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Will Facebook be Forced to IPO by Spring?

Looks like those exorbitant transfer fees weren’t enough to put a damper on the growing market for shares of companies like Facebook and Zynga.

The New York Times and The Wall Street Journal have been reporting that the Securities and Exchange Commission has launched an inquiry into the trading of shares of Facebook,  Zynga, Twitter and LinkedIn in secondary markets like SecondMarket and SharesPost.com.

The Commission declined to comment on the matter, but that’s to be expected as inquires are always conducted confidentially unless an administrative proceeding or legal action are filed.

Both articles also note that the inquiry appears to be focused, in part, on certain investment funds set up to purchase the companies’ shares (Bloomberg did a piece on three such funds back in November) and both question whether the inquiry could ultimately force Facebook into filing for an IPO.

But how do you force a company to IPO?

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 Section 12(g) of the Securities Exchange Act of 1934.  The required registration statement must be filed within 120 days of the end of the first fiscal year in which a company meets both the asset and shareholder tests.

As an aside, registering under the Exchange Act isn’t the same as filing for an IPO.  Exchange Act registration only requires that a company comply with applicable disclosure requirements, such as the filing of quarterly and annual reports.  When a company files for an IPO it does so by registering securities for sale to the public under the Securities Act of 1933.  What frequently happens when a company is forced to register under the Exchange Act is that it will simultaneously file for an IPO under the Securities Act.  This was the case in the often cited example of Google, which filed for registration under both the Securities Act and Exchange Act on April 29, 2004.

Each of Facebook,  Zynga, Twitter and LinkedIn have already surpassed the asset requirement of Section 12(g), so the deciding factor in whether they will be forced into registration under the Exchange Act is whether their securities are held of record by 500 or more shareholders.  As currently defined, the holder of record is the person identified in a company’s records as the owner of the securities in question.  Meaning that securities held in the name of an entity, like one of the investment funds being set up to purchase shares of Facebook, are only counted as being held by one person, regardless of how many investors make up the funds.  There is an exception to this rule, however: if Facebook knows or has reason to know that the investment funds are primarily being used to avoid Exchange Act registration the Commission can count the beneficial owners of the securities as the holders of record, meaning, in our example, the investors that make up the funds.  This may be where Facebook and other companies run the risk of being forced into Exchange Act registration.

If this is the case, and assuming Facebook uses the calendar year for its fiscal year, then if the Commission finds that Facebook had 500 or more shareholders of record on the last day of its fiscal year end on December 31, Facebook would be required to file a registration statement under the Exchange Act by April 30, 2011.

Another potential explanation for the inquiry is that the Commission may be considering amending the definition of “held of record”, the current version of which was adopted in 1965.  In 2003 a group of investment funds petitioned the Commission to revise the definition to count the beneficial owners of securities held in street name as the holders of record.  Interested parties have been commenting on the proposal since its introduction, with the most recent comment letter being submitted in April 2009.

With the growth of secondary markets for illiquid assets and the increased use of alternative investment vehicles, perhaps the Commission is reconsidering how it tallies up shareholders and whether a company the size of Facebook should be required to disclose certain information to its investors.

Update: January 10, 2011

At this point this topic has pretty much been covered to death. Rapper 50 Cent has opined on Facebook’s reported $50 billion valuation and there was even a rumor floating around that Mark Zuckerberg was going to shutter the company by March 15, because it was just too stressful for him to run.  With that kind of competition, I don’t think there’s much for me to add.  In the interest of being complete, however, I did want to include a few links to round out the story.  So, in summary:

Facebook did not have 500 shareholders as of its December 31, 2010 fiscal year end, so no IPO until next spring; the Commission is still investigating the trading of private company shares in the secondary markets (and I’ll probably have something more to say on the subject if, and when, we get details); some of Facebook’s financial information was leaked; and it looks like the Goldman Sachs offering was a success; but not everyone thinks that’s a good thing.

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