What is a Secondary Market?

From stocks, to bonds, to commodities and more, most investors are familiar with the options when it comes to trading on the public markets. But what about secondary markets? What makes trading secondary shares on these exchanges different from what happens, for example, every day on the New York Stock Exchange?

First of all, the assets you can invest in are different, and the way each transaction works is a little unique. At the very highest level, a secondary stock market is one in which investors trade existing shares of a company. The proceeds from these sales go to the selling investor, not the issuing company.

This is in contrast to primary markets, where companies sell shares directly to investors, as in an IPO.

Secondary market transactions do not involve the creation of new shares and do not serve to finance the company; rather, secondary markets are a marketplace for shareholders and outside investors to buy and sell secondary shares. Share prices in primary markets are fixed (e.g., an IPO offering price), while share prices in secondary markets fluctuate with supply and demand.

Private Markets, Private Shares

One of the most common secondary stock markets involves private company shareholders selling equity to outside investors prior to the company going public. It’s something you often see with startup employees who want to cash in on some of their equity in their company before its IPO.

This happens when, as part of a pre-IPO compensation package, an employee is awarded stock in a company. The employee’s shares may be quite valuable, but it is an illiquid asset until the company goes public. Perhaps the employee wants to buy a house or finance another expensive venture - what are they to do with company stock that is of no immediate value? If the employee is vested in the stock (i.e., owns the equity it represents), they may be able to sell it to an investor eager to acquire the company’s stock before it goes public.

The secondary market is where they would do that.

These secondary stock markets work by connecting shareholders wanting to sell with those investors who are wanting to buy. Companies like EquityZen facilitate these transactions by providing the platform for shareholders and investors to connect and the logistical support needed to facilitate the exchange.

For an outside investor looking to acquire pre-IPO equity in a company, these secondary markets present a unique opportunity. In exchange for cash, an investor can walk away with shares in a company that, post-IPO, may be worth quite a bit more than the cost of their original investment.

On the other end of the transaction, for a shareholder looking for liquidity or diversification, the theoretical future value of stock in a pre-IPO company may not be worth as much as some immediate amount of cash.

With the right kind of facilitation, this exchange is mutually-beneficial for both parties.

Risk Factors in the Secondary Markets

And nothing about this is particularly new.

Stock markets are excellent examples of secondary markets in action. Founded in 1602, the Amsterdam Stock Exchange is generally considered to be the oldest, still-operating stock exchange in the world. Created primarily to benefit the growth of the mighty Dutch East India Company, the Amsterdam Stock Exchange transformed stocks from a financial curiosity to a real asset, and helped fuel the Netherlands’ rise in becoming a global economic powerhouse.

However, despite this long history, accessing the secondary markets carries with it an extra layer of risk when compared to investing in public assets such as stocks and bonds.

The first is liquidity risk. Since the secondary markets are by definition limited in the number of investors who can access them, there is less liquidity in the market than in something like typical public equities. You may not always be able to find a buyer for shares you’re looking to sell.

What’s more, the private companies that trade on the secondary markets are not held to the same reporting and transparency standards as those on the public side. They are still private, after all. As a result, it can be difficult for investors to gather information about the underlying performance and financial security of a company before accessing shares.

What’s Next for Secondary Stock Markets?

Since the end of the Great Recession, secondary markets have been growing rapidly.

One reason for this is the fact that U.S. companies are staying private longer. According to McKinsey and Company, the average age of U.S. technology companies that went public in 1999 was four years. By 2014, that average was 11 years.

Meanwhile, private investment in U.S. technology companies has boomed, giving rise to the “decacorn” (privately-held startup with a valuation in excess of $10 billion). Employees holding equity in increasingly valuable companies that take a long time to get IPO-ready may be anxious to offload some of that equity to an investor looking for unique access.

Broad access to this secondary marketplace is a relatively new development. As noted in a 2018 Stanford University study: “The pre-IPO marketplace has traditionally been dominated by networks of venture-capital firms, private placement agents, brokers, and banks. These markets have historically been fragmented and opaque, severely limiting access and transparency for potential investors. In response to the trend of companies staying private longer, a number of secondary private-company marketplaces have evolved to facilitate transactions between employees or early stage investors wishing to liquidate a portion of their holdings and qualified buyers.”

The advent of pre-IPO secondary marketplaces have provided “everyday” investors with previously-unavailable access to private companies. As companies stay private longer and are worth significantly more when they do finally go public, it is reasonable to expect that this access will become an increasingly valuable asset for savvy investors.

There is a tremendous amount of value locked up in private, pre-IPO companies, and secondary stock exchanges are unlocking that value.

Participating in Secondary Markets via EquityZen

At EquityZen, our approach to secondary shares is unique among our competitors in that the company whose shares are being exchanged is considered a key stakeholder in our process.

On EquityZen, shareholders list their vested, private technology company stock. We then place those shares in a Special Purpose Vehicle (SPV), a legal entity created for a specific purpose, and list them on our website. In the context of raising capital, an SPV (usually structured as LLC) can be used as a funding structure, by which all investors (or investors under a given investment threshold) are pooled together into a single entity. Investors can access these shares through EquityZen’s pooled funds.

If the company goes public, investors receive shares after the lockup period. If the company gets acquired for cash, investors receive cash.