spokeswoman says it has "strict transfer restrictions" on shares
and tries to "limit any fraudulent activity." Legitimate purchases
of Uber stock can be made only through the company, she adds.
Uber's last round of funding valued it at $41 billion.
The shadowy trading marks a dramatic shift in how wealth is
being created during the continuing technology boom compared with
the dot-com bubble of the 1990s. Back then, the biggest gains came
after companies went public. For example, Amazon.com Inc. shares
are up more than 20,000% from the online retailer's IPO price in
1997. The company was then worth roughly $400 million, compared
with about $171 billion at the close of trading Thursday.
In contrast, Facebook Inc. was worth $104 billion in 2012 when
it sold shares to the public, or less than half of the
social-networking company's current stock-market value.
At least 78 privately held, venture-capital-backed companies are
now worth at least $1 billion apiece, with a combined valuation of
more than $310 billion. Just 49 companies were worth $1 billion or
more a year ago.
The dizzying rise is fueling runaway demand from investors who
want a piece of the investment profits before companies go
public--and an opening for hedge funds and other financial firms to
create a lucrative market in the illiquid securities, according to
an investigation by The Wall Street Journal based on emails,
government documents and interviews with dozens of traders,
investment bankers, hedge-fund managers, venture-capital
executives, lawyers and company officials.
No one knows the exact size of the so-called secondary market
for shares of private companies that are held by employees and
other investors. Participants in pre-IPO trading estimate that $10
billion to $30 billion in stock changed hands last year.
"It's a telltale sign the world has gone mad for these
companies," says Timothy Keating, chief executive of BDCA Venture
Inc., a publicly traded fund in Greenwood Village, Colo., that
invests in companies before they go public. BDCA buys shares
directly from companies.
Mr. Keating says the use of financial engineering to facilitate
trades in private-company shares is financially risky to buyers and
sellers. "It doesn't make sense to own a derivative of something
that itself is hard to value," he says.
Regulators are monitoring the surge in pre-IPO trading, which is
permitted under federal and state rules for unregistered
securities. So far, the Securities and Exchange Commission has
filed a handful of enforcement actions related to trading of
pre-IPO shares.
Three of the cases alleged misleading investors and failing to
disclose fees before Facebook went public. One brokerage firm was
accused of falsely claiming that their investment fund owned
Facebook shares and of misrepresenting Twitter Inc.'s revenue to
lure investors.
The defendants paid back gains and penalties to the SEC, without
admitting or denying guilt, and a top executive at the brokerage
firm agreed to be barred from the securities industry. Two other
securities firms paid fines without admitting or denying guilt.
In March, federal prosecutors charged Gregory Gray Jr. of
Buffalo, N.Y., with criminal fraud for allegedly persuading an
unnamed investor to put $5 million into a venture-capital fund that
said it would buy Uber shares. Mr. Gray hasn't entered a plea.
Prosecutors claim he used the money to repay other investors.
The SEC filed civil charges against Mr. Gray. His lawyer, Peter
Katz, says: "Things are not always exactly as they appear in
allegations that are brought by the government," declining to
elaborate.
Andrew Ceresney, the SEC's enforcement chief, declines to
comment on ongoing investigations but says the agency could file
additional cases against middlemen if they flout the law. "When
investment advisers raise money for the purpose of purchasing
pre-IPO shares and they fail to actually purchase those shares, it
can be securities fraud," he says.
Kenneth Guernsey, a partner at law firm Cooley LLP, which
represents companies, investment banks and venture-capital firms,
says there is a "proliferation of players beyond the organized
markets." Some of the participants "will be fantastic, and others
will be disastrous," he adds.
Some buyers aren't bothered at all by the risks, saying they
just want shares in the hottest private companies. Rohit Dhawan, a
financial adviser in Palo Alto, Calif., plowed about 5% of his
personal investment portfolio into Palantir Technologies Inc.
shares last year, looking for the money to make a down payment on a
house.
The data-analysis company, also based in Palo Alto, was valued
at the time by its venture-capital investors at about $9 billion,
according to people familiar with Palantir's fundraising
transactions.
"We were playing cards one night, and my friend said he could
get me some Palantir stock, so I put money in," says Mr. Dhawan,
who never saw any in-depth financial data about the company. "Do I
care about valuations? I'm not following it as much as I should,"
he says. "I'm hoping it's a double."
Palantir was recently valued at about $15 billion.
