Longtime Glom readers know that I've been interested in the new private secondary markets for quite some time. Indeed, my summer writing focused on these new markets, where accredited (i.e., wealthy) investors can buy shares of pre-public companies from current shareholders. Security Law's Dirty Little Secret, forthcoming in the Fordham Law Review, was the result.
In the piece one of the concerns I voice is that these new markets risk disrupting the "nurturing" model of venture capital. The dominant VC narrative is that part of what makes Silicon Valley et al. so successful is that venture capitalists bring not only dollars, but also expertise and support, to the entrepreneur. VCs take seats on a start-up's board and actively advise it on the myriad challenges a fledgling company confronts. My worry was that the secondary market, by providing an easier exit for venture capitalists and substituting faceless investors for engaged, experienced VCs, risked upsetting the successful Silicon Valley start-up model.
Enter AngelList, a website backed by SecondMarket, one of the two big players in the new secondary market. According to today's WSJ, AngelList allows angel investors to invest directly in start-ups via the web. Using this website, accredited investors can buy shares straight from the company. Investors may never meet or even speak with the entrepreneurs at all.
Off the cuff, here are some thoughts:
- Angels aren't VCs. The loss-of-expertise point may matter less here. Angels generally are less active investors than VCs and take fewer control rights, so substituting unknown web investors for angels may not make much of a difference. Where you come out on this depends upon what kind of intangibles you think angels bring to the table.
- Small dollar amounts from investors--as low as $1,000, according to the article--may lower the incentives of the angels to monitor any one investment. The WSJ quotes one investor: "You say how much, hit 'go,' and you're committed," he said. "It's almost as easy as the Amazon one-click checkout." This ain't you grandmother's--or Peter Thiel's-- angel investment, boys and girls.
- This money, unlike with the secondary markets, goes straight to the start-ups, and gets there closer to when they need it. That seems like a huge plus.
- It's more egalitarian. One attraction of Angelist is that it brings the Internet's "cut-the-middleman" angle to angel investing, and makes it less dependant on who you know in the Valley.
- But it's only available to accredited investors, and thus ripe for criticism from two fronts. First, from the "$1 million ain't what it used to be" crowd, investors with that net worth and/or $200,000 in annual income aren't necessarily sophisticated enough to handle these kinds of risky investments.
- On the flipside, if you're intrigued by AngelList, you're out of luck unless you have the money to get in the door. With more and more Americans qualifying as accredited investors, AngelList is just one more reminder that, when it comes to investing in the U.S., some investors are more equal than others.
VentureBeat has created a list of leading IPO Candidates for 2013, and there are some exciting prospects. Box, Dropbox, Eventbrite, LivingSocial, Square, Survey Monkey, and Twitter are some of the familiar names on the list. Still, in a recent survey by the National Venture Capital Association, VCs and CEOs were rather restrained in their outlook. The outlook for VC investment is also muted, and I am wondering: will Fred Wilson make an investment in 2013?
P.S. If you are interested in whether the JOBS Act will have any effect on startup financing, you might be interested in the Hot Topics Program at AALS entitled "Jobs," the JOBS Act, and the Future of Small Business Finance and the U.S. Equity Markets. It is scheduled for this Sunday at 10:30 am, and speakers include Glom friends Steve Davidoff, Joan Heminway, Kristin Johnson, Jeff Schwartz, and Bob Thompson.
A recent report from Wilson Sonsini on venture-backed IPOs has lots of interesting tidbits, for example:
- Almost all of the companies are incorporated in Delaware (94%).
- More companies separated the chairman and CEO roles than combined them.
- Board committees at these companies frequently included venture capitalists who had invested in the companies (counting the VCs as independent," despite their share ownership).
- Almost all of the companies (98%) had adopted a code of business conduct.
- Over 80% of the companies implemented a classified board in connection with the IPO.
Lots more in the report. Thanks to Richard Blake for the tip.
The latest edition of The Economist has a fascinating article on “Chilecon Valley” that discusses the emergence of a startup community in Chile. The article focuses on a unique program of Startup Chile (a new Chilean governmental body) that gives grants to entrepreneurs in the United States and elsewhere to move to Chile for several months as they work on building their company and developing their technology. The grant recipients are then expected to network with, speak to, and mentor Chilean entrepreneurs.
