It's every investor's dream to get in on the ground floor of the next Google or Apple. Would you pass up the opportunity to buy stock in Facebook for $25 a share believing that once the hottest private company on the planet goes public those shares could be worth 10 to 20 times as much in a matter of months?

That's the enticing allure of the private equity market and its close cousin the private equity secondary market. It's where the big money investors play. And it's become very popular lately as news spreads that a recent auction of 165,000 private equity shares of Facebook sold for $25 a share.

You need at least $200,000 a year in reported income and a net worth of $1 million to qualify as a potential investor in this market and some firms put the bar even higher, at $5 million in investable assets, so unless you have any of those, stop drooling.

But if you do qualify, then see this article as a cautionary tale because there a few things you should know before dipping your toes, or tossing your hard-earned money, into a pool that just could be stocked with a school of hungry piranha.

Should you be among the fortunate few million Americans who actually qualify, you may have received an email recently from a private equity secondary market company.

For example, a friend of mine recently received an email from SharesPost telling her that its affiliated broker dealer has just completed a sealed bid auction of 165,000 shares of the Common Stock of Facebook for $25 a share. It said that if she was interested in participating in the next auction on January 10, 2011 as either a buyer or a seller to contact them. As expected, that auction is already over-subscribed, but not to worry, because Sharespost promises to have more throughout the year.

What's going on?

What you should worry about, however, is just what is really going on here? What are these so-called "shares" that investors are supposed to be buying? Are they actually shares of Facebook? Answer: Not always. So what are they? Answer: It depends, and it depends on a lot of things, all of which are completely out of your control and not that easy to explain, but we'll try.

First, let's look at what we do know.

Facebook CEO and Founder Mark Zuckerberg went on the CBS program 60 Minutes recently where he proclaimed that he prefers Facebook to remain a private company and has no plans to go public. Now one main reason to invest in private equity is to be able to recoup a substantial return when the company goes public. But if you take that possibility off the table, then what is it that you're investing in?

Greg Brogger, CEO of Sharespost, doesn't seem worried. He says all it means is that Facebook has decided to stay private a while longer simply because it can. Facebook reportedly has so much money already it doesn't really need any more. But there are other companies out there that may need the extra capital a public offering would bring. They just don't happen to be online companies or located in Silicon Valley.

In fact, Facebook and other online hot social networking firms like LinkedIn and Twitter, are fairly representative of the newer breed of online companies that have decided to remain private. This is a different world than what caused the tech bubble at the turn of the century when hundreds of high-tech IPOs flooded the market place. Last year, there were no online-company IPOs and in 2010, less than 10.

Valuation

One of the most difficult aspects of private equity investing is valuation. How do you really know how much a private equity share of a company is really worth when the value of the company is kept private?

Well-known high-tech analystHenry Blodget at Business Insider, who used to be with Merrill Lynch, thinks Facebook is now worth $56 billion. This is much higher than what SharesPost values it at, which is somewhere in the neighborhood of $35 billion. Even with Sharesposts number, only two other online companies are estimated to be worth more, Google and China's search leader Baidu, but both of those are traded publicly. So then, where does Sharespost get its figure?

There is an ocean of difference between publicly traded equities and those traded in the private equity secondary market. The main difference is in regulation. The private equity market is barely regulated and shares are not listed on any exchange. Some of that could change when the Financial Regulatory Authority, or FINRA, issues its new rules in July of 2011.

But for now, it is buyer beware and be prepared to lose everything. There are some regulations and restrictions to private equities. Most are offered to individual investors under the Securities and Exchange Commission's (SEC's) Rule 506, which allows sales to what it considers accredited investors who have a net worth of $1 million or $200,000 in annual income and Rule 144 that restricts how these shares are sold.

Rule 506 assumes that accredited investors have the sophistication to evaluate private equity investments. That's one heck of an assumption. I know quite a few millionaires and people who earn north of $200,000 a year that couldn't tell the difference between commercial paper and toilet paper, let alone be able know if a share of a private equity offering is worth what it claims.

A better way to judge financial sophistication would be to give them all a test to accurately gauge their financial literacy before allowing them entry into a world of deranged derivatives, strangely structured products and pretentious private placements that often value themselves.

How can anyone expect some 19-year-old basketball player who just received a $5 million signing bonus to know how any of this works when so few within the financial services world even know?

The recent financial overhaul bill enacted in last July directs the SEC to exclude primary residences from the net worth calculation and to study the accredited investor standards. But right now neither the SEC nor state regulators review private equity firms to make sure they aren't taking advantage of wealthy investors who have no idea what they're getting in to. FINRA says complaints about private placements have jumped 35% this year, on top of a more than 50% increase in 2009.

Distinct disadvantage

Granted, most private equity offerings are not fraudulent and can be lucrative for some investors; otherwise the market for them wouldn't be so attractive. Even a casino has to have some winners or no one would place any bets. Still, the lack of information in these markets will put you at a distinct disadvantage, especially since there's not enough disclosure to even reveal the risks involved.

