TALK BACK: What to Do with the 500 Shareholder Rule
Welcome to our new feature, TALK BACK, where the writers and editors of peHUB will engage with readers on a topical issue once a week.
This week’s topic: the 500 shareholder rule.
Yesterday, we reported that House lawmakers are considering expanding the 500 shareholder rule and eliminating certain parties from the new, increased threshold of 1,000 shareholders. Any bill the House comes up with would still have to get through the Senate and signed by President Obama, who has kept mum on his secondary markets stance to date.
Currently, the rule requires that a company begin providing the SEC with filings in anticipation of an IPO if a business entity shareholder base grows beyond 500 people. And the ramifications are such that we couldn’t even cover it all in just one column. So, instead, we’ve decided to crowd-source this one.
Check out our comments section (directly beneath “Related Posts”) and weigh in with whether you feel this is a watershed moment for VCs and secondary markets, or if it is a non-event that isn’t applicable to the overwhelming majority of startups.
Several of us from peHUB — and our sister publications Buyouts and Venture Capital Journal — will chime in on this issue. We welcome debate, and will be checking back to gauge responses.
Keep an eye out for select reader comments in peHUB Wire as the week progresses.
Related posts:
- SEC Looks Broadly At 500 Shareholder Rule And Capital Formation For Small Companies
- Congress May Loosen 500-Shareholder Limit
- Talk Back: peHUB Reader Comments from Dave McClure, Matthew Stotts, Kurtis Fechtmeyer, Others
- Mega-Funds Talk Back To FDIC on Bank Deals
- Carlyle’s Rubenstein: Banks Will Pull Back on PE, Prep for Volcker Rule
Giles Somerville said on June 15, 2011
What’s interesting is that lawmakers claim they want to allow the expansion of the shareholder base because†in today’s market environment it is a hindrance to private companies continued funding effortsâ€. Nothing could be further from the truth, private companies that are successful and able to attract “real funding” never have an issue with the 500 shareholder rule hurting future funding efforts. This rule is completely for the benefit of shareholders and secondary market participants; the extra liquidity that will be provided by an expansion of the allowable shareholder base will all go to shareholders, internal & external, not the actual company itself. As a investor in the secondary market I am all for the expansion; I just find it a little bit frightening that once again the governing bodies are so completely clueless.
Giles Somerville
Managing Partner
Clearview Capital Partners
Jonathan Marino said on June 15, 2011
Well, I had best get the ball rolling then! To be frank, I don’t think this piece of legislation will get passed, nor do I feel it is particularly important. First, financial rules de-regulation remains a prickly-post recession issue, and some lawmakers will blanch at the prospect of creating a new “grey area†for wealth to be created (and destroyed). Just because the S.E.C. has indicated a stance in favor of expanding the threshold doesn’t mean Congressmen and Senators—of which, some have recently taken to the commission to task for perceived failures to investigate—will go along for the ride. Further, I strongly suspect that the overwhelming majority of startups are nowhere near the 500 shareholder threshold, and that substantially loosening rules to allow for a company like Facebook to remain private longer would benefit, almost exclusively, Facebook. This is a unique case of widening the barn door, then removing its hinges, after the proverbial horse has escaped—instead of shutting it. The proposed legislation places more power in the hands of startups’ management and takes it from venture capitalists. Ultimately, their goal is to exit the investment. Does allowing a company to remain public, virtually interminable, help VCs realize this goal? Won’t fund returns be impacted if they have fewer exits—and, do LPs want to accept shares of a privately-held company when it comes time for redemption? At the end of the day, what this legislation needs is some hard-hitting lawmakers to back it up, ones with deep experience in financial regulation and ones that have President Barack Obama’s ear. As well as a great defense from its future critics…
Alastair Goldfisher said on June 15, 2011
I think you hit the nail on the head, Jon. This doesn’t affect a big universe of startups. And with the IPO market opening up, those companies that the 500 rule does affect are likely already on a path toward a public debut.
Joanna said on June 15, 2011
Seems to make sense to increase the limit from an enforcement budget standpoint. The SEC has enough to do investigating actual crime. Seems like a costly layer of regulation for companies that choose, presumably with board and majority shareholder approval, to take on more than 500 shareholders shouldn’t be a priority.