The article touches on how law can foster or hinder the growth of a startup community, including by liberalizing immigration laws and allowing failed ventures to get a fresh start in bankruptcy.
Chile is making considerable efforts to diversify its economy beyond extractive industries like mining and agriculture. My spouse is co-organizing a fantastic three-day conference in Santiago from November 28 to December 1st that will focus on social entrepreneurship, sustainability, and innovation. The conference includes a fantastic line-up of speakers, including a keynote address by Al Gore, a pitch competition for social entrepreneurship startup companies, and some awesome music, including Devendra Banhart and Denver’s own Devotchka. Several panels will analyze the contribution of law to developing a entrepreneurial ecosystem in Chile.
You can check out my wife’s newly launched blog and website on the Chilean startup community here.
Permalink | Conferences| Economic Development| Entrepreneurs| Entrepreneurship| Family| Globalization/Trade| Innovation| Investing| Social Entrepreneurship| Venture Capital | Comments (0) | TrackBack (0) | Bookmark
So, just as I was getting a handle on moderation with the timesuck that is Facebook, a friend tells me about Pinterest. If Facebook is a timesuck, then Pinterest is a black hole: a very pretty, tasteful, affirming black hole.
So, what is Pinterest? I'm still not sure. It's official description is an "online bulletin board." In fact, each user (you have to be invited or get on the waiting list) may have numerous "boards," categorized by topic. Then, users "pin" images to their boards. These may be photos by the user, but almost all the time these are photos that are captured elsewhere on the web with the "pin it" app. The user may comment on the image or just pin it. When you log on to Pinterest, you are shown all the images that users have pinned on their boards -- the users you are "following" or the ones that Pinterest automatically had you follow when you joined based on your interests. If you like another user's image, you can repin it to your board. Generally, you will follow your friends, possibly other users you encounter, and then I sort of get confused.
What are people pinning? The folks I follow (and me) generally pin recipes, design ideas, fashion ideas, kids' ideas, and crafts. There are a lot of topics. I haven't pinned that much. I'm more of a browser than a pinner. I still am not quite sure what the point is except to have a pretty website to scroll through every day with photos of things most of my friends (and me) like -- a recipe to turn a watermelon into an open-mouth shark with fruit salad coming out, instructions on how to turn your builder-quality bathroom mirror into a framed thing of beauty, witty poster sayings, crock-pot recipes. what's not to like? And, unlike Facebook, there is no pressure to be witty, no requirement to read posts about other people's kids, no fear of running into extreme politics, and no fear of old sweethearts seeing your beach pictures. If we are putting our shiniest face forward on FB, then on Pinterest you are putting the shiniest face forward that you can conjure up from design/fashion/food images -- this is what my house would like like and the cooking smells it would be filled with if I had unlimited time and money.
So, now to the point. How does this make money? So far, Cold Brew Labs, headquartered in Silicon Valley, has raised $27 million in funding based on a $200 million valuation. Hmmm. If you look on Pinterest, there is no advertising. And ads would completely ruin the visuals. There is some sense out there that Pinterest may be making money based on links back to merchants. So, if I decide I like a dress I see on a website, and pin that to my board, then someone clicks back to that website, there is some opportunity for revenue there. There also seem to be commercial folks joining Pinterest. A radio station we listen to here in Champaign has been mentioning (all the time) that it has joined Pinterest. The radio station is nonprofit, but surely there are forprofit firms joining Pinterest. There are a lot of Etsy folks on there. There's also the possibility that some users who create boards like "New Dresses From X That I Love" are really X employees. Then the "ads" would be hard to distinguish from "user pins," wouldn't distract from the visual flow and would generate revenue. But this is guessing.
I have two problems with Pinterest. First, I can't really figure out how to use the site. I can't find my own friends that I know are on it. (Unlike FB, the "find friends" search engine can't find squat.) More importantly, I'm worried it has copyright problems. People are pinning anything they want from anywhere they want. If the pin comes directly from the original image on the web, then under the image, the link appears, but that's it. But who knows what images are going up without any sort of attribution. Here are the Terms and here is the Copyright Policy. Basically, users promise not to violate copyright when they pin stuff up there, and Cold Brew Labs promises to consider, in its discretion, any complaints that users have violated copyright.
Besides that, I did make the slow-cooker basalmic pork tenderloin, and it was good.
