The recent stock market volatility only reaffirms my previous assertions about the casino-like trading atmosphere in the U.S. public stock markets. As I mentioned in my first post in this series, high-frequency trading essentially ignores small-cap companies, and is one of the factors that has caused private companies to shy away from going public. I also previously discussed the role of SecondMarket and the private company stock market as a solution for startups that are not yet ready to navigate the public markets. Today, in my final post in this series, I will address two congressional bills that should immediately be passed to support U.S. private companies.
The Future: Proposed Changes to Support Growth-Stage Companies
Earlier this week, I had the opportunity to testify before the House Financial Services Committee regarding a number of capital formation bills (create an exemption to the securities laws to permit crowdfunding, allow community banks to have 2,000 shareholders, ease the compliance requirements for Sarbanes-Oxley) that were recently introduced in the House of Representatives. I support these measures to improve access to capital for growth-stage companies and other small businesses.
Furthermore, I feel strongly that two of the bills should immediately be passed by Congress:
1. "The Private Company Growth and Flexibility Act" (H.R. 2167), which modernizes the so-called 500 Shareholder Rule that compels private companies to become public reporting companies once they have exceeded 499 shareholders and have more than $10 million in assets. This important legislation would increase the threshold from 500 to 1,000, while also exempting from the shareholder count (1) current and former employees who received equity under an exempt equity compensation plan and (2) accredited investors.
The pay structure at startups generally involves giving employees below-market salaries along with options which vest over several years. The options are an economic incentive that allows employees to realize the financial upside of contributing to a successful startup. The companies prefer to give equity in lieu of cash compensation because startups generally need to conserve capital in order to grow their business. Option holders, in fact, are exempted from counting under the 500 Shareholder Rule, so awarding options to employees does not adversely impact the shareholder count until the option holders exercise the options. However, in the new reality of companies taking nearly a decade to go public, option holders are often fully vested well before an IPO, and shareholders who exercise their options are counted towards the 500 shareholder cap.
The significance of this development cannot be overstated. The 500 Shareholder Rule has created a disincentive for private companies to hire new employees, or acquire other businesses for stock, as these private companies are fearful of taking on too many shareholders. Application of the rule also discourages companies from providing equity-based compensation to employees, removing one of the great economic incentives attracting the country's best and brightest employees to startups.
The 500 Shareholder Rule also directly impacts a company's financing decisions. When a private company raises capital, its management team understands that there are only 500 total "slots" for shareholders -- both employee owners and investors. That means limiting the pool of potential individual and institutional investors that will have access to the investment opportunity.
The Private Company Flexibility and Growth Act modernizes the rule by proposing to raise the shareholder limit to 1,000 shareholders, while also exempting current employees and accredited investors from the shareholder count. The term "accredited investor" covers a range of sophisticated investors, from individuals whose net worth exceeds $1 million to institutions such as venture capital firms. The SEC has determined that accredited investors do not require the enhanced protections provided to the average retail investor.
2. "The Access to Capital for Job Creators Act" (H.R. 2940), which eliminates the ban against general solicitation and advertising in the context of issuer private placements under Rule 506 of Regulation D, provided that the ultimate purchaser qualifies as an accredited investor.
The prohibition against general solicitation is similarly problematic. Under many of the existing SEC private placement exemptions, only accredited investors are eligible to purchase private company stock. The prohibition against general solicitation and advertising requires that issuers and intermediaries have a pre-existing relationship with the accredited investor in order to make offerings available. In fact, if a non-accredited individual is even aware of an offering of unregistered securities, the entire offering may be at risk due to the prohibition against general solicitation.
Frankly, if only accredited investors are eligible to purchase unregistered securities, shouldn't we strive to maximize the pool of accredited investors that have access to the offering? It should not matter that non-accredited individuals know that unregistered securities are available for sale. No one prohibits car manufacturers from advertising, even though children under the legal driving age are viewing the advertisements, and pharmaceutical companies are free to advertise to people who do not have (and are not eligible for) prescription medication. The general solicitation prohibition unnecessarily limits the pool of potential investors, thereby restricting companies' ability to raise capital to fuel growth, and it is time to eliminate this unnecessary ban.
SEC Chairman Mary Schapiro has said that the SEC is reviewing the regulatory landscape to lessen the burdens on private companies. In this year's State of the Union address, President Obama ordered a review of all government regulations. He added: "When we find rules that put an unnecessary burden on businesses, we will fix them." This month, in his address on job creation, the president was even more pointed in his remarks: "We're also planning to cut away the red tape that prevents too many rapidly-growing start-up companies from raising capital and going public."
I applaud the focus of the Administration and I believe that we begin to cut the red tape by supporting passage of these two bills. The problems facing growth-stage companies in this country must be addressed, and these straightforward bills are initial steps in the right