How to Buy Shares in Facebook, Twitter and Other Private Firms

Lots of investors out there would love to get their hands on Facebook's stock -- if only it would go public. For now, most of its equity is held by its founders and employees. But Peter Lattman from DealBook explains that there's a shadow market that has developed to allow private stock holders to sell shares of companies like Facebook and Twitter to the public.

Here's Lattman explaining one exchange set up for these kinds of transactions:

SecondMarket, the leading trading exchange handling transactions in these securities, is expected to execute about $400 million in trades involving about 40 private companies this year, roughly a fourfold increase from 2009, the first year it began making markets in the companies, according to a company spokesman.

He also notes that the S.E.C. is interested in this new market (see clarifying note below), but the regulator hasn't said why. It isn't hard to guess. For starters, the S.E.C. likes to be able to have full information about stock offerings for regulatory monitoring purposes. It would probably like to have lists of stockholders in private firms for the seame reasons it monitors the public market. For example, some these investors could be manipulating the market to increase the value of their holdings, unbeknownst to the S.E.C.

But in general, the S.E.C. probably doesn't like the idea of another shadow market growing. One of the problems during the financial crisis was that shadow markets developed for some assets and securities, providing firms with risks that weren't well-understood by regulators. When some of those assets went bad, they helped to push the financial industry towards near-collapse. While trading stock privately isn't likely to cause a similar problem at this time, the S.E.C. would surely want transparency where these transactions are concerned, so they could be monitored.

The Wall Street Journal's Venture Dispatch provides another reason why the S.E.C. may be concerned with company-specific funds:

These funds - news of which VentureWire reported exclusively here, here, here and here - have said that one of their advantages is being able to keep companies under a critical 500-investor ceiling due to their pooled-investment model, in which the fund becomes one shareholder buying on behalf of multiple individual investors.

The 500-investor figure is significant because private companies exceeding it would be required to file their financial information publicly.

Regulators aren't the only ones who are probably annoyed by the emergence of this shadow market: Wall Street can't be thrilled. By utilizing little private exchanges and avoiding public stock offerings, these investors are also cutting out Wall Street. There aren't big advisory fees being paid to bankers for pricing the equity or fat commissions for their salesmen as trades clear. For years, Wall Street has argued that the value it provides companies is worth the lofty fees it charges. This new shadow market could cause corporations to question the validity of its claim.

Does this shadow market provide any benefit to anyone that can't afford the private stocks it sells? It does in at least one way: it provides market-based valuations for private companies that would otherwise be pretty hard to determine. Lattman reports today that a recent offering of Facebook shares puts the company's value at $56 billion. That puts its value somewhere between Kraft Foods and Home Depot.

Clarifying Note: I was contacted by SecondMarket who reiterated what it says in the DealBook article -- that the company has not received a request (formally or informally) from the S.E.C. or other information about an S.E.C. inquiry. Unlike some participants in this market, SecondMarket is a registered broker-dealer, regulated by the S.E.C. and FINRA. Presumably (me talking, not SecondMarket here), the S.E.C.'s focus is on those other unregulated market participants.