Private Companies

SharesPost: The Evolution of a Broker-Dealer

by Vanessa Schoenthaler on March 15, 2012

Yesterday the Securities and Exchange Commission announced that it settled a proposed administrative and cease-and-desist proceeding against SharesPost, Inc., an online private capital marketplace, and its founder and president, Gregg Brogger, for acting as an unregistered broker-dealer.

First, What is a Broker-Dealer?

Under the Securities Exchange Act a “broker” is broadly defined as “any person engaged in the business of effecting transactions in securities for the account of others,” and a dealer as “any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise.”

Before a broker-dealer can “effect any transactions in, or … induce or attempt to induce the purchase or sale of, any security …” it must register with the Commission and become a member of FINRA and the SIPC. Additionally, broker-dealers must comply with the registration requirements of the laws of each state in which they intend to operate.

Once a broker-dealer is registered it becomes subject to a number of specific conduct, financial responsibility and reporting requirements, as well as to periodic compliance examinations by the Commission, FINRA and the state securities commissions.

What Does it Mean to be “Engaged in the Business” of Effecting Securities Transactions?

Neither the Exchange Act nor the rules promulgated thereunder define what it means to be “engaged in the business of effecting transactions in securities,” and the courts and the Commission, by means of administrative and enforcement proceedings and through interpretive decisions in the form of no-action letters, have come to construe the phrase broadly to include activities such as:

  • soliciting, structuring or negotiating securities transactions;
  • providing valuation advice;
  • disseminating quotation information;
  • receiving transaction-related compensation;
  • preparing, conveying or collecting transaction-related documentation; or
  • otherwise acting as an intermediary in a securities transaction.

So, What Happened in the SharesPost Case?

SharesPost started out in June 2009 as an online bulletin board for buyers and sellers of private company securities. They charged a flat membership fee for access to their platform and left members to arrange and execute their own transactions. But private sales of securities can be complicated and many members ended up needing “substantial assistance from SharesPost and/or a representative of a registered broker-dealer” in order to complete their transactions. At this point SharesPost probably should have either registered as or merged with a broker-dealer.

Instead, in 2010, SharesPost entered into a series of agreements with registered representatives from various other broker-dealers. The representatives were designated as “Company Specialists” and were each assigned to cover certain categories of companies (e.g., social media, green tech., etc.). Their role was to facilitate transactions between buyers and sellers. As compensation for these services their supervising broker-dealer was paid a transaction based fee. The broker-dealer in turn paid a portion of that fee over to the representative, pursuant to a separate agreement between the broker-dealer and the representative.

To make things a bit more complicated, each representative also entered into an arrangement with SharesPost whereby they agreed to pay 35% of their gross commissions to another broker-dealer to be designated by SharesPost in the future. The only problem is that SharesPost never designated a broker-dealer. It did, however, keep track of the commissions owed and when one of its representatives left SharesPost itself received the accrued commissions (even though it still wasn’t a registered broker-dealer).

By late 2010 SharesPost decided “that maintaining arrangements with multiple registered representatives affiliated with multiple broker-dealers was cumbersome” and so (rather than registering as or merging with a broker-dealer at that point) SharesPost entered into a “Broker-Dealer Independent Affiliate Agreement” with “Broker-Dealer A.”

Pursuant to this latest agreement SharesPost employees who were also registered representatives of a broker-dealer, including its then CEO and other senior executives, facilitated transactions between buyers and sellers on a commissioned basis. Any commissions earned were paid into a compensation pool at Broker-Dealer A. The CEO of SharesPost would then provide Broker-Dealer A with written instructions as to what percentage of funds in the commission pool were to be distributed to each representative and to Broker-Dealer A.

Beyond the creative compensation arrangements SharesPost also engaged in other activities that made it more like a broker-dealer and less like the passive bulletin board that it started out as. Among other things, it made available through its website and suggested that members use its own copyrighted form transaction documents. SharesPost personnel, some of whom were not registered representatives, served as intermediaries between buyers, sellers, companies and transfer agents. It made available free research reports detailing information about the companies whose securities were posted on its bulletin boards and it created a “Venture Index” that aggregated and weighed certain known or estimated data for its most active companies.