..and that's the problem Mitt Romney's got right now. You can argue that it's hard to feel too sorry for private equity types: they certainly tend to live up to their name, keeping their name and doings out of the limelight (unless they're going public this year, and have to reveal that their top 3 execs made $402 million). It's that privacy that's hurting Romney now.
The mystery of private equity is something I confront each spring as I being my Life Cycle of the Corporation course. As the title suggests, it covers a corporation's life, from founding through venture financing, going public, and being public (and M&A and bankruptcy, time permitting).
Fully a third of the substantive classes focus on venture financing. That because it takes a while for the students to grasp what venture capitalists do. We watch a movie. We discuss term sheets and Series A financing documents. We have a negotiation exercise, pitting company counsel against investor counsel. By the end of the unit, they really do get it. But it takes three weeks.
Most of America hasn't done this. So maybe when they hear, as the Journal reported yesterday, that of the 77 companies Bain invested in during its tenure, 22% filed for bankruptcy or stopped operations by year 8, or that "most of the 50-80% of annual gains" Bain produced came from "a relatively small number of deals, and some of these winning companies later ended up filing for bankruptcy protection", that sounds scandalous. To me, it sounds like Bain hit it out of the park. But I know the odds are against a successful exit, even for a venture-backed corporation. I know it's normal for a few "home-runs" in a fund to make up for a lot of ho-hum investments and some real stinkers. Most Americans don't know that.
Like Gordon, I think Perry's "vulture capitalist" label is unfair and misplaced. But there aren't really any venture capitalist household names--Gordon Gekko is one popular image of private equity, and he plays a villain. Steve Jobs may be an entrepreneur-hero, but the public doesn't lionize the VC funds that got Apple off the ground.
Gordon says this issue "should be a winner for Mitt, if he can make the connection to average voters." The question for me, is whether Romney is going to try to explain venture capital and private equity to the average American in soundbites. My experience tells me that might be a tall order.
Rick Perry is trying to label Mitt Romney and his old firm, Bain Capital, as "vulture capitalists," and Sean Hannity is not buying the rhetoric ...
Ron Paul also came to Romney's defense against Perry, Newt Gingrich, Rick Santorum, and Jon Huntsman, all of whom are criticizing Romney's record at Bain. Ron Paul is right on this one. So is the WSJ:
Private equity helps to promote dynamic capitalism that creates wealth, rather than dinosaur capitalism of the kind that prevails in Europe and futilely tries to prevent failure. Sometimes this means closing parts of the company and laying off employees, but the overriding goal is to create value, not destroy it.
This debate will be with us through the general election, it appears, either because Romney figures out how to make it a plus with the middle class or because Newt Gingrich or President Obama figures out how to make it a liability for Mitt. While the particulars of many Bain investments leave some room for interpretation, the venture capital industry in the US has been the envy of the world, and the argument in favor of European-style capitalism seems especially weak right now. This should be a winner for Mitt, if he can make the connection to average voters.
If you are at Law & Society this Friday and Saturday, come to the mini-conference on Entrepreneuship & Law that Brian Broughman (Indiana - Maurer School of Law) and our own Gordon Smith (BYU) have organized. Here is the line up:
Friday, June 3, 2011
8:15 am to 10:00 am Regulating Entrepreneurs 2122 (Chair: Brian Broughman)
- Mira Ganor (Texas), The Power to Issue Stock
- Erik Gerding (New Mexico), Shadow Banking, Financial Innovation, and Regulatory Arbitrage
- Michelle Harner (Maryland), Mitigating Financial Risk for Entrepreneurs
- Poonam Puri (Toronto), The Regulatory Burden of Corporate Law
- Discussants: Kristin Johnson (Seton Hall) & Sarah Lawsky (UC Irvine)
12:30 pm to 2:15 pm Governance Structure of Entrepreneurial Firms 2322 (Chair: Brian Broughman)
- Brian Broughman (with (Jesse Fried & Darian Ibrahim), Delaware Law as Lingua Franca: Evidence from VC-Backed Startups
- George Geis (Virginia), Organizational Contracting and Third Party Rights
- Alicia Robb (Kauffman Foundation), Entrepreneurial Finance and Performance: A Transaction Cost Economics Approach
- Discussant: Bobby Bartlett (UC Berkeley)
Saturday, June 4, 2011
8:15 am to 10:00 am Law, Entrepreneurship, and Innovation 3116 (Chair: Gordon Smith)
- Mike Burstein (Harvard), Exchanging Information without Intellectual Property
- Sean O’Connor (Univ. of Washington), Transforming Professional Services to Build Regional Innovation Ecosystems
