By: Jared Sorin
The recent near collapse of the US financial markets revealed problems in the public stock markets that have made them inhospitable to growth-stage companies, directly negatively impacting new company formation, innovation, job creation and America’s position in global competitiveness. For several decades, startup and emerging growth companies in the US followed a rather predictable path, raising angel capital, then engaging in one or more rounds of venture capital financing and, ultimately, undertaking an initial public offering – often in under five years from inception. Smaller, innovative companies thrived with access to the public markets, creating new products and services that fueled economic growth and job creation. In the last fifteen years, however, the market structure has changed and the public markets have become inhospitable to smaller companies. As a result, companies are electing to remain private longer and the very profile of the IPO candidate has transformed from the innovative, growing company to only the very largest companies. The absence of a robust IPO market for early stage and emerging growth enterprises reduces the amount of capital that flows to such companies, reducing innovation and creating a liquidity problem for such companies’ investors and employees. In turn, the “systemic failure of the US capital markets to support healthy IPOs [for emerging growth companies]inhibits our economy’s ability to create jobs, innovate and grow.” §12(g) of the Securities Exchange Act of 1934, as amended (the “Act”), colloquially known as the “500 Shareholder Rule,” is one source of the problem. It mandates that private companies register their securities with the Securities and Exchange Commission (the “SEC”) and comply with costly, time consuming SEC public reporting requirements if the company has total assets exceeding $10 million and a class of equity security held of record by 500 or more owners. Numerous commentators recognize the negative implications associated with the low shareholder limitation, especially in the absence of a robust IPO market.
Although the SEC enacted the “500 Shareholder Rule” to extend disclosure requirements in an attempt to increase investor confidence, the provision’s effect on access to the capital markets mandates that the rule be revisited. By delaying access to public markets, if not outright inhibiting access altogether, the “500 Shareholder Rule” impedes the transferability of equity securities in private companies and chills capital formation. Moreover, by imposing the high costs and time consuming efforts of SEC disclosure obligations, the rule also disincentivizes hiring and retaining key personnel through equity compensation methodologies for fear of taking on too many shareholders. In response, Congress has proposed the “Private Company Flexibility and Growth Act (H.R. 2167).” The bill would increase §12(g)’s shareholder limit from 500 to 1,000 and, of even greater importance, exempt accredited investors and employees holding stock through compensation plans.
The proposed legislation represents a welcome development in the small business and emerging growth company communities. Relaxing the shareholder limit will motivate growth-stage companies to hire and retain key employees utilizing equity compensation arrangements. It also should foster capital investment by both large and small investors. Additionally, the bill is likely to galvanize the burgeoning secondary markets in stock of private companies, which would provide shareholders of such companies increased access to liquidity prior to an IPO. The Private Company Flexibility and Growth Act would better serve the capital formation process and promote economic expansion and job creation, especially for small and emerging businesses.