For example, private placement investors lost more than $1 billion in a company called Medical Capital, which offered financing to health-care providers. An oil and gas investment firm named Provident Royalties took private investors for close to half a billion, according to SEC estimates. The SEC says both firms, which are in receivership, made misrepresentations and misappropriated money.

Getting back to Facebook. It's easy to see why there's a feeding frenzy in the secondary private equity market. It has 500 million members and growing daily on a global basis. Just remember, Facebook isn't available in China yet, but Mark Zuckerberg traveled there recently hoping to change all that. So any day now, that 500 million member number could triple.

There are estimates that Facebook generates around $2 billion a year in revenue. But how can we even know that? The company is private so it doesn't have to tell anyone how much it makes except perhaps the IRS.

Recently an issue was raised about whether Facebook needs to be concerned about crossing what's known as the 499-shareholder line. That refers to an SEC rule that states once a private company has 500 shareholders, it has to disclose its financials. So if Facebook has less than 500 real shareholders, what are these other shareholders holding?

Shares in what?

To answer that we need to shed some light on the murky world of the private equity secondary market where you can buy and sell so-called shares of private companies. But what are these shares anyway? Even if they're called "common stock," legally, they're known as pre-existing investor commitments to private equity and other alternative investment funds. Sellers of private equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds. What does that mean? What's an unfunded commitment?

There are a number of restrictions imposed on the sale of private equities by Rule 144 that say you have to hold these shares for at least two years before you can sell them and there are further restrictions on who you can sell them to.

Companies like Sharespost.com and its chief competitor, Secondmarket.com, seem to be taking advantage of an SEC rule change that relaxed some of the restrictions on selling shares of private companies.

If you look on SharesPost.com/s website and go to its Legal page you'll read that, "Though each participant in a SharesPost facilitated contract is solely responsible for making their own legal determination about the availability of an exemption from the securities laws, we believe we have constructed the SharesPost process such that Buyer and Seller can generally make use of a section exemption them from Rule 144. Supporting such an exemption is the fact that only SharesPost members with a password protected account are able to participate in postings, only accredited investors can be SharesPost Buyers, and only sellers holding their shares for at least a year can be SharesPost Sellers."

If I'm reading it correctly, SharesPost is trying to say that most investors will qualify under a safe harbor provision in Rule 144. The requirements listed seem focused on meeting the holding periods in Rule 144 and ensuring that this is not a public distribution but a re-sale to specific buyers who pass the sniff test when it comes to being a sophisticated investor.

What's at stake?

So what's at stake here for a company like Facebook? First, re-sales of private equity in the company can threaten to bring the number of shareholders to over 500, triggering full-fledged registration requirements under the SEC. Second, issuers seem to be worried about potential insider trading problems, which prompted Facebook to ban its employees from selling shares on SharesPost.com except during certain windows.

Facebook employees reportedly had sold some of their private Facebook stock to Digital Sky Technologies (DST). It was rumored that after the sale Facebook assigned its rights of first refusal over future secondary sales to DST as well to restrict the number of future shareholders.

You should know that by their nature, most private equities are illiquid. That means, they're not made to be traded but rather held as a long-term investment. For the vast majority of private equity investments, there is no market. There is however, a growing and robust secondary market for sellers of private equity assets.

Now here's a question. Why would any smart private equity investor sell his or her share of Facebook? Answer: chances are they probably wouldn't.

So where are all these so-called "shares" coming from? Since there is no one regulating these things they can come from a number of sources. They could be employees selling their shares or it could involve the sale of private equity fund interests, or portfolios of direct investments in privately held companies through the purchase of these investments from existing institutional investors seeking to diversify their portfolio.

Investments in the secondary private equity market are often made through a third party fund vehicle. Here's where it gets real tricky. These funds are structured like a fund of funds which means they really are investing in another fund that in turns invests in the private company. They are, in a sense, derivatives.

Besides Sharespost, there are a number of secondary market providers including the previously mentioned SecondMarket, which bills itself as "the largest secondary market for illiquid assets." SecondMarket started selling private startup stock in 2008 when one Facebook private equity shareholder asked if SecondMarket could find him a buyer. To say this is a relatively young market is to state the obvious.

SecondMarket says it began facilitating private company stock sales on a regular basis in April of 2009. It claims to have completed $150 to $200 million in private company transactions since then. SecondMarket currently has over $280 million of private company stock listed for sale. For the right buyers, it has over $1 billion worth of private company stock "available" for sale.

The distinction between "listed" and "available" arises out of the fact that while every shareholder has a price, not every shareholder wants to publicly disclose that price. So SecondMarket tries to find out those prices and keep an eye out for potential buyers.

'Sure bets'

Buying shares in hot companies like Facebook, LinkedIn or Twitter would seem like sure bets, until they're not. Let's say you own 1% of a company that gets bought for $100. How much of the purchase price is yours? In the case of today's widely publicized tech startups, the answer might be "none."

