May 10, 2011
When Does a Company Get Too Big to Stay Private?
Posted by Usha Rodrigues

My titular question is dumbed-down, I'll admit.  U.S. securities laws don't concern themselves with size of company measured in terms of revenue or assets--years ago I represented Mars, a multi-billion dollar enterprise that was resolutely privately held (yes, the candy company, although it's really a conglomerate that owns companies as diverse as Pedigree dog food and Uncle Ben's rice.  More to the point, yes, they do have free M&Ms available at corporate headquarters).

Company size does matter when it comes to the securities laws, though, because when you hit 500 shareholders of record, you have to register your shares with the SEC.  Today SEC Chairman Mary Schapiro testified on the Hill about the SEC's role in capital formation.  She highlighted a counting problem:

Today, the vast majority of securities of publicly-traded companies are held in nominee or “street name.” This means that the brokers that purchase securities on behalf of investors typically are listed as the holders of record. One broker may own a large position in a company on behalf of thousands of beneficial owners. However, since the shares are all held “in street name,” those shares count as being owned by one “holder of record.” This shift has meant that for most publicly-traded companies, much of their individual shareholder base is not counted under the current definition of “held of record.” Conversely, the shareholders of most private companies, who generally hold their shares directly, are counted as “holders of record” under the definition. This has required private companies that have more than $10 million in total assets and that cross the 500 record holder threshold – where the number of record holders is actually representative of the number of shareholders – to register and commence reporting. At the same time, it has allowed a number of public companies, many of whom likely have substantially more than 500 shareholders, to stop reporting, or “go dark,”31 because there are fewer than 500 “holders of record” due to the fact that the public companies’ shares are held in street name. 

She concluded: "I believe that both the question of how holders are counted and how many holders should trigger registration need to be examined."  The counting question is easy--sure, we should count shareholders consistently for public and private firms.  The real question is, when do we think a company has so many shareholders that the government should be able to force it to go public?

Why do we have the 500-person rule anyway?  According to Steven Davidoff's excellent Goldman/Facebook post,

The underlying 500-person rule was enacted in 1964 to ensure that investors in significant companies had sufficient information to make their investment decisions, with size here set by the number of shareholders. It was designed to curb a private trading market which had sprung up on the over-the-counter market.

Readers of the Glom know that a private trading market is in full flower today, thanks to SharesPost and SecondMarket (which has held talks with the SEC about a no-action letter approving its transactions, according to yesterday's WSJ).  So is the 500-shareholder rule outdated, unduly constraining private companies by forcing them to go public, as House Oversight and Government Reform Committee Chairman Darrell Issa believes?  Or is Columbia Law School Professor John Coffee right?  According to MarketWatch, Coffee argues that

loosening the rules for trading of non-public shares of private companies would hurt transparency, make the market less efficient and increase fraud. He argued that private companies would be discouraged from conducting initial public offerings if they can get more private investors without needing to comply with SEC registration and disclosure rules.

“The market is less efficient with less transparency, and in the long run you are going to move to darkness, and bad things happen in darkness,” Coffee said.

I'm not sure where I come out on this.  My gut instinct is that you take the bitter with the sweet.  If you're an early investor or employee in Facebook, you get in on an investment that make you a lot of money in the event of an exit event like an IPO or an acquisition.  But you suffer through diminished liquidity until that event.  If you're a public shareholder, you enjoy the benefit of publicly-traded liquidity, but the growth potential is nowhere near as meteoric.  Sites like SharesPost and SecondMarket upset the applecart by giving early investors a chance at early exit.  I can't see VCs being all that thrilled about this--venture contracts typically have co-sale rights to ensure that founders and key employees don't jump ship.  But that doesn't seem to be stopping the feeding frenzy, so what do I know?

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