Public Exchanges and Private Marketplaces

Private markets are ripe for disruption. That is our belief and the motivation behind Texture Capital. Over the last few weeks we have seen confirmation of this as a number of other companies have announced plans to tackle private markets or doubled down on their existing strategy. 

In April, GTS, the electronic market maker, announced their plans to create a trading platform for private company securities. And last week, Carta, the software company specializing in cap table management tools, unveiled their plans to enable secondary trading in private securities, while established players Forge and Sharespost announced a tie-up.

When most people think of a stock exchange, the first thing that probably comes to mind is the bustling trading floor at the NYSE or the electronic order board at the Nasdaq marketsite. These are both examples of public stock exchanges. A private marketplace is very different to a public stock exchange however, and many different considerations have to be taken into account when designing the appropriate market structure. We outline some of the key considerations below:

Types of Securities

A key difference of course is the securities traded - public vs private. Public securities are registered under the Securities Act of 1933. There are significant disclosure requirements associated with public securities registration, including detailed information about the company and the securities being offered, and audited financial statements.

Private securities can be sold under an exemption from registration under the ‘33 Act. The main exemptions are: Reg D, Reg A+, Reg CF and Section 4(a)(2).

Class of Security 

Public equities listed on major stock exchanges are generally common equity (with a few exceptions). In private markets you can have common equity which is typically held by founders and employees, and preferred equity held by investors. In addition, you can have different tranches of preferred stock for each funding round a company has had - e.g. Series, A, B, C...etc.

Preferred stock issued in one series is not fungible with preferred stock from a different series, creating complexity when it comes to secondary trading.

Restrictions around Secondary Trading

Most private company securities that will be available in new private marketplaces will have been issued under Reg D or Section 4(a)(2) and will be “restricted securities,”. This generally means that resale is restricted, and must follow certain rules, the most common of which are rule 144 and 144A. In addition, many private securities have embedded “rights of first refusal” (ROFR). This gives the issuer the option to purchase any shares before they are sold in a third party transaction.

Participants

Literally anyone with capital to invest can participate in public markets. That’s why they are called public. And while Reg A+ and Reg CF are open to retail investors, in general participants in private markets consist of accredited and high net worth investors, family offices, angel investors and certain institutional investors such as venture capital and private equity funds. Another important constituent are private company employees, who acquire stock through employee incentive programs.

Most mutual funds, hedge funds and market makers do not participate in private markets. Pensions and endowments typically gain exposure via LP interest in PE and VC funds.

Data

Public markets are awash with data. All public exchanges provide order and execution data, tick by tick depth of book, and auction data. In addition, public companies are required to report quarterly earnings and audited annual financials.

There is very little data on private market transactions, by contrast. Transactions are not reported to a public tape, and corporate fundamental data is closely held by the issuer. Without data, it is very difficult if not impossible for participants to make investment decisions. For this reason, private marketplaces will need to incorporate some kind of data transparency solutions.

Clearing & Settlement

Public equities are centrally cleared through the DTCC on a t+2 settlement cycle. Private securities, however, are not DTC eligible which means they cannot be centrally cleared. Settlement must therefore take place directly between buyer and seller or potentially through a clearing broker.

Liquidity

Constraints on secondary trading, a smaller investor universe, limited market making, a lack of data transparency and complex clearing and settlement all result in much lower liquidity in private markets than public markets.

Reimagining Market Structure

Given all the factors discussed above, creating a liquid secondary market for private securities, will not simply be a case of replicating the public market systems. At Texture Capital we are reimagining market structure and designing a new marketplace from the ground up, utilizing the latest technology available. We leverage blockchain to create a complete record of securities beneficial ownership and transaction history, and smart contracts are able to programmatically enforce the complex compliance regulations and other constraints around secondary trading. In addition, by implementing blockchain at inception, our marketplace can support future innovations such as real-time DVP settlement.

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