- Peter Lee (UC Davis), The Accession Insight and Patent Infringement Remedies
- Karl Okamoto (Drexel), Law and Entrepreneurship: An Assessment Approach
4:30 pm to 6:15 pm Global Entrepreneurship 3519 (Chair: Gordon Smith)
- Afra Afsharipour (University of California, Davis), US Private Equity Investments in India
- Sofia Johan (York Univ.)(with April Knil and Nathan Mauck), Determinants of Sovereign Wealth Fund Investment in Private Equity
- Gordon Smith, Stability and Adaptability
Permalink | Conferences| Empirical Legal Studies| Entrepreneurs| Entrepreneurship| Finance| Financial Crisis| Law & Economics| Law & Entrepreneurship| Legal Scholarship| Transactional Law| Venture Capital | Comments (0) | TrackBack (0) | Bookmark
First we had a technology IPO that doubles the first day, now we have a law firm establishing a fund for the purpose of investing "in or with" their clients. Foley Lardner has announced that the firm's $4 million investment fund will be for the purpose of investing in their venture capital clients' funds or in portfolio companies themselves. Hearkening back to the 1990s, Foley's announcement emphasizes that "[b]y having a vested interest in our clients’ businesses, we are further demonstrating our commitment to their success by literally putting our money where our mouths are.”
First, the establishment of the fund and the reasons for it seem very retro. Foley is attempting to brand itself, and its "Private Equity and Venture Capital Practice" as part of the VC culture. Foley now has an office in Silicon Valley, and also promotes its presence near Madison, Wisconsin (in Milwaukee) and in Boston. So, if you thought Foley was a boring old East Coast or Midwest firm, now think of them as a hip, savvy incubator-type firm that can meet all of your private equity needs. This seems a little Venture Law Group to me, and VLG isn't around any more. Of course, this model has also been great for Wilson, Sonsini, which didn't skip a beat when the tech boom ended.
Second, I have written about ethical problems with law firms making equity investments in IPO clients. However, at least form the announcement, it seems that many of Foley's investments won't have that conflict. If Foley's client is the VC, and the fund invests in an issuer the VC invests in, then Foley has no conflict with the non-client issuer. I'll have to think some more about this, but it's not obvious that Foley would have a conflict with the VC in advising the VC on its investment in the startup issuer. I suppose there could be a conflict on governance of the VC fund, but I'll have to think more about that.
Third, this seems like another harbinger that we may be entering a hot IPO market. Yes, Wilson, Sonsini's investment fund has run for decades, but it seems that Foley wouldn't be starting a fund now focusing on investing alongside VCs if some nice exits weren't on the horizon. Exciting for us corporate law geeks.
Prior to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Investment Advisers Act of 1940 had an expansive exemption for advisers of private funds (including hedge funds, private equity funds and other types of pooled investment vehicles excluded from the definition of “investment company” under the Investment Company Act of 1940). Dodd-Frank removed that exemption, but expressly provided a new exemption from registration for advisers to venture capital funds. The SEC has a proposed regulation to implement these changes, and the venture industry is worried.
Because, according to the SEC release, the new venture capital fund exemption "provide[s] that the Commission shall require advisers relying on [it] to provide the Commission with reports and keep records as the Commission determines necessary or appropriate in the public interest or for the protection of investors. [The] new exemption [does] not limit our statutory authority to examine the books and records of advisers relying upon [this] exemption."
In a release implementing amendments to the Investment Advisers Act of 1940, the SEC proposes reporting requirements for exempt advisers comprising "a limited subset of items on Form ADV." That limited subset consists of seven items on Form ADV (Items 1, 2, 3, 6, 7, 10, 11), and the disclosure filed by exempt advisers would be publicly available.
You can judge for yourself whether the disclosure is "burdensome and costly," but the logic of this regulation is a bit hard to follow. As observed by one commentator, "Exempting advisers on the basis that their registration is not necessary for the protection of investors while at the same time requiring the public filing of detailed information about those advisers would seem to be inconsistent if not opposite positions."
Legendary VC Don Valentine tries to explain his success. Why the obsession with the market?
"Because our objective always was to build big companies. If you don't attack a big market, it's highly unlikely you're ever going to build a big company."
