Vital Signs #135: Silicon Valley Employees Cash in Early

By Susan Pulliam, 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.

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 Friday.

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.

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.”