Lawrence Aragon said on June 15, 2011
I agree with Giles on this one. This expansion is not only unnecessary, it could be detrimental to small shareholders. It is scary enough that so many people are willing to speculate on private shares of Facebook, etc. on the secondary market without any transparency into those companies. We need more transparency — not less. This will only encourage more companies to stay private and trade on secondary exchanges, where they can keep their shareholders in the dark. Of course, that will only happen for so long before a deep-pocketed shareholder sues over insider trading when it gets burned by one of these private companies. Then the feds will rush in and over-regulate the secondary market. Let’s not go down that path.
We already have a venue for companies to raise money from more than 500 shareholders; it’s called the public market. And let’s call a spade a spade, here. The only company that “needs” the 500-shareholder rule modified is Facebook.
Lawrence Aragon
Contributor
peHUB
@laragon
Giles Somerville said on June 15, 2011
Jonathan, only in very unique situations will this give power to companies over VC’s (read: Facebook); the overwhelming majority of the time big VC’s control the boards of the companies they fund. If anything, again see Facebook, this will benefit VC’s as it gives them an alternative market to get liquidity in their portfolio’s. One big problem for the VC model the last 10 years has been the much longer path to liquidity for their best companies via the M&A & IPO market. In general it now takes about twice as long for a successful VC backed company to get liquid. Facebook is a good example of this as they will be twice as old when they IPO as Google was when they went public. We are seeing a real trend of VC’s using the secondary market to exit positions thus realizing positive returns for their investors quicker and increasing their liquidity. Bad returns and lack of liquidity of had a major negative impact on the VC model since 2008.
Giles Somerville
Managing Partner
Clearview Capital Partners
Mark Boslet said on June 15, 2011
Not to be a contrarian on this one. But I think the new rule as proposed is a good idea. But let’s call it what it is: it is the Facebook rule. Startups do bump up against the 500 shareholder limit. But only the larger, more successful ones, AKA, Facebook. It is smart to expand ownership of these more substantial companies. It gives them more options. But don’t suggest in the same breath that this will be a pro IPO bill, if passed.
Lawrence Aragon said on June 15, 2011
Some comments from the Twittersphere:
TWEET: “Why is Facebook so scared to go public? – New Law Would Allow Companies Like Facebook To Stay Private Much Longer http://goo.gl/vmZdl”
–John Valentine (@JohnnyStartup)
Boston
Training for a triathlon this summer. Trying to resuscitate my backhand in tennis. Hustling @SCVNGR. Talking tech every chance I get.
TWEET: “So does change to ’500 shareholder’ rule mean #Facebook is going to delay its rumored upcoming IPO?”
–Ariez Dustoor (@adustoor)
San Francisco
Yahoo! Corporate Development, ex-McKinsey, ex-private equity, passionate about consumer internet and US politics
TWEET: “Bill proposed to amend SEA; allow for 1000 shareholders, would not count employees & accred investors. Perfect for #fb. http://goo.gl/vmZdl”
–Ryan den Rooijen (@ryandenrooijen)
London
Decade of experience in user behaviour and community development. Currently exploring value creation in social networks. Occasional entrepreneur.
Lawrence Aragon said on June 15, 2011
Here’s the reaction from the National Venture Capital Association about the proposed change to the 500 shareholder rule:
NVCA Reaction to Bill to Raise 500 Shareholder Rul
Today there was an annoucmenet of plans for a Congressional bill that would amend the Securities Exchange Act of 1934 to increase the 500 shareholder count threshold to 1000 shareholders for public company reporting requirements as well as exempt certain types of shareholders from that count. The NVCA supports policies that allow our portfolio companies to prosper and grow. Therefore, we view positively the current effort to grant companies the flexibility to remain private, if such a strategy is indeed in the best interest of investors and employees. To date, the 500 shareholder rule has impacted a very limited number of highly visible, venture-backed companies. Thus, we do not anticipate an increase in this threshold to affect a large majority of our portfolio companies going forward.
This being said, the implied need for even a limited number of companies to remain private longer, or indefinitely, is indicative of a much larger problem in the U.S. capital markets. It is here that the NVCA has been and will remain focused. It must once again be compelling for our country’s most promising companies to enter the public markets and continue on their growth trajectory as public companies. Addressing this issue is important for the long-term health of the US economy across all sectors and the NVCA feels our country is best served by a sharp focus on fixing the public markets rather than working around the edges. We are looking forward to efforts taking place this summer to offer recommendations in this regard.
–Mark Heesen
President, NVCA
David Toll said on June 15, 2011
An interesting question is whether this law would also apply to private limited partnerships. Today PE firms can’t have more than 499 investors in their funds (without having to file 10qs, 10ks, etc.), even though all are accredited or even qualified. Under this proposal PE firms would presumably no longer have, in effect, any limit at all on their number of investors (since accredited investors wouldn’t count toward the total). As a practical matter, this would probably only be good news for the firms that raise multi-billion dollar funds.