An elegant explanation of how to change the world.
P.S. Valentine tells a story (start around 50:00) about Sandy Lerner's termination from Cisco. You might be interested if you know Urban Decay. He describes her as "tough beyond all comparison." Hmm.
Yes, we're all addicted to Facebook now, but many Facebookers are not just posting pictures or telling us what they made for dinner -- they are playing games. And this is the big money-maker now. So, there are 3 big players, all of which were venture financed: Playdom, Playfish and Zynga. (Quick overview: Zynga is Mafia Wars and FarmVille; Playdom is Tiki Resort; and Playfish is Who Has the Biggest Brain?) Playfish was recently acquired by Electronic Arts (EA, best known in our house for video games such as "Madden") for at least $300 million, and Disney announced this week that it is acquiring Playdom for $563 million, plus up to $200 million in earnout. The Disney announcement was huge news not only because Playdom is a two-year-old venture, but also because Disney is about mainstream entertainment. Are social network games mainstream?
Apparently, yes. I think this is the brilliance of these games, which are available on Facebook and the like. They are video games for non-gamers, much in the way that the Wii was a video game console for non-gamers. Anybody can play, and you don't need to know how to hook up a $200 box to your television. Or buy multiple $50 controllers. Yes, there are many people who play their friends over the Internet on their XBox or Wii or who participate in MMORPG (massively multiplayer online role-playing games). But zillions of people play their friends on these social network games, without even knowing how to use a joystick or nunchuk or whatever.
The amateur aspect also drives the profits. Yes, they make profits. Coincidentally, before the Disney-Playdom announcement, the NYT had an article on Zynga on Sunday, called Will Zynga Become the Google of Games? Zynga makes money, even though its games are free? Why? Because it allows gamers to purchase virtual goods with real money if they don't feel like waiting to earn enough virtual currency. My sense is that real gamers hate this. I once went to a conference where expert World of Warcraft players were bemoaning the fact that amateurs were buying access to high levels on eBay, ruining their play by letting in these rookies to the high levels. Well, these rookies are encouraged to buy the pink tractor for $3.50 any time their hearts desire it.
So, Zynga is the last independent social network game. It's valuation is over $5 billion, making an acquisition unlikely unless by a major player, such as Google. The Securities Regulation professor in me is chanting "IPO, IPO," but who knows. Some watchers are worried that Facebook's curtailment of the games' constant bombardment of members' newsfeeds may cut the market way back; this may be the top of the valuation. We'll see.
Do I play Facebook games? No. I tried Typing Maniac, and I was exceptional at it, much better than my friends and family. But I played so much I think I got carpal tunnel, so I banned myself from it.
First of all, apologies for absence this summer. My summer travels are now complete (as far as I know), so I can focus on keeping first things first, like the Glom!
Now, for the fun. I love movies, and I love to think about both microfinance and peer-too-peer investing and borrowing. So, yesterday on the plane (of course, the plane) I loved this article on Kickstarter, a crowd financing website that enables all kinds of artists to raise money for their projects. Apparently it has been so successful that this week it is hosting the Kickstarter Film Festival (which it Kickstarter financed).
Reading the article, I assumed that Kickstarter was allowing artists to use its website to find angel investors for their projects. So, of course, I was interested to see how the site was going to satisfy SEC regulations on registering securities. But, I was wrong. When you "back" a project on Kickstarter, you are not an investor. Or a lender. Or even a donor. What are you? You're a backer.
So, if you look at the FAQ, you'll see that Kickstarter goes to some length to explain that backers are not making an investment. Project owners must keep 100% of the ownership and "may not offer financial return or equity under any circumstances." Investment and loan solicitations are "forbidden." OK, so if I can't get a return, I must get a tax deduction, right? Um, probably not. Your "pledge" is not tax deductible, unless the project owner is a 501(c)(3) entity. In fact, Kickstarter tells project owners that this is "not a place for charity projects" or "donations to causes."
