Hot startup companies face a dilemna: how to generate liquidity for early stage investors and employees without conducting an IPO, or “initial public offering.”
An IPO requires the preparation of a prospectus in a process that is overseen by investment bankers, lawyers, accountants, the stock exchange and, not least, the SEC. Not until the SEC declares a registration statement (which includes the prospectus) prepared by the company and its legal and financial advisors “effective” can a company actually sell its shares to the investing public.
But when that prospectus is filed, even if in early draft form, it becomes public and is available on the SEC’s EDGAR database. And that means the core business model of the company is available for competitors to review.
Some years ago Google ran into a version of this problem. It had handed out more than $80 million of options to buy stock to employees and consultants. At a certain point the company crossed the threshold of 500 investors set by the SEC and, as well, it ran afoul of a ceiling on securities allowed to be issued to employees and consultants by the SEC without disclosure to them. Google was therefore obligated to file an annual report roughly equivalent to a prospectus or provide recipients of the stock options with details about the company’s business. They did not do so and that led to an SEC investigation and in turn the SEC slapped their wrist, extracting a promise not to do it again.
Of course, by then Google had gotten away with what they had wanted to do: time their IPO without giving up the ability to hand out shares prior to filing their prospectus.
Now the weak public markets have caused some problems for companies like Facebook, Twitter and others. In theory they are now profitable businesses with sustainable cash flows that would allow them to go public. In the mean time they, too, like Google have used equity distributions to hire workers and consultants and to woo early stage investors. Since these recipients of shares are either insiders or sophisticated or fall within a “safe harbor” provided by the SEC under Rule 701 they are felt not to need the protections offered by the disclosures in a prospectus or annual report.
But at a certain point shares may be ending up in the hands of investors who may not have that bargaining power or sophistication, some of whom might be rank and file employees or who might be relatively unsophisticated outsiders. New private trading exchanges now facilitate a wider distribution of private company shares than ever before. This is driving up the alleged value of these firms, which they may be using to their advantage in negotiations with existing investors.
An SEC probe into this development is welcome. If companies like Facebook are gaming the securities laws – in part by stirring up interest in their shares without full disclosure of their business model and financial information – it hurts the overall integrity of the stock markets. And there is precious little of that integrity left these days.
(For the technically interested, Facebook and Twitter and similar firms can potentially run into both a 701 problem and a 12(g) problem. Rule 701 provides a safe harbor from registration as required by Section 5 of the Securities Act of 1933 to an issuer for a certain dollar volume of securities issued to employees and consultants (up to 15% of the firm’s asset value in a year). A company like Facebook most likely has a sufficient ceiling under 701 to avoid disclosure. Of course, no safe harbor exempts issuers from the anti-fraud obligations of the 33 Act.
(If most of the distributions are in the form of options then the companies would not have a 12(g) problem until the options are exercised since option holders are not shareholders. Facebook received no action relief in 2008 for the 12(g) problem because of their concern about the issuance of the restricted stock units they use in compensating employees. The letter is available in the Lexis database. In the letter they stated they did not (yet) have 500 shareholders.)