Analysis: Note to regulators: don’t kill the IPO

By Clare Baldwin and Sarah N. Lynch

NEW YORK/WASHINGTON (Reuters) – As U.S. regulators review rules on shares issued by private companies, they must not make it too easy for hot Internet companies such as Facebook or Twitter to avoid the scrutiny that goes along with an initial public offering.

Privately held companies are bound by the 500-shareholder rule, which states that once a company has that many shareholders of record — and at least $10 million in assets — it must make the same financial disclosures as a public company.

As it stands now, the rule effectively forces a company to go public when it has too many investors: the 500 limit was one of the reasons Google Inc decided to launch its IPO in 2004, and why Facebook is expecting to go public next year.

The U.S. Securities and Exchanges Commission is considering whether to raise the 500 limit, as part of a move to update decades-old regulations and revitalize U.S. capital markets which have been outshone by faster-growing emerging markets.

Allowing a company to remain private for longer means it can sacrifice near-term profitability for the long-term health of the business, which is hard for a public company struggling to meet quarterly earnings targets. Remaining private can also protect business secrets from competitors.

But companies that grow as large as Facebook without disclosing information go against a growing trend for greater disclosure, and represent a change of course for a regulator that has stepped up a campaign against insider trading.

“In this regulatory age that we live in, of Sarbanes-Oxley, Dodd-Frank, etc., generally the direction of regulation has been to be stricter — so it would be a surprising 180 degree turn to suggest loosening things up and having less transparency,” said Richard Truesdell, co-head of the global capital markets group at law firm Davis Polk & Wardwell LLP.

The SEC has not indicated which direction it will go in its broad review. It is also considering revising another rule on special purpose vehicles (SPVs) that could greatly restrict the number of investors in privately traded companies.

An SPV, such as the one Goldman Sachs set up to invest in Facebook, counts as one shareholder even though it contains money from multiple investors.

SEC Chairman Mary Schapiro said on Friday the review was to update outdated rules. The SEC is wrestling with the needs of private companies to raise capital against the investing public’s need to make informed decisions.

The issue has jumped into the spotlight as Wall Street banks and electronic markets offer investors a chance to buy and actively trade stakes in hot Internet companies such as Facebook, Twitter, Groupon and Zynga before they go public.


The growth of private exchanges, such as SecondMarket, have delayed IPOs, analysts and bankers say. These private markets have rules that limit who can buy or sell shares, but there are no standards that govern information disclosure.

These markets typically require hundreds of thousands in annual income or minimum net worth of more than $1 million, high barriers for ordinary retail investors.

“These private markets are correctly restricting purchasers to institutions and accredited individuals. That excludes 95 percent of the investing population,” said Jay Ritter, a finance professor at the University of Florida.

“If it is easier to raise money or get liquidity without the company formally going public, it will postpone some companies going public.”

Any move that affects the U.S. IPO market, which was estimated at nearly $40 billion in 2010, would have an impact on venture capital firms, which invest in start-ups in the hope of cashing out when they go public.

The National Venture Capital Association said it was not taking a position on the 500-shareholder rule, but that it is important for the economy to have more companies go public.

“We continue to support proposals that allow private companies to have better access to temporary liquidity as they approach an ultimate exit,” NVCA President Mark Heesen said in a statement. “But an environment where companies remain private indefinitely will have a long term negative impact on the economy, innovation and the VC industry.”

The SEC’s review comes as regulators are sharpening their focus on enforcement, with a string of insider trading investigations.

“If you are allowing lots of investors to make investments in companies that are not required to make the same disclosures that public companies are required to make, then there is some risk those investors get wrapped up in offerings that are fraudulent or ill-advised,” said a New York-based capital markets lawyer who spoke on condition of anonymity.

“It’s hard to forecast how you would limit opening up this part of the market without freeing a bunch of fraudsters. On the other hand I’m not sure the 500-holder limit really stops fraudsters anyway,” the lawyer said.

(Editing by Tiffany Wu and Richard Chang)

Analysis: Note to regulators: don’t kill the IPO