How Wall Street Middlemen Help Silicon Valley

Employees Cash In Early

Financial firms create ad hoc market where hot stocks of closely held
technology companies trade largely out of sight of regulators
By SUSAN PULLIAM and TELIS DEMOS
Updated March 27, 2015 4:41 p.m. ET

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 didnt 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. havent 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 stocks 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 didnt 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 didnt 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. Ubers 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 retailers
2

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 companys 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 publicand 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, venturecapital 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.

Its 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 doesnt 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 venturecapital fund that said it would buy Uber shares. Mr. Gray hasnt entered a plea.
Prosecutors claim he used the money to repay other investors. The SEC filed civil
chargesagainst 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 SECs 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 preIPO shares and they fail to actually purchase those shares, it can be securities fraud,
he says.

Smartphone-based car service Uber Technologies tightly restricts stock sales by employees. PHOTO: VICTOR J.
BLUE/BLOOMBERG NEWS

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 arent 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 Palantirs
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? Im not following it as much as I
should, he says. Im hoping its 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 isnt
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 wont
say how much she made on the sale.

Kevin Chou, chief executive of Kabam, at the video-gaming companys headquarters in San Francisco. Kabam has
helped employees sell shares in the privately held company, valued last year at $1 billion, as a reward for hard
work. PHOTO: JASON HENRY FOR THE WALL STREET JOURNAL

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, VSLs website included Uber on a list of leading pre-IPO
companiesfor 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 VSLs website.
Uber says its policy doesnt permit employees to pledge shares or engage in derivative
transactions.
DocuSign Inc. Chief Financial Officer Mike Dinsdale says the electronic documentsignature 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 DocuSigns policies.
The company doesnt interfere because it wants to steer clear of transactions that it
hasnt 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. EquityZens 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. Balleneggers stock or a cash equivalent at the sale
price. Youre not selling the shares, so the right of first refusal doesnt apply, Mr.
Ballenegger says.
Equidates 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 Ubers 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 funds
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 Ubers
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 Colleges Tuck School of Business
who has studied valuations of private companies, says the projection by Mr. Sands is
outlandish.
Write to Susan Pulliam at susan.pulliam@wsj.com and Telis Demos
attelis.demos@wsj.com