You've probably never heard the term "liquidation preferences." That ignorance could be expensive if you're thinking about buying shares in companies like Facebook and Twitter on the secondary market.

A liquidation preference is a right given to a startup's early investors, who are typically venture capitalists. If the company is acquired, investors with those preferred shares get the first slice of the proceeds. Common shareholders are in the back of the line and they collect what's left after all liquidation preferences are paid off. That means they could get nothing if a company sells for less than was invested in it.

That's what happened with software maker AmberPoint in February, when Oracle bought it for a reported $50 million. Common private equity shareholders didn't make a cent. For them it was as bad as if there had been a bankruptcy.

Since private companies have no reporting obligations, it's a challenge for potential investors to figure out the liquidity preferences involved in these stocks. There are an estimated 150 pre-IPO companies listed on SharesPost.

But Larry Albukerk, who advises SharesPost customers about social media stocks, says the reports vary in their reliability about liquidation preferences. For example, in a report on SharesPost for Zynga, the social gaming company, the title of a chapter involving liquidation preferences admits that it's "just a total guess."

All this means that investors on secondary markets looking to get in early on the next YouTube, which was bought by Google for $1.6 billion, may be taking on more risk than they realize.

Scott Sandell, general partner with the venture capital firm of New Enterprise Associates, says he's often shocked at the prices being paid on secondary markets for some of the startups that he's invested in as a venture capitalist. He says some people are paying valuations that are completely absurd.

So where does this leave us? There is a secondary market for private equity in companies like Facebook, but it is extremely risky and nearly unregulated. Sharespost.com is not registered with the SEC or FINRA and therefore answers to no regulator body.

You are then enticed to invest in a private equity fund, that in turn, could invest in another private equity fund or some kind of equity arrangement, but any valuation such as suggested share price is pure speculation. It's a guess, based on, well, nothing.

Betting on hype

Sharespost has auctions of these shares that seem like great bets but what are you really betting on? You're betting on all the hype surrounding companies like Facebook. They talk about future IPOs but no one can even predict if there will even be an IPO. In the case of Facebook, even the CEO says there won't.

Still, you enter an auction and bid on some shares and you think you own a percentage of something. But how much is your percentage actually worth? Even with a company like Facebook with an estimated $35 billion dollar valuation, your percentage could amount to zero when you try to cash it out.

As for SharesPost, this is a free membership service that has created stock purchase agreements for most variations of private company stock transactions. It claims to have designed its forms to be straightforward and balanced between Buyer and Seller.

When a member wants to buy or sell his or her private equity shares they have to answer a series of questions such as whether their shares are subject to a stockholders' agreement, right of first refusal, co-sale right or other transfer restriction. If they are, the seller uploads the documents containing the transfer restrictions so that prospective buyers can understand the restrictions that will be applicable to any transaction.

Once the member has reviewed their post, they click "Confirm" and their post goes live on the website. When a member clicks the "Agree to Buy" or "Agree to Sell" link next to a post, the SharesPost system asks them the same questions about their standing under the securities laws.

When a Seller posts a contract to sell, the following process occurs. Her or she:

  • Inputs their desired terms such as price and number of shares

  • Answers questions relevant to the securities laws

  • Indicates which restrictions, if any, are applicable to their shares

  • Uploads documents containing any restrictions

  • Reviews and confirms post.

Then any prospective buyer reviews the post and transfer restrictions and if the buyer clicks "Agree to Buy" next to seller's post, he or she must:

  • Answer questions relevant to the securities laws and suggest a contract for transaction

  • Review and electronically sign contract

  • Email link to page where they reviewed and counter-signed contract

Now binding agreement is emailed to U.S. Bank for processing of transaction

When a Buyer posts a contract to buy, the following process occurs:

  • Buyer answers questions relevant to the securities laws

  • Buyer reviews and confirms post

  • Prospective sellers review post

  • Seller clicks "Agree to Sell" next to buyer's post

  • Seller answers questions relevant to the securities laws

  • Seller indicates which transfer restrictions, if any, are applicable to their shares

  • Seller uploads documents containing any restrictions

  • SharesPost suggests a contract for transaction

  • Seller reviews and electronically signs contract

  • Buyer emails link to page where they review and counter-sign contract

  • Now binding agreement is emailed to U.S. Bank for processing of transaction

  • Buyer inputs their desired terms such as price and number of shares.

Not so simple is it? Investing in the public markets is tricky enough but to play in the land of private equity you should probably have an advanced MBA. That, or be a really good card counter, although I don't think that skill will help you much in this casino

There are a lot of gullible rich people out there looking to make a killing and when they hear about getting in on the ground floor of a hot company or being able to invest in Facebook, well, what can I say. It's a little like cattle being led blindly down the chute to slaughter.

On the other hand, you could just hit the jackpot. So step and place your bets. The wheel is spinning. And where it stops, nobody knows.