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Stock Trading in Private Companies Draws Scrutiny

A red-hot trading market has developed in the shares of the world’s leading social-networking companies: Facebook, Twitter, Zynga and LinkedIn. What is unusual is that none of the companies are listed on a public stock exchange. Each is privately held.

Close-up of a pen on stock price chart
Close-up of a pen on stock price chart

Now, the Securities and Exchange Commission wants to learn more about the business of these stock trades. The agency has sent information requests to several participants in the buying and selling of these four companies’ stocks, according to two people with direct knowledge of the inquiry who requested anonymity because they were not authorized to speak about it.

It is unclear exactly what has piqued the agency’s interest. An S.E.C. spokesman declined to comment on the matter. But the S.E.C.’s interest comes as a crop of new exchanges is popping up to facilitate these trades.

Over the last year, several private exchanges have matched up buyers and sellers of shares in these fast-growing companies. Though the volume remains thin, the number of transactions is increasing each month.

At the same time, Wall Street brokerage firms have begun forming investment pools to buy these companies’ shares.

Driving this activity is the social-networking phenomenon, which has created the hottest, and most hyped, segment in Silicon Valley in years.

Businesses like Facebook, the social-networking leader, and Zynga, a popular maker of online games, already generate hundreds of millions of dollars in revenue. Twitter has more than 150 million users, and just received $200 million in venture financing. LinkedIn, another social-networking site, has become a Facebook for professionals.

Who is selling these shares? Much of the supply comes from former employees at these companies and their early-stage venture capital investors looking to exit their stakes.

The buyers in these so-called secondary trading markets are mostly wealthy speculators looking to snag a piece of the next Apple, Microsoft or Google before the rest of the investing public can.

Part of what is driving this emerging market is the shifting dynamics of initial public offerings on Wall Street, particularly in the technology sector, as companies take longer to tap the public markets.

“We are serving a growing need,” said David Weir, the chief executive of SharesPost, an online marketplace for private investments started last year that now has 39,000 registered members. “A decade ago, these companies would be public by now. Investors can now buy into these businesses and sellers can exit their already valuable stakes.”

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

Facebook, run by Mark Zuckerberg, is SecondMarket’s most actively traded company. Last month, SecondMarket held an auction in which approximately $40 million worth of Facebook shares changed hands.

Facebook's Implied Value: $42.4 Billion

As the volume has picked up, the worth of these nonpublic companies has ratcheted up as well. The combined value of the top 11 private venture-backed technology businesses has increased by 54 percent since June, according to a recent study by Nyppex, a brokerage firm that facilitates trading in private companies.

Facebook is now trading at an implied valuation of $42.4 billion, according to SharesPost, more than tripling in value from earlier in the year. Twitter is worth $3.6 billion, more than doubling over the last several months.

Another batch of small Wall Street firms is also trying to get in on the action. These companies, which include GreenCrest Capital and Felix Investments, are raising “Facebook funds” or “Twitter funds.” These firms are pooling their clients’ money into investment vehicles to acquire blocks of stock of these companies.

Investors are taking on substantial risk when buying shares in these private companies. Despite Facebook’s ubiquity (it is the subject of at least two books, countless magazine features and a critically acclaimed motion picture) it does not disclose its financial results. And Twitter, despite its popularity and influence, generates minimal revenue.

But investors are betting that Facebook, Twitter and their brethren will ultimately go public at sky-high valuations, delivering big profits similar to Google’s initial public offering in 2004.

It is uncertain what exactly the S.E.C. is looking into, but several securities lawyers say it could relate to understanding the number of shareholders at these companies.

That would be relevant to regulators because Facebook and other start-ups have a reason to keep the number of shareholders to under 499. If they had 500 shareholders, S.E.C. rules would force them to disclose their financial results to the public.

The pooled vehicles being set up to acquire Facebook stock, for instance, could push the company’s shareholder count above 499 if the S.E.C. counted the number of investors in the funds.

In 2008, the S.E.C. and Facebook tangled over a related issue. Then, the agency allowed Facebook to issue restricted stock to employees without having to register the securities, which would have forced the company to provide financial information to prospective investors.

Although the trading in these companies has increased over the last year, the market remains illiquid.

The market is capped by the amount of stock for sale. At Facebook, for example, only former employees can sell stock. In March, Facebook announced a ban on current employees selling stock.

It also announced an “insider trading policy” to better comply with the securities laws and “to protect the interests of the company and its employees and shareholders.” Also, recently hired Facebook employees are given restricted stock units that do not have value unless the company goes public or is sold.

The number of potential buyers is also limited. Because these privately held companies are considered high-risk securities by the S.E.C., the agency’s rules permit only qualified institutions (like ones that manage $100 million or more) and accredited investors (individuals whose net worth exceeds $1 million) to buy their shares. Also, many of the companies, including Facebook, have the right of first refusal to buy any shares of its stock offered on these private exchanges.