Beginner’s Guide to the Secondary Market and Its Types
In this article we will get to know the types of Secondary Market, its secondary market and some examples of secondary market transactions.
A stock market is where companies issue shares and other securities for trading. It provides investors with different financial instruments that offer them a wide range of securities to invest in, as per their risk and financial goals. The Stock market is classified into two types they are Primary market and the Secondary market. We often need clarification on these two terms. As the name implies, Primary Market is where securities are created and sold for the first time. Once the shares are issued in this primary market, they are traded in the Secondary market. What is a Secondary Market? How does it work? What is a Secondary transaction, and how does it works? In this article, we will learn the types of Secondary Markets, the importance of secondary markets, and some examples of secondary market transactions.
The Secondary Market is also known as After Issue Market. The secondary trade-in market is carried on a day-to-day basis. The securities are first issued in the primary market, and then it is moved to the Secondary Market, and the trade in the secondary market is carried on between the public.
What is the secondary market?
Investors trade in the secondary market without the involvement of issuing companies. Certain entities involved in the Secondary Market are SEBI, Stock Exchange, Depositories, Banks, Stock brokers or Depository Participants, Foreign Direct Investment & Domestic Institutional Investors, Retail Investors, or traders. And the Secondary trade-in market is carried on publicly between any type of investors, including individual investors. Every sale after the initial sale of securities is a sale in the Secondary Market.
How does the secondary market work?
Initially, after the issuance of securities or financial instruments in the primary market, an underwriter purchases these securities directly from issuers, such as corporations issuing shares in an Initial public offering or stock launch or through private placement. And then, the underwriter resells the securities in the Secondary market. Thus all ranges of investors get to trade in securities or financial instruments without the intervention or involvement of issuing companies. This helps a range of investors to conveniently trade in securities as the hindrance of large companies looking to sell to large investors who can buy a large number of securities at once is removed.
Importance of secondary market
The importance and significance of the Secondary market are elaborated as follows:
- The rise or fall in share prices showcases an economy’s boom or recession cycle. Thus the Secondary market helps measure the economic condition of a country.
- The stock can be easily bought and sold for cash, allowing for high liquidity.
- The economic efficiency is improved as each sale of security involves a seller who values the stake less than the price and a buyer who appreciates the security more than the price.
- With the help of fundamental economic forces of supply and demand, the Secondary market helps drive the price of securities towards their genuine, fair market value, thereby providing a suitable mechanism for the proper valuation of a company.
Risks of secondary market
As risk and return are directly proportional in terms of investments made in the stock exchange, the Secondary market also has risks, and it is listed as follows:
- In a Secondary market, the prices of securities are subject to high volatility, and such price fluctuations may lead to sudden and unpredictable losses to investors.
- There needs to be consistency in cash flows for investments made in the Secondary market.
- The procedures involved in transactions in a Secondary market are usually a time-consuming process, so investors will have to put a lot of time into it.
- Due to the brokerage commission levied on each transaction of buying and selling of securities, the investor’s profit margin may experience a dent.
- Generally, due to the influence of multiple external factors, investments and trade in the secondary market are subject to high risk.
- At times government policies can also act as a hindrance in the Secondary market.
Types of secondary market
There are two types of secondary markets; stock exchange and over-the-counter markets. Let’s discuss further:
- Stock Exchange – These are centralized platforms where securities trading occurs without contact between buyer and seller. Transactions in the stock exchange are subject to stringent regulations in securities trading. The counterparty risk is almost nonexistent as the stock exchange is a guarantor. A safety net can be assured due to higher transaction costs being levied on investments in the form of commission and exchange fees.
- Over-the-counter Markets – It is a decentralized space where investors trade among themselves. Very fierce competition can be observed in these markets to achieve higher volumes, resulting in prices differing from one seller to another. As the dealings between buyers and sellers are one-to-one, it is comparatively riskier than exchanges.
Secondary market platforms
The Secondary market platforms that facilitate exchanges between the investors and the companies are as follows:
- Equity Zen – It is a Secondary market platform based in Manhattan’s Flatiron District. It operates a marketplace in which employee shareholders in private companies can make their equity available to outside investors. The venue often links employees from private companies with investors who would not otherwise be able to invest in the company before an initial public offering (IPO). It works with accredited investors to find the private stock in pre-IPO companies. It also features tools for accessing liquidity for pre-IPO investments, venture-backed companies, portfolio analysis, valuation, etc.
- Forge – Established in 2014, it is also a marketplace and a regulated broker-dealer that enables private company shareholders to trade private company shares with accredited investors by combining world-class trading technology and operating expertise. Forge also exists for pre-IPO investing. Its trading, custody, data, and company solutions streamline trading private shares, managing compound-sponsored liquidity programs, and accessing data to inform private market strategy. It assists employees in selling their vested shares in start-ups. Forge guides companies to stay private, invest and reward employees with the support of private investors. It also suggests administrative tasks, allowing users to control eligibility, share price, and program timelines from a dashboard. Thus it is an effective Secondary market platform.
Secondary transactions in the secondary market
It is a transaction that takes place when there is a sale of shares or warrants or any convertible instruments from the primary owner of a company.
What is a secondary transaction?
The investors buy or sell the shares between each other, the company issues no new shares, and the company is not offered any capital in a secondary transaction. A secondary transaction may be necessary for many reasons. One of the primary reasons would be for a company’s 409A valuation. 409A valuation is nothing but an appraisal of the fair market value (FMV) of the common stock of a private company by an independent third party. While looking into the potential impact of the secondary transactions, the following points are to be considered:
- The time at which the transaction took place
- The details of parties involved in the transaction and if they are related how they are related
- The total number of shares involved in the transaction and their price
- The manner in which the costs of these shares were determined
- Check if every shareholder of the company can sell the shares at the same price
- The type of transaction, whether it is a recurring transaction or a one-off event, should be determined
How does a secondary transaction work?
A secondary transaction works when shareholders in a private venture capital-backed company sell their stock to an investor. It is valued by calculating the stakes’ Net Assets value (NAV). The various forms of a secondary transaction are:
- A sale transaction made by an early investor concerning the company stock to a third party
- In case of Insolvency of companies, Liquidation for the founders as a part of a financial round
- In case of issuance of employee stock options by a company then exercising the same
Types of secondary transactions
There are five major types of secondary transactions. They are:
- Transfers – The prominent element in every transaction is that the stakes are transferred from the selling party to the buying party
- Cancellations – It is nothing but the cancellation of a share transaction by the company
- Exercises – In this type, the option or warrant is converted into shares of the company
- Conversion from Debt – The convertible instruments are converted from debt to claims of the company
- Repurchase – It involves repurchasing or buyback of shares of the company
Why should you add your secondary transaction to your cap table?
The capitalization table, which lists out the full security details of a company, is shortly addressed as the Cap table. Auditors investigate secondary transactions for private companies as they consider it an essential factor. Considering its significance, in addition to managing the cap table, it is highly recommended to record these transactions in the cap table.
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