Well, this will almost certainly keep Kickstarter's legal costs down, if money goes directly to the project and is not a security, or a loan, or a charitable deduction. But what is in it for the backer? Well, Kickstarter requires project creators to deliver "rewards" worth between $1 and $10,000. (Not sure why the $10k limit. Gift tax?) So, what are some of the rewards? I looked through the film projects and was intrigued by a film that is already fully funded, so in using it as an example, I don't think I'm really hawking it. The film is Green Corn, about a U.S. family that illicitly grows marijuana. The project wanted to raise $6,000, a fraction of the film's cost. Backers receive various rewards, depending on their funding level. For example, $25 gets you a DVD, $50 gets you a t-shirt and a DVD. Interestingly, although creators aren't supposed to offer equity, $1,000 gets you a single share of "Green Corn LLC," which will issue only 25 shares. (My crude internet research skills found a Nevada LLC of the same name with a Las Vegas address, but that's all.)
Another project I clicked on, which is not yet fully funded, seemed to also walk the line on Kickstarter's prohibition against "funding your life" through Kickstarter. In this project, which I won't name, a creator wants $5,000 to be used walking through a geographical region. $2,000 is for backpacking equipment, and $2,000 for living expenses, and the rest to make "rewards" for backers. The rewards seem to be photographs of the walk. The creator may very well be a professional photographer, but it still makes me wonder if I could fund my next family vacation this way. My kids are really cute and sometimes photograph very well.
Projects are picked by the backers by reviewing information provided by the creators themselves. Kickstarter seems to have adopted a "caveat backer" approach and merely tells would-be backers to "use your internet street smarts." One small protection is that if a project is not fully funded within a certain time period, then the backers' credit charges will not be charged and no money changes hands. So, perhaps if your internet smarts are not as refined as the rest of the backer market, the backer market will save you.
So, why are so many people backing these creative projects without hope of a financial return or even a tax deduction? I can think of at least three reasons, which may all amount to one reason. First, perhaps most financial backers of artists don't receive much of a return anyway, if at all, so this just tosses away the burdens of that expectation. Maybe it's better to send a t-shirt to a stranger even if your film doesn't get picked up then have to look your father-in-law in the eye next holiday season after the film dies into obscurity. Second, perhaps backers just like being part of something, like the idea of getting a unique reward (a t-shirt and DVD of an indie film seems like a pretty good reward for $50) or even a "thank-you" in the credits in the film. The ability to show your friends that you're in the credits of the next indie film sensation may be worth a lot more than a thousand dollars or two. Third, lots of people gamble away $25 here or there anyway with low probabilities of return because of the consumption value of gambling. Here, the consumption value seems pretty high. You get to scroll through fun, new projects, follow it along, feel some moral investment if it comes to a festival near you, etc.
Two final thoughts about Kickstarter. First, why isn't Kickstarter organized like Kiva for the arts. Why didn't they become a 501(c)(3) and make all pledges tax-deductible? I think Kickstarter would prefer to be the next Facebook, not the next Kiva. Watch for a Kickstarter IPO near you. (And wouldn't it be amazing if it was an online IPO!!)
Second, do we need a charitable deduction for backers of the arts? Would Kickstarter attract more funding for the arts if it offered a tax-deduction? This model makes an interesting opportunity to see whether the arts needs the tax deduction to attract donors. Perhaps it's the intangible rewards of arts funding that attracts donors, not the tax deduction.
In Business Associations, I try to drive home the message that shares in a closely-held corporation are theoretically freely transferable, but in practice not so much. The market is illiquid, and finding others to purchase your shares, particularly if they reflect a minority interest, will not be easy. As an outsider, it's hard to value the shares. In addition, the most assured route to receiving an return on investment of minority common shares is either through discretionary dividends or possibly through employment at the corporation, leaving the outside investor uneasy. But what if you could overcome these obstacles -- a market that connects buyers and sellers, provides market-based valuation, and signals the potential of an eventual liquidation event?
Sharespost.com is apparently a website that attempts to connect sellers and buyers of unregistered shares in private corporations. These are shares that would be owned by founders, employees, perhaps angel investors? Note, however, that these are share in venture-backed corporations, not in your family business. So, the venture-backed nature sends a signal to the market not only of value, but also of potential exit. This website, in fact, is mentioned in a Recorder article on Facebook shares.
