Did you catch this recent Businessweek article? Facebook and Zynga, two of the most popular social networking sites on the web, and already touted by some as two of the most highly anticipated IPOs of 2012 or possibly 2013, are now charging fees of between $2,500 and $6,000 for share transfers.
Why so much? The Businessweek piece cites two possible reasons:
- the companies are passing on the administrative costs of complying with applicable securities laws; and
- they are trying to avoid Exchange Act registration.
At least in the case of Facebook, and most likely for Zynga too, I think the latter explanation is the true motivation.
Companies with an excess of $10 million in assets and a class of equity securities held of record by 500 or more persons are required to register that class of equity securities under the Exchange Act and comply with applicable reporting requirements, such as the filing of periodic reports.
Both Facebook and Zynga have already surpassed the asset requirement and, with the recent surge in secondary markets for illiquid assets, like SecondMarket and SharesPost.com, they really can’t afford to take a passive position on the 500 persons of record requirement, not if they intend to push out the possibility of an IPO until 2012 or beyond.
Increasingly, it looks as if Facebook and Zynga are actively trying to limit their shareholder bases, but did they move soon enough and will they be able to effectively hold back the growing secondary market for their securities?
This past April Facebook put into place an insider trading policy that prohibits current employees from selling shares unless the company opens a trading windows; Zynga has contemplated a similar insider trading policy. Prior to that, some time in late 2007 or early 2008, Facebook stopped issuing employee stock options, switching instead to restricted stock units.
A restricted stock unit is essentially a promise to deliver shares of stock in the future, subject to the satisfaction of any vesting requirements. In the case of Facebook, holders of restricted stock units will not receive their vested shares until the company undergoes a change in control, such as an acquisition or an IPO. In a 2008 no-action letter request to the Securities and Exchange Commission, Facebook was granted relief from Exchange Act registration requirements with respect to its issuance of the restricted stock units. The grant was based, in part, on Facebook’s representation to the Commission that the restricted stock units have been specifically designed to preclude any transfer or trading from taking place.
While the issuance of restricted stock units and the new insider trading policy may have effectively curbed sales by current employees, former employees are still capable of selling their shares in the secondary markets. Hence the recent imposition of steep transfer fees, if Facebook and Zynga can’t prevent former employees and subsequent transferees from selling shares altogether, at least they can make it cost prohibitive for them to do so in small blocks, which will not only impede the development of a liquid market but also further check the expansion of their shareholder bases.
If that doesn’t work? There’s not too much else Facebook and Zynga can do, other than maybe buying back their own shares, which is not generally the best use of a late-stage startup/early growth company’s funds, or arranging for a third-party buyer (as Facebook has done in the past).
What can other companies learn from this? I think most clearly, that we need better planning. The environment for growth companies has definitely changed. This is partly because of the current state of economic affairs–it’s taking much longer to find an appropriate exit–and partly because of regulatory changes that have led to the development of unanticipated markets. It’s important that companies not be forced to prematurely IPO, but at the same time it’s important to offer employees meaningful incentives. Restricted stock units seem to have helped Facebook find that balance, but they’re operating on the basis of a no-action letter and they’re likely to IPO or otherwise exit in a reasonable enough time frame to keep employees engaged. So where does that leave the rest of us?