It is one of the few private companies that often lets employees
cash in their stock, partly because Palantir has no current plans
to go public. Some sellers turn to firms like Disruptive Technology
Advisers LLC, of Beverly Hills, Calif., led by Alexander Davis, the
grandson of late oil and entertainment tycoon Marvin Davis.
In the past year, Mr. Davis has traded about $1.4 billion of
Palantir shares, says a person familiar with the company. Palantir
co-founder Joe Lonsdale, a venture capitalist at Formation 8 in San
Francisco, is a former adviser to Disruptive Technology
Advisers.
Video-gaming company Kabam Inc. has helped employees sell stock
through two secondary offerings, including a $46 million sale last
December.
Kent Wakeford, chief operating officer at Kabam, says the San
Francisco company isn't planning to launch an IPO soon and wanted
to "reward employees for the work they have done and time they put
in."
Kristel Fritz, a 31-year-old Kabam human-resources manager, sold
about 10% of her Kabam shares, using the proceeds to set up college
funds for her two young children. "There is a little left over, so
we are taking a trip to Disneyland," she adds. She won't say how
much she made on the sale.
Most startup companies require employees to get approval for any
stock sales or have a "right of first refusal" if employees want to
sell. But middlemen have figured out how to get around those
restrictions, including deals that enable employees to get cash
without actually selling their stock.
Some of the transactions can take the form of pledges in which
the shares are used as collateral for a cash payment to the
employee, says Dave Crowder, a partner at VSL Partners. The San
Francisco firm primarily helps employees at pre-IPO companies
manage taxes tied to stock options.
Earlier this year, VSL's website included Uber on a list of
"leading pre-IPO companies" for which VSL said it has provided
financing to shareholders.
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Mr. Crowder declines to comment on the Uber deals but says "all
kinds of transactions get done in stock where companies have some
transfer restrictions." Uber is no longer mentioned on VSL's
website.
Uber says its policy doesn't permit employees to pledge shares
or engage in derivative transactions.
DocuSign Inc. Chief Financial Officer Mike Dinsdale says the
electronic document-signature company, based in San Francisco, is
aware of transactions between employees and EquityZen Inc. The New
York brokerage firm has raised funds to own stakes in derivatives
and private-company shares.
Mr. Dinsdale says such deals "toe along between" the bounds of
DocuSign's policies. The company doesn't interfere because it wants
to steer clear of transactions that it hasn't arranged.
EquityZen Chief Executive Atish Davda says the firm seeks
company approval for the transactions. "Any transaction [that a
company] is not aware of is a violation of company rights," he
says. EquityZen's deals can be stock transfers or derivatives,
depending "on what the company is prepared for."
Kenneth Ballenegger, 23, says he is negotiating a deal to get a
cash payment from Equidate Inc., another secondary-stock
marketplace, for some of the shares he got while working as an
engineer at Chartboost Inc., a software maker for advertising in
mobile games.
Terms of the deal call for Mr. Ballenegger to pay back the money
if Chartboost goes public or is sold. Meanwhile, Equidate would
sell promissory notes to other investors that entitle the investors
to Mr. Ballenegger's stock or a cash equivalent at the sale price.
"You're not selling the shares, so the right of first refusal
doesn't apply," Mr. Ballenegger says.
Equidate's chief executive, Sohail Prasad, says a deal like that
is a "private financial contract" and is permitted because the
seller can opt to pay cash instead of stock. Chartboost declines to
comment.
Mr. Sands, the hedge-fund manager who pitched an Uber fund to
potential investors, told another hedge-fund manager in a January
email that he was "purchasing Series E preferred shares directly
from the company."
"Our partners are very close with Uber as well as members of
Uber's board," the email added. "They have been in direct dialogue
with senior management at Uber as recently as last evening about
this investment."
Mr. Sands said he would collect a 1% fee plus 15% of the profits
after the fund's investors made an 8% return. But there was a
hitch: A $2.8 billion round of funding begun in December allows
just Glade Brook Capital Partners LLC, of Greenwich, Conn., to set
up an Uber-only fund.
In a phone conversation with one potential investor, Mr. Sands
predicted that Uber's earnings before interest, taxes, depreciation
and amortization would rise to $7 billion by 2018. He says in an
interview that he "built a model" and derived the estimate
himself.
Anant Sundaram, a finance professor at Dartmouth College's Tuck
School of Business who has studied valuations of private companies,
says the projection by Mr. Sands is "outlandish."
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