Sound perfect, but what are the concerns? My first thought was securities law. The article says "Companies such as Sharespost.com and Secondmarket.com have sprouted up in the past two years, following an SEC rule change that relaxed restrictions on selling shares of private companies." OK, but the SEC hasn't promulgated any safe harbor that says any person can sell any shares to any other person at any time. Looking on the SharesPost.com website's "Legal" page:
Though each participant in a SharesPost facilitated contract is solely responsible for making their own legal determination about the availability of an exemption from the securities laws, we believe we have constructed the SharesPost process such that Buyer and Seller can generally make use of a Section 4(1) exemption, and in some cases, Rule 144. Supporting such an exemption is the fact that only SharesPost members with a password protected account are able to participate in postings, only accredited investors can be SharesPost Buyers, and only sellers holding their shares for at least a year can be SharesPost Sellers.
First, I think SharesPost means that most will qualify for the safe harbor in Rule 144, and in some cases the more restrictive original 4(1) exemption. The three requirements listed seem focused both on meeting holding periods in Rule 144 and ensuring that this is not a public distribution but a resale to specific buyers who can fend for themselves under 4(1) (or 4(1 1/2), in securities professor jargon).
So who is really concerned? Issuers. First, resales can threaten to bring the number of shareholders to over 500, triggering full-fledged registration requirements under 12(g) of the Securities Exchange Act. Second, issuers seem to be worried about insider trading problems, prompting Facebook to ban their employees from selling shares on SharesPost.com except during certain windows. Facebook may be trying to control a different problem than insider trading, however. (In fact, having the company set windows for trading seems to raise more insider questions than not.) Issuers may be worried about 12(g). They may be worried that whatever exemption they used to issue the shares will be busted by an untimely resale. They may also be worried about feeding a secondary market that may be too incomplete to give good information or even a little too complete. Private issuers don't have to tell the market as a whole how well they are doing day-to-day. An incomplete market can mess up going public plans (like Facebook's rumored plans) by inadequately reflecting that private information so as to send a lower, incorrect pricing signal. Or, premature negative inside information may make the market a little too complete when an issuer would prefer opacity.
My research has focused on how sophisticated entrepreneurial parties – including angel investors, venture capitalists, venture lenders, and entrepreneurs – structure their relations, and how the corporate, securities, and commercial laws respond to their unique needs. In my venture debt paper, I discuss how lender liability and equitable subordination rules shape venture lender practices. In this post, I’ll focus on the securities laws.
First, there’s the exit structure of venture capital (with credit to Gordon for an excellent paper of the same name). In the past, hot IPOs allowed VCs to return big gains to their fund investors. In this recent public policy proposal (click on the Apr. 29, ’09 doc), the National Venture Capital Association laments that there were only six IPOs total in the U.S. in 2008. The securities laws aren’t helping the situation. As Larry Ribstein and others have observed, the costs of going public thanks to Sarbanes-Oxley have dampened the IPO market, and there’s a legal minefield we teach in the securities course known as the gun-jumping rules that makes the IPO process far more cumbersome and error-prone than the process for seasoned public offerings. Sure, a start-up needs to provide more disclosure than Microsoft, but it’s not like no one has vetted these companies. They have been subject to rigorous and repeat scrutiny from (venture) capital markets from their inception. Why are the gun-jumping rules so complex?
Second, long before exit, private placement rules and broker-dealer laws might be impeding optimal levels of funding from angel investors, the precursor to venture capital. In my last paper, Financing the Next Silicon Valley, I explored both the ban on general solicitations in private placements and the reach of the broker-dealer laws to see whether angels had reason to fear the application of these laws to their activities. I concluded that there is a plausible case that the letter of these laws, if not the spirit, are indeed violated by routine angel group practices. First, when entrepreneurs approach angels (and VCs) without a “preexisting relationship,” as they do whenever they send a business plan cold, there appears to be a general solicitation. This leads to a host of potentially bad outcomes including recission rights, dissuading follow-on VC financing, and delaying an IPO. Second, when individual angels take the lead on a start-up’s due diligence for their group and receive extra stock in the start-up as compensation, they arguably fit within the definition of a broker-dealer. I can’t imagine that the broker-dealer laws were meant to apply to this situation, and granted the SEC hasn't enforced either of the laws I mention (to my knowledge), but the cloud of uncertainty they hang over angel group practice certainly isn’t enticing more angel investments, at least according to my sources.
Bottom line: with our traditional economic engines like Wall Street finance and the auto industry in crisis, we need start-ups more than ever, and there won't be start-ups without angels and VCs. Market forces have already hit these investors hard; the securities laws shouldn’t exacerbate the problem. The SEC and Congress should re-examine these laws and ease up a bit to help keep our entrepreneurial culture going strong.