Traders work on the floor of the New York Stock Exchange on the one year anniversary of the "flash crash,' Friday, May 6, 2011. (Henny Ray Abrams/AP)

Shares of the social networking company LinkedIn doubled in price on the first day of its initial public offering last Thursday, prompting tech experts and stock watchers to call it a clear sign of a new bubble for Internet stocks. They may be right. New York Times columnist Joe Nocera noted that LinkedIn bankers may have shortchanged management by underpricing the IPO — behavior that was epidemic during the last Internet bubble.

But the bubble in publicly traded Internet shares pales in comparison to a much larger bubble that has inflated in the private markets where companies and investors can buy and sell shares. This secondary markets bubble, which is well into the hundreds of billions of dollars, represents a danger to America’s leadership position in the technology sector and a serious threat to the culture of innovation that made Silicon Valley great. Worse still, secondary markets have the potential to generate fraud on an Enron-like scale.

Unlike public markets, secondary markets are only open to so-called accredited investors. That term used to be code for “rich people.” But the Securities and Exchange Commission requirements — a net worth of more than $1 million or income consistently exceeding $200,000 ($300,000 if married) — have not kept up with the times. Millions of Americans meet those criteria, but how many of them could make heads or tails of a C-Round Term Sheet, could tell you the difference between preferred and common stock, or know what a liquidation preference is? Hardly anyone knows this; but their ignorance doesn’t stop them from jumping in.

It doesn’t end there. Secondary markets place minimal disclosure requirements on participating companies. In reality, shares offered by companies on secondary markets are nothing more than a handshake and a promise. The SEC has largely decided not to police secondary markets. Yes, a few companies on secondary markets do disclose some information, but nothing like what is required of publicly traded companies. So there are basically no rules, no real disclosure and minimal registration of issues. Welcome to the Wild, Wild West.

Beyond fraud risks, the secondary market bubble is also destroying the tried and true process for creating a durable and valuable technology company. Before the rise of secondary markets, the only way to cash out shares was to wait for an IPO. Sure, founders could take some cash off the table during funding rounds. But for most tech start-up employees, it was Nasdaq or nothing. Even after the offering, lock-ups typically lasted six months to a year.

The sprint to the IPO and the period when lock-ups expire is typically when most of the important innovation occurs. Look at Google and Microsoft. Their most remarkable innovation happened before their IPOs. For a company like Facebook, the secondary markets offer an easy way to cash out shares — a pre-IPO, in effect. That means lots of distractions. Shopping for a Ferrari on company time is supposed to be a post-IPO behavior.

By now, a significant proportion of Facebook’s top managerial and programming talent has cashed out enough that they don’t have to work anymore. They can also afford to launch their own startups. Path and Quora are two examples of companies founded by Facebook managers. The ranks of early Facebookers are flooding the Rolodexes of venture capitalists looking for seasoned senior people to staff their start-up portfolios.

Not surprisingly, innovation at Facebook has slowed as the company has focused on layering on “me, too” features. Even at companies that eventually go public, such as LinkedIn, innovation suffers when employees and executives can easily unload shares onto secondary markets. LinkedIn has barely changed its user interface in the past five years and is often seen as a technology laggard built on a creaky back-end. LinkedIn shares have been trading for years on secondary markets.

When will we see the next big fraud and a massive burst in the secondary markets bubble? Not soon enough, I fear. Like termites eating at the foundation of a once solid house, the secondary markets may have already damaged the fabric of Silicon Valley. We do need to provide a better way for technology company founders and investors to exit after they have achieved success. But does this have to be by selling stock to uninformed investors?

Vivek Wadhwa is a senior research associate at Harvard Law School and executive in residence at Duke University. Read more about Vivek Wadhwa and what's next in innovation at