Venky Ganesan said on June 15, 2011
Proposals like this remind me that sometimes we have legislators with nothing useful to do with their time. Among the list of challenges we face, the 500 shareholder rule is not even on the first 10 pages of the list. This affects a small number of companies and there are many easy ways to manage this. All I can say is great job lobbying SecondMarket. If people care about early stage financings then let us talk about reforming Sarbox (not removing it but modifying it), let us talk about how to make our stock exchanges the best place to list for young companies, let us talk about reducing government and promoting free enterprise.
Eric Hippeau said on June 15, 2011
As VCs we support rules that allow growing companies to extend their runway while remaining private if that’s in their best interest. Having been CEO of a public company and on the Board of others I know too well how being public shifts your focus and creates distractions and added costs. There is a time for that. Congress should next focus on relaxing the Sarbox rules.
Eric Hippeau
Partner
Lerer Ventures
Connie said on June 15, 2011
I’m with Venky on this one. Seems to me this proposal is mostly a way for two first-term congressmen to raise their profile. It’d be really awesome if they could instead focus on actual problems that need solving.
Dave Weir said on June 15, 2011
The average time to exit through an IPO has lengthend from about five years to over ten years and the threshold to becoming a viable public company has increased dramatically during the past ten years. As companies stay private longer, the ability to efficiently raise capital from a universe of qualified investors that reaches beyond a small handful or two of late stage fund investors (think accredited individuals, family offices, small and medium sized funds) greatly benefit entrepreneurial ventures by reducing the cost of $ and timeframes to close a round of financing. The 500 shareholder cap restricts a company’s ability to access this capital in investment sizes that make sense for these investors which in turn negatively impacts private capital formation. Removing the cap will will allow these investors to more actively particpate in financing private companies which will provide fuel to help companies cross the chasm between their venture funded stage to the point where thay become viable publicly listed companies.
JPHauser said on June 15, 2011
Hard to understand the government’s thinking in allowing the few hot companies this would impact to be traded only by the well-heeled qualified investors rather than by public investors. If they don’t call it The Facebook Rule, they could call it The Let’s Not Spread the Opportunity to Retail or Mutual Fund Investors” Rule. By the time a company has 500 investors, it ought to be required to deliver fully audited financial statements to those investors (should they care to read them). The rule does not require a company to become a publicly traded entity, only to make audited financial information available to the 500 and others who might have interest. Allowing more “investors” to speculate without access to fundamental information looks good on the way up, and litigious when the music stops.
Raising the limit would simply allow private company investors to capture even more of the potential upside before sharing with those only able to buy listed stocks.
Scott Maxwell said on June 15, 2011
I have two points of view:
1. The regulation limiting the number of investors doesn’t do anything helpful, so it shouldn’t be in place. Hopefully, weakening it is the first step to eliminating it.
2. The real protective mechanism is only allowing “sophisticated” investors or investors with sophisticated advisers to purchase these securities. The current “sophisticated” definition is based on wealth, which makes no sense as their are young sophisticated people that can’t invest and older unsophisticated, yet wealthy, people that can. I would like to see a qualification level that is more aligned with sophistication.
My point is that the number of people should be unlimited and if the regulators really wants to protect people from themselves, then set a regulation that only allows people who understand the consequences invest. I think that this would really open up the capital markets to more liquidity and I don’t think that it will change the number of financial charlatans.
Scott Maxwell
OpenView Venture Partners
Alastair Goldfisher said on June 15, 2011
Well put, Scott, and thanks for commenting. I like your view, that expanding the rule will help to weaken it. It’s almost too rational.
Jonathan Marino said on June 16, 2011
I would like to see what employees w/ founder shares have to say on this. They have no actual “constituency,” no common factors more likely to make them heard as a group. They certainly don’t have the lobbyists SecondMarket, startups and VCs can access. Essentially, their most likely early exit from their company-granted stock and options will be… to sell it back to the company! They might as well be getting paid in coupons at the company store. At least they will have the private investors to help them get a fair price for their stock/options–too bad for many of those investors, that instead of having the opportunity to buy shares, they will get ROFR-ed after setting a benchmark for startup stock.
