Goodwin Procter’s Hutchinson & Hancock: Will the Proposed Changes to the 500 Shareholder Rule Really Change Anything?
Rep. David Schweikert’s (R-AZ) bi-partisan legislation will dramatically alter the Securities Exchange Commission’s registration requirements for private companies with more than 500 shareholders and will change the timing and logistics of when and how certain high growth companies would effectively be required to go public.
The Private Company Flexibility and Growth Act could open up new alternatives for companies to seek and receive growth equity capital and bring new legitimacy to the markets for secondary trading of private company shares. But the question remains as to whether such changes would ever impact more than a handful of companies.
Eliminating the “Forced” IPO
Section 12(g) of the Securities Exchange Act of 1934 currently requires a company with a class of equity securities held of record by 500 or more shareholders and assets of at least $10 million, to “register such security by filing with the Commission a registration statement.” The 12(g) registration statement closely parallels the disclosure requirements of an IPO and subjects the company to ongoing financial reporting and other Sarbanes-Oxley compliance.
Faced with the administrative and financial burdens of this regulatory oversight, companies will generally “elect” to conduct a full IPO. A number of companies in the past were forced to go public as a result of this rule, most notably Google, in 2004. Even the much-anticipated IPO of Facebook is believed, by many pundits, to be in part driven by the company’s shareholder base growing past that threshold.
Rep. Schweikert’s new bill would change the existing requirement in two significant ways:
• The 500 shareholder threshold rule would be increased to 1,000 shareholders.
• Several categories of shareholders would be excluded from the calculation of shares “held of record” for purposes of the rule, including accredited investors and employees receiving stock pursuant to compensatory stock plans.
Will Long Term Effects Include Unintended Consequences?
The proposed legislation would have several likely long-term effects, but could also potentially create unintended consequences that appear to run counter to objectives of the bill’s sponsors.
The legislation looks to provide growing companies additional financing options as they expand and develop. For example, rather than limiting companies to VC firms for raising capital, companies would be able to seek investments from an unlimited number of accredited investors without ever being required to meet public company reporting requirements.
In reality, few successful growth stage companies are likely to choose this path.
Experience shows that raising growth capital from a small number of institutional investors is simply a more efficient way to finance a company. Entrepreneurs are typically hyper-focused on building their businesses and often worry that the capital raising process will divert their attention from growing the business and make them “take their eye off the ball.”
In addition, VC firms bring much more to the table than just their cash. Most companies looking for outside financing are also attracted to VC firms for other benefits, including board participation, contacts with customers, and supplier and other industry expertise. The new bill would also provide a legislative solution to avoid counting employees who acquired shares through the exercise of incentive stock options against the proposed shareholder limit. However, an administrative end-run already exists.
The SEC has routinely granted waivers of compliance from the 500 shareholder rule for companies that issue Restricted Stock Units (RSU) as opposed to traditional stock options. RSUs provide the same employee incentives as traditional stock options but may only be transferred upon an IPO or change of control transaction.
Indeed, both Facebook and Zynga (as of June 17, just three days after the new bill was announced) have received No-Action Letters from the SEC allowing the issuance of RSUs to employees not be included in the current 500 shareholder rule. Notably, these RSUs cannot trade in the secondary markets for private company shares.
The cost of obtaining such No-Action Letters may realistically limit the number of companies utilizing this option, but those who anticipate their company may become “the next Facebook” can currently head off the 500 investor rule by adopting a RSU program in lieu of a stock option plan.
A New Legitimacy for Direct Secondaries and Secondary Markets
The most dramatic result of the new legislation, however, would be the establishment of a recognized and permanent market for secondary trading of private company shares.
Adoption of this bill would help solidify a permanent role in the market for direct secondary transactions that enable larger institutional investors to provide liquidity for founders and early VCs, such as mutual fund giant T. Rowe Price’s recent acquisition of shares of Facebook, LivingSocial and Zynga, as well as encourage other private trading on platforms including SecondMarket and SharesPost.
Positive Step/Limited Impact
While the new legislation would open a new path to liquidity for a small number of companies, it is unlikely to dramatically change the way the vast majority growth stage companies are financed.
A very small number of the most successful growth companies, who might otherwise have been forced to go public in the past, will instead elect to stay private. Facebook is currently the most high profile example of a company that is expected to exceed the 500 shareholder limit and will be required to become a public reporting company unless the current law changes. Given the options offered by the bill, Facebook might have elected to defer an IPO.
For a variety of reasons, however, most growth companies will not opt out of the public financing system; instead, these new choices will simply reinforce the current trend of the most successful private companies leveraging the availability of private capital and trading on secondary platforms to grow their companies, and choose when and how they will time their initial public offerings.
Jamie Hutchinson is a partner at Goodwin Procter LLP in Washington and Breck Hancock is an associate with the firm in New York. They practice in the firm’s Private Equity and Technology Companies Groups and served as legal counsel to Russian private equity giant DST in structuring its investments in growing Internet companies such Facebook, Groupon, and Zynga.