Also in late 2010 SharesPost created a series of funds each designed to purchase the securities of one of the companies posted on its bulletin boards. These funds were used to create an auction process. To quote at length from the Commission’s Order:

[P]otential sellers of a company’s stock would set a reserve price for the block of shares they wished to sell. In turn, SharesPost members who posted indications of interest to buy interests in the [fund] were contacted by SharesPost personnel, who were registered representatives of Broker-Dealer A to see if they wanted to participate in the auction. The buyers were bidding on interests in the fund and the fund would in turn purchase the stock. The auction process began to feature prominently on the SharesPost website – thus, at that point, SharesPost was using the website to sell securities (interests in the fund) in which it had a financial interest. The SharesPost subsidiary management company [that oversaw the funds] charged a one-time service fee, which was five percent of the investment and a three percent fee on any distributions to the fund.

Finally, in December 2011, SharesPost acquired a broker-dealer which it also registered with the Commission as an alternative trading system, a development first announced in a press release yesterday.

Overall I think this is a good outcome, SharesPost should have registered or acquired a broker-dealer from the beginning (or at least earlier on) and it’s good to see the Commission reaffirm it’s commitment to both innovation in the market and investor protection. Or as Robert Khuzami noted in the Commission’s press release: “[w]hile we applaud innovation in the capital markets, new platforms and products must obey the rules and ensure the basic fairness and disclosure that are the hallmarks of sound financial regulation.”

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The Commission’s New Advisory Committee on Small and Emerging Companies

by Vanessa Schoenthaler on September 13, 2011

Today the Securities and Exchange Commission announced the formation of a new Advisory Committee on Small and Emerging Companies.

The Committee, made up of nineteen voting members and two observer members, will provide advice and recommendations to the Commission on issues related to emerging privately held small businesses and publicly traded companies with market caps of less than $250 million.

Some of the issues the Committee will address include:

  • capital raising through private and limited offerings and initial and other public offerings;
  • trading in securities of emerging privately held small businesses and small publicly traded companies; and
  • public reporting and corporate governance requirements.

The Committee will formally be established with the filing of its charter, fifteen days after publication of the Commission’s notice in the Federal Registrar, and will operate for a period of two years unless earlier terminated or renewed.

A final copy of the charter will be available on the Commission’s website, but below is the undated copy on file in the Federal Advisory Committees Database.

The Committee currently anticipates meeting at least three times each year.

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Want to Stay Private Longer? Plan Ahead.

by Vanessa Schoenthaler on August 25, 2011

The median number of years that it takes to for a venture-backed company to go from startup to IPO has been increasing over the last two decades. According to data assembled by University of Florida Professor Jay Ritter, as of 2010 that number was at 10 years, down from a high of 15 years in 2009.

Median Age of IPOs with VC and Buyout Backing, 1980-2010

See Table 4: Median Age and Fraction of IPOs with VC and Buyout Backing, 1980-2010

One aftereffect of this lengthening of time to exit has been an increase in demand for secondary market transactions in private company shares, both as a means for early investors and employees to achieve liquidity and for late-stage investors to get into promising companies pre-IPO. While definitely a boon for the business model of private marketplaces like Share Post and SecondMarket, this outgrowth has left some companies that have shares quoted in these markets with mixed feelings.

Why? Well among other things, with these burgeoning markets come a whole new set of responsibilities and an added level of complexity for a company otherwise focused on growth, and, if not monitored or properly managed, a company’s shareholder base could get the better of its own IPO timeline.

The 500 Shareholder Rule

Which brings us to the requisite discussion of Section 12(g) of the Securities Exchange Act of 1934, popularly referred to as the “500 shareholder rule”.