Jim Sanger said on June 16, 2011
I agree with Scott Maxwell, as well. The limit is no longer useful, if it ever was. There are many reasons why the rule just makes no sense at the present – the rise in angel investing over the last decade (which rivals the dollars from VCs in aggregate size, but comes in smaller increments from many smaller pockets), the length of time that it takes to exit a company (8+ years for M&A, 10+ years for IPOs), and the big jump in scale and costs involved in taking a company public.
To me, this prospective rule change is not just about Facebook; it’s a response to what is realistically required for companies these days to position themselves for larger-sized exits. There are many private companies with hundreds of investors and high-hundreds to thousands of employees, because too often now (and perhaps sadly) it takes that kind of scale to set the stage for — and justify — a public markets offering.
With respect to some people’s objections to secondary sales of shares, I think that this is a kind of pining for the good old days of 4 year average holding periods between first angel or VC investment and exit. But, alas, times have changed. Given how dramatically the time-to-exit has elongated for most angels, traditional VCs and employees, is it really fair to expect stakeholders of all stripes to willy-nilly sign on to 8 to 10+ year holding periods between receiving shares or options and getting some liquidity?
I think that the ability for some shareholders to monetize a portion or all of their investments 4-5 years into their involvement with a company without forcing a premature trade sale is not only reasonable, but — if approached properly — extremely healthy for the entire venture ecosystem. So while some sensible limitations relating to transactions involving “unsophisticated” or unaccredited shareholders may be beneficial, arbitrarily low limits on numbers of investors allowed to hold stock in a non-reporting private company create unnecessary obstacles to the development of the secondary market as a rational, alternative path to liquidity.
Jim Sanger
ABS Ventures
Jamie Hutchinson said on June 16, 2011
As folks have noted, until recently, the IPO market has been relatively anemic and founders, employees and early venture investors in many of the most successful private companies have seen the hold times for liquidity extended. By not counting employees and accredited investors in the 1000 shareholder threshold, Rep. Schweikert’s “Private Company Flexibility and Growth Act” will basically eliminate the requirement for the Facebooks and Zyngas of the world to go public based on the number of shareholders they have. The new rule if passed, coupled with the choppy public markets, have and will continue to result in the fastest growing private companies choosing an alternative path to liquidity through direct secondary transactions of private shares (dubbed “DST deals” after the Russian private equity giant that innovated the transaction structure). A change in the 500 shareholder rule and this new type of investment structure will continue to give private companies more opportunity to mature under the guidance of their founders, while providing both liquidity for early investors and access to growth equity capital, without the regulatory burdens associated with going public. Indeed, contrary to JPHauser’s comments, some of the biggest participants in the secondary market for private company shares are the world’s largest mutual fund complexes. According to recent T. Rowe Price filings, retail investors can get exposure to the likes of Facebook and Zynga by investing in certain T. Rowe Price domestic mutual funds (e.g. New America Growth Fund).
Jamie Hutchinson
Partner
Goodwin Procter
JPHauser said on June 16, 2011
Hi Jamie,
Have you looked at the size of the New America Fund’s investment relative to the size of the fund? It is completely inconsequential and so the return to those individuals, no matter how successful the private investment, will be distributed over an enormous number of shareholders and will be miniscule relative to the possible impact of buying shares separately. Would you be OK with the 1000 investor rule those 1000 could only be large funds over a minimum threshold, with no individual participants allowed, regardless of their financial sophistication? While many larger funds have invested in both public and private companies the impact of those investments, up or down, is a fraction of the potential for those who buy the stocks as separate entities.
And yet all of this still ignores the real issue that the 500 shareholder rule does not require a company to go public, it only says that when you have that many kids in the pool, there should be some standardized rules to insure they are all equally well informed about what’s in the water.
JPHauser said on June 16, 2011
Hi Jamie,
Ah yes, New Horizons and New America Growth do have investments in private companies, but have checked the size of the investment relative to the size of the fund? No matter how well the investment does (or how poorly) the returns will be spread across such a large number of fund investors that the impact will be miniscule to the individual participants, particularly as compared with the potential impact had they been allowed to invest directly. I suppose if the new rule said 1000 shareholders as long as all non-employees are all large venture or private equity funds with no individuals allowed to participate, and only a handful of those funds at that, at least wealthy and those with smaller trading accounts would be on a level field.
Look out for unintended consequences. If valuations are pushed too far by extended private rounds for companies less well known than Facebook, consider that we may have a much bigger IPO challenge than anything seen to date. If you doubt the value of an enthusiastic group of mom and pop investors on the IPO scene, just talk to the folks at LinkedIn.
