Congress will soon consider whether to revise a 77-year-old rule that is encouraging Facebook Inc. and other companies with at least 500 shareholders to register for an initial public offering.
Rep. David Schweikert (R-Ariz.) today introduced a bill (read it below) that would amend the Securities Exchange Act of 1934, allowing private companies to have 1,000 shareholders instead of the current 500 before they’re required to publicly disclose their finances, often compelling them to go public.
Called the Private Company Flexibility and Growth Act, the bill would also exempt accredited investors and employees from the 1,000-shareholder limit. Fortune earlier reported news of the bill.
Schweikert said in an interview,
“Our goal is simple–to create another path for capitalizing a business instead of business owners going straight to venture capitalists or saying, let’s go public even though we’re not ready . If a company is really growing, it could start to hit its 500-shareholder limit just from its employee base.”
If the bill becomes law, it could further depress the number of U.S. IPOs, which fell after the dot-com bubble burst to an average of about 130 since 2001 from an average of 503 during the 1990s, according to research firm Dealogic. It could also make it harder for ordinary investors to invest in fast-growing technology companies, since the companies would presumably stay private longer.
Some of the most sought-after technology companies, such as Facebook and social-gaming company Zynga Inc., are still private and are also at or near the 500-shareholder threshold because their shares trade on the secondary market, where the value of transactions in private company shares is growing. Exchanges like SecondMarket have encouraged employees to sell their shares to others.
Not surprisingly, SecondMarket is in favor of the bill. Aishwarya Iyer, a spokeswoman for SecondMarket, said:
“The proposed change to the ’500-shareholder rule’ is an important first step to help growth-stage companies and bolster American global competitiveness. Modernizing this decades-old regulation would provide companies with the needed flexibility to more readily and cheaply access capital, hire new employees and retain existing ones, and ultimately go public when it makes strategic sense.”
Some venture capitalists also support the bill, even if it means holding onto companies longer. Institutional Venture Partners General Partner Norm Fogelsong, whose late-stage investment firm is an investor in Zynga and Twitter Inc., told VentureWire in an email:
“This higher limit makes the regulation more in line with the reality faced by rapidly growing innovative companies. The revision is most welcome by the entrepreneurial community.”
But the trade association that represents the venture industry has reacted cooly to such a move. In response to news in April that the SEC was reviewing whether it should ease constraints on share issues by private companies, Mark Heesen, president of the National Venture Capital Association, said that
“An environment where companies remain private indefinitely will have long-term negative impact on the economy, innovation and the VC industry.”
The bill has bipartisan support and should become law before the end of the year if it stays on track, Schweikert said. Other bills, including one to address the impact of Sarbanes-Oxley financial regulations on private companies, are coming, and a bill to update the Securities and Exchange Commission’s Reg A rule is through sub-committee, he said. That bill would allow companies to go through a streamlined registration process for an IPO if they were offering up to $50 million in shares, rather than $5 million in shares, in an IPO.
Schweikert said he’s had good response on the bills from young private companies in his district–including Internet, biotechnology and life sciences companies–and from Arizona State University, which has become a hub for new technology.
However, he said, the bills are also aimed at non-technology companies that are creating jobs but may not have the same cachet as technology companies among potential investors.
COMMENTARY: The problem that I have with loosening private company stock sales by increasing the maximum number of private shareholders from 500 to 1,000, is that there is no way for outsiders to determine what you are really buying since private companies do not disclose financial information. Only insiders know the true condition of the company. Sales of popular private company stock have been on an auction basis with bids starting at a set price. This is not democratic like it would be under a public stock market.
Deep pocket institutional investor's like hedgefunds, investment bankers and venture capital firms will swoop in and buy the shares leaving very few if any for mainstreat buyers. This creates a temporary "pop" in the price of a private company's stock in the secondary market like Sharespost and SecondMarket by making the number of shares available for sale very scarce.
The secondary market has become a country club for a few priviledged investors. This shadow market has raised the prices of private company stock like Facebook, Twitter, Zynga and Groupon to multiples not seen since the Dotcom era. Share prices are based solely on future potential and driven by a good dose of hype and euphoria. Share prices have no relationship to the real value of the private company. The shares of a lot of these startups shouldn't even be available for sale on the secondary market.
LinkedIn shares were selling for $30-$35 in the secondary market, but when it had its IPO, shares skyrocketed to a peak of 122.70 before settling at $94.25 the close of trading. The market effectively priced those shares at 593 times earnings and 36.65 times revenues. Shares are now trading at $65.53 per share. All of this was driven by insiders who cashed in their shares at nearly double the secondary market price. Other examples where the price of shares quickly collapses after they had their IPO include SINA Corp, Renren, Sino-Forest, Dangdang, and Pandora. A lot of those share price multiples were driven up in the secondary market, and stayed that way when they had their IPO. Now we find that those shares were significantly over-priced.
I really believe that we are playing with fire, and a lot of smaller mainstreet investors are going to get burned in the process, including employees of those startups that were paid in stock options. Prices will drop significantly at the very first sign of bad news or rumor mill. I say let's get it all out in the open. Make things more transparent. Keep the SEC 500 shareholder rule intact and if you want to sell shares in the secondary market, some financial information should be made available so that investors will know what they are buying.
Courtesy of an article dated June 14, 2011 appearing in The Wall Street Journal's Venture Capital Dispatch
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