SEC Looks Broadly At 500 Shareholder Rule And Capital Formation For Small Companies

Securities & Exchange Commission Chairman Mary Schapiro mailed what is certain to be a widely-debated letter to Rep. Darrell Issa (R-Calif.) earlier this week. I don’t know if you’ve read it.

The headline news came out Friday in a Wall Street Journal piece noting that Schapiro (pictured) is rethinking the crucial 500-investor threshold rule. This rule is what pushed companies, such as Google, to public offerings and may do the same for Facebook.

But there is a great deal more to the 26-page communications. Schapiro points out the SEC staff is examining special purpose vehicles. These vehicles allow investors to buy interests in private companies by pooling their cash into single accounts and registering as single shareholders.

She goes on to say she ordered her staff to conduct a broad review all regulations governing capital formation for small companies, including:

*The restrictions on communications in initial public offerings;
*The general solicitation ban and whether it should be revisited in light of current technologies, capital-raising trends and SEC mandates to protect investors and facilitate capital formation; and
*New capital raising strategies and whether they pose questions for regulators.

I’m not going to pretend I can predict how each rule change, if it comes, would impact the nation’s sluggish, though improving, IPO market. More communications from companies should be good.

But I can say this: I don’t think changes to the 500 shareholder rule will have as broad an impact as some predict. All of you know that once a company has more than 499 shareholders and more than $10 million in assets, it is required to release financial information, and young firms often choose to file S-1s and sell shares to the public rather than report as private entities.

It is understood the 500-shareholder rule is behind Facebook’s possible 2012 IPO, especially after it distributed shares through Goldman Sachs and an SEC probe of secondary markets began.

“I believe that both the question of how holders are counted and how many holders should trigger registration need to be examined,” Schapiro said in her Wednesday letter, referring not only to the absolute number of shareholders on record but to special purchase vehicles.

Schapiro did not give a clue as to where she would like to the see the new shareholder threshold for private companies. But you can guess the operative word is higher.

There will undoubtedly be lots of chatter about how this change will impact IPO markets. But I am not yet convinced it will in any substantial way. Certainly companies such as Facebook or Twitter will be affected, since with their popularity they could easily sell shares to more than 500 people. Any rule change might help them avoid filing an offering.

But the average startup with $60 million in annual revenue and continued losses due to rapid expansion may not face that same wealth of opportunity. In fact, this lessened opportunity is why many choose to go public, to raise their profile and take advantage of new ways to raise money.

In short, a modest revision of IPO rules will grease the skids a bit more than they are today. This is also true of efforts to ease Sarbanes Oxley provisions concerning the smallest of companies. But ultimately the market depends on investor sentiment and when it is good (as it looks to be today) companies will sell shares to the public. When it isn’t, they won’t.

Here is a comment from Mark Heesen, president of the National Venture Capital Association, on the Schapiro letter:

“The NVCA is not planning to take a position on the specifics of the regulation of the private markets at this time – including the 500 investor rule,” however, “it is encouraging to see that the SEC recognizes the need to assist emerging growth companies in reaching potential investors, as well as the need to review long-standing regulations to assess their current impact.”

SecondMarket said, via a statement: “We are encouraged that the SEC is reevaluating their rules in an effort to stimulate the capital markets while still recognizing investor protection. Updating and clarifying the rules will improve the capital formation process for small, high-growth companies, thus invigorating innovation and job creation in the US.”

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2 Comments

  • Not talked about, but important: if the shareholder rules are to be relaxed, then rules requiring placement agents for companies be registered will also have to be changed. Otherwise, broker dealers will go out of business.

    (I am a VC, and have no financial interest in a broker dealer.)

  • This will be great until the first multi-billion firm goes under and investors get hosed. The SEC can’t regulate what they have on their plates now. The public investor doesn’t belong in VC investments.

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