The SEC is examining the use of derivatives in the secondary market for shares of private companies.1 The trading of shares of private companies remains robust, and we are writing this alert to remind everyone that whether you are a buyer or a seller, using derivatives for these types of transfers is problematic and may be unlawful and unenforceable.
The SEC has already acted once. It recently shut down and fined Sand Hill Exchange (“Sand Hill”), an online Silicon Valley exchange for derivatives covering pre-IPO, venture-backed companies. Sand Hill sold contracts whose payouts were linked to the valuation of private companies at a liquidity event, such as a merger or IPO. In other words, “You pay me X dollars for my Uber shares today, and I promise to pay you Y dollars equal to what I receive after Uber goes public.” The SEC considered these contracts to be derivatives.
Background on Derivatives
As a general matter, derivatives include any agreement, contract, or transaction whose value is based upon — or “derivative” of — the occurrence of an event or the value of something else, e.g., interest rates, currencies, commodities, or securities. A contract whose valued is linked to the occurrence of an event (like an IPO) affecting the value of stock of a private company is considered a derivative.2 Under the securities laws, “retail” investors generally cannot enter into private derivative transactions. An exception exists for people who meet the high standard of “eligible contract participant”.3 Individuals often need to have $10 million invested on a discretionary basis to qualify. Many of Sand Hill’s participants were not “eligible contract participants.” Sand Hill was therefore shut down and fined.
Done properly, derivatives may be used to transfer economic exposure to private shares. They can be effective in bypassing contractual transfer restrictions governing the private shares. Done improperly, however, the transfer is unlawful and has risks of unenforceability. Looking forward, online derivative exchanges may, eventually, facilitate greater liquidity in start-ups and pre-IPO companies. Until they are structured properly, though, the Sand Hill action shows the government’s willingness to police this frontier.
Here is a link to the SEC’s enforcement action: https://www.sec.gov/litigation/admin/2015/33-9809.pdf. For further information, please contact the authors of this alert or your regular counsel at Mintz Levin.
2 Note: The use of a special purpose vehicle to acquire shares is not considered a derivative.
3 An eligible contract participant includes an individual who has amounts invested on a discretionary basis in excess of (i) $10 million or (ii) $5 million and who enters into the transaction for hedging purposes.