Section 12(g), enacted in 1964–right around the same time the venture capital industry was getting underway–requires that a company with an excess of $10 million in assets and a class of equity securities held of record by 500 or more persons register that class of equity securities under the Exchange Act within 120 days of the end of the first fiscal year in which both the asset and shareholder tests are met.

Once a company’s securities are registered it has to comply with the Exchange Act’s reporting requirements, including filing quarterly and annual reports containing interim and audited financial statements. That’s why when a company reaches the 500 shareholder threshold it will often file for an IPO (an offer and sale of securities to the public under the Securities Act of 1933); if a company’s going to have to make the disclosures anyway it may as well raise some money in the process.

Time for an Upgrade?

While 500 shareholders may seem like a lot, especially to a company that’s just starting out, if you add a number of years, a few rounds of financing, a hundred or more employees and maybe even an acquisition or two, all of a sudden 500 shareholders isn’t really that many.

So is it time for an upgrade, after all in a lot of ways 1964 was a long time ago? Perhaps. Some members of the Senate and House certainly think so, and in May, in testifying before the House Committee on Oversight and Government Reform, Chairman Schapiro acknowledged that the Commission is reviewing the rule, both in terms of the number of shareholders that a company should have before triggering Section 12(g)’s registration requirements and in how those shareholders should be counted.

In the Meantime, Plan Ahead

In the meantime, given the 500 shareholder limitation, what can a private company do to manage its shareholder base in the face of an expanding secondary market for private company shares?

Go Dutch or Shift a Portion of Share Transfer Fees

One tactic is to pass some or all of the legal and administrative fees associated with effectuating a private share transfer onto the transferor.

This is not to suggest imposing exorbitant transfer fees in an attempt to stifle a developing market, but all parties should be well aware of the costs–in terms of time, money and disclosure risk–that are associated with private share transfers. By passing some or all of the monetary costs onto transferors a company can deter frequent or casual trading.

Adopt An Insider Trading Policy

The federal securities laws prohibit insiders from buying or selling securities on the basis of material nonpublic information in breach of a fiduciary duty or relationship of trust or confidence. While this prohibition against illegal insider trading applies equally to public and private companies, historically it hasn’t been much of an issue for private companies, because there hasn’t been much in the way of a market for their securities.

By adopting an insider trading policy that prohibits insiders, such as officers, directors or employees, from trading in company securities outside of certain designated trading windows, a company can effectively mitigate the risks of illegal insider trading and to a certain extent control the degree to which insiders contribute to an expanding shareholder base.

Switch to Restricted Stock Units

As a company advances it may be advisable to switch from issuing stock options to issuing restricted stock units. Once a stock option has vested the holder can generally exercise that option and receive the underlying shares. In contrast, a restricted stock unit is essentially a promise to deliver shares, subject to the satisfaction of any vesting requirements, at some point in the future, such as when a company is acquired or IPOs.

In 2008 the Commission issued Facebook a no-action letter relieving it from the registration requirements of Section 12(g) with respect to issuance of its restricted stock units. The Commission’s decision was based, in part, on Facebook’s representation that its restricted stock units were specifically designed to preclude any transfer or trading from taking place. In June of this year the Commission issued a similar no-action letter to Zynga with respect to its restricted stock units.*

IR and Arranged Marriages

Investor relations isn’t just for public companies. Communicate with your shareholders, part of the beauty of being private is that, comparatively, there aren’t that many of them, plus you actually know who they are. Understand where their interests lie and be prepared for those interests to change over time.

Because it takes longer to exit there are more shareholders with wealth tied up in private companies than in periods past. Early employees with vested options, former employees that have exercised their options and now hold shares, and even early investors with funds approaching the end of life, may all be looking for their own exit opportunities. Rather than each of these parties going out on their own and potentially expanding a company’ s shareholder base, it may be possible to arrange for one or a small group of third-party buyers, or for the company to raise funds and buy the shares itself.

Maybe the Commission will end up raising the 500 shareholder threshold, maybe Congress will pass a bill requiring it to, or maybe not. Either way, with a little bit of planning there’s no reason why a company can’t control its own IPO timeline and still keep its shareholders engaged.

