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.
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.
*Update September 13, 2011: Twitter was issued a similar no-action letter with respect to its restricted stock units today.
[…] of control over the composition of their shareholder base–at least for the time being, if the market for private shares continues to grow, that may not always be the […]