Finally, I thought most of the readers of this site were unhappy that it takes too long to get a company public these days relative the good old days. I’m sensing a bit of a 180. Is everyone in a hurry or not? Or is it a hurry to pass along the shaky companies and a desire to reap even greater rewards from those that are more solid?
Very last comment again is that the rule does not require any company go public. All it says is that once a company has grown large enough to have accepted money from 500 investors, it should treat them all fairly and be willing to educate them about financial progress of the business.
Dara Albright said on June 16, 2011
Thanks, Jonathan, for creating this discussion. I think it is an important one to debate. I believe it greatly enhances capital formation as well as a company’s shareholder base. The rapidly expanding marketplace for private company stock is unique in that it is the ONLY “long only” marketplace. None of the companies that trade here can be shorted, bought on margin or leveraged in any way. Without stock manipulation and leverage, companies have a much better chance of thriving. This marketplace attracts the longer term common stock purchaser, the ideal investor to have. As opposed to prematurely going public and risk placing stock in the hands of manipulators, traders and shorters; issuers will be able to more effectively control its liquidity and manage its shareholder base. It also gives companies an alternative to issuing preferred shares to VCs. Imagine a company’s growth potential if its stock is placed with investors whose interests are actually aligned with the company’s. Now, envision the economic impact of an entire marketplace comprised of these companies. Feel free to read more about it at http://nowstreetjournal.com.
John said on June 17, 2011
As someone who deals with wealthy investors but is not personally wealthy, I assure you that it makes no sense to allow only “sophisitcated” investors to make these private transactions (and to invest in private equity as a whole) when sophisticated is just a code word for rich, as Scott rightly suggests above. Wealthy and sophisticated are entirely different, especially when dealing with investments. Even if they are sophisticated people it does not mean they know anything about investing their wealth. This is a discriminatory law which makes no sense, if someone wants to invest their money in any company or endeavor, it is their right to do so and they have the responsibility to diligence their investments. The government does not need to save people from themselves, thank you very much. That said, if the private exchanges are run by private companies, they obviously should be able to do as they please.
As for 500 or 1000 investor threshold, this is a pointless rule. Why should a company be required to release financials if they are a private company in any situation? They are private! If their investors are investing without the company financials they do so at their own risk. If people want to trade private equities on private exchanges, let them do so and stay out of their business. And if private companies are worried about the ramifications of their shares being traded on private secondary exchanges then they can bar employees from trading company stock on them or keep their stock off these exchanges altogether.
Last – Dara, I believe what you are talking about is called a stock market. Unfortunately, anything that hedge funds and banks (much less our government) can get their hands on will be manipulated, shorted, leveraged, etc. – So if these groups can get access to your new ideal stock exchange it will be pointless, they are creative and will find a way.
Mark Boslet said on June 17, 2011
Just a brief comment given the tenor of what I read in this discussion. Yes, giving private companies more leeway is a good idea, especially as they take longer to go public. But the SEC ‘s goal is transparency, and transparency is a key foundation to free markets. Let’s expand the 500 rule to 1,000, or whatever. But let’s not forget that as companies get larger there is greater public interest for investors wide and far to be able to examine the fundamentals that make them go. (Remember Enron?) Requiring public disclosure of financials is important to well functioning markets. As I see it, the free flow of information will ultimately be what makes secondary markets success or not.
Barry Silbert said on June 20, 2011
These proposed legislative changes are a critical step in the right direction. They’ll provide companies with flexibility related to financing, employee compensation and acquisitions. The 500 Shareholder Rule was established in 1964 and worked well for several decades. For many years, companies were going public within a few years of founding, and were not getting close to the shareholder count. That is no longer the case.
As most readers know, the pay structure at startups generally involves giving employees options which vest over several years. Stock options provide an economic incentive that allows employees to realize the financial upside of contributing to a successful startup. Option holders do not count against the 500 Shareholder Rule. However, now that it takes nearly a decade to go public, option holders are often fully vested well before an IPO and must exercise their options before they expire. At this point, optionees are counted under the 500 Shareholder Rule.
The significance of this development cannot be overstated. The 500 Shareholder Rule has created a disincentive for private companies to hire new employees, or acquire other businesses for stock, as these private companies are fearful of taking on too many shareholders. The rule must be reexamined in light of the new reality that companies are remaining private much longer than in previous decades.
Venture-backed companies fuel job growth in this country. It is essential that the regulatory framework recognizes this dynamic and permits these startups to flourish.