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*Update September 13, 2011: Twitter was issued a similar no-action letter with respect to its restricted stock units today.

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The SEC Releases its 29th Annual Forum on Small Business Capital Formation Report

by Vanessa Schoenthaler on June 14, 2011

Earlier today the Securities and Exchange Commission released its Final Report from the 29th Annual Forum on Small Business Capital Formation held in November 2010.

This year’s forum yielded 36 recommendations from three working groups and a number of written recommendations submitted by organizations concerned with small business capital formation.

Participation was down slightly, with a total of 60 participants in the three working groups, as compared to 72 last year, and with 37% voting to rank each of the final recommendations, as compared to 44% last year.

There are a few proposals that show up each year, but many of this year’s recommendations focus on Regulation A, the requirements of Exchange Act Section 12(g) and scaled reporting/eligibility requirements for smaller issuers.  The top 5 recommendations include proposals that the Commission:

  • specifically consider the impact of Dodd-Frank Act rulemaking on small business investing;
  • adopt a private offering exemption that does not prohibit the general solicitation of, or advertising to, purchasers that do not need the protections afforded by Securities Act registration;
  • provide better scaling of reporting requirements for smaller companies;
  • exempt companies with a market capitalizations of less $250 million from Section 404(b) of the Sarbanes-Oxley Act (we already know that this one was rejected in April); and
  • increase the permissible offering amount under Regulation A and the number of shareholders that trigger registration under Section 12(g) of the Exchange Act (As an aside: both Fortune and PeHUB are reporting today that there’s a bill in the works that may actually take care of the latter portion of this proposal, by increasing Section 12(g)’s shareholder trigger requirement from its current level of 500 holders of record to 1,000 holders of record exclusive of accredited investors and employees holding stock options.).

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How Important is a CEO’s Education to Company Performance?

by Vanessa Schoenthaler on September 25, 2010

Not very, according to a recent academic study that looks at whether a CEO’s educational background has a significant affect on a company’s long-term performance (as measured by indicators like return on assets and stock returns) and finds “… virtually no evidence of a systematic relationship between CEO education and long-term firm performance”.

The study also takes a look at the relationship between educational background and a company’s decision to replace its CEO–finding that companies replace poorly performing CEOs regardless of education–and at the role education plays in choosing a successor.  In sum, the authors conclude:

CEO education is not significantly related to firm performance … results suggest that education is a poor proxy for CEO ability. Nevertheless education does play an important role in CEO hiring decisions; boards still use educational qualifications as criteria in evaluating potential CEOs.

If there’s no correlation between a CEO’s education and a company’s performance, then why rely on educational background in the CEO selection process at all?  The study’s authors suggest that perhaps the difficulty of evaluating qualities like leadership ability and interpersonal skills lead a board to rely on more discernible measures, like the ranking of a school attended or the level of education attained.  This seems entirely functional; candidates have to be sorted by some means and educational background often serves that role.  Still, those involved in the selection process need to be mindful of the weight assigned to a potential CEO’s educational background and of how early in the process they apply the educational filter to narrow their pool of potential candidates.

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How Information Flows Though the Twitterverse

by Vanessa Schoenthaler on September 13, 2010

Somewhat related to my prior post, and definitely cool, check out this post over at the Hubspot Blog which offers visual representations of the different ways information spreads through the twitterverse:

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Public Company CFOs Earn More than Their Private Company Counterparts

by Vanessa Schoenthaler on August 23, 2010

CFO Magazine reports that:

According to the Financial Executives Research Foundation’s 2010 financial executive compensation survey, public-company finance chiefs make an average base salary of $285,000, compared with $204,800 for their private-company counterparts. But when goodies like stock options and retirement benefits are thrown in, the average total compensation of public-company CFOs soars to $680,407, far outpacing the average total compensation of $367,311 for private-company finance chiefs.

It’ll be interesting to see what, if any, effect the Dodd-Frank Act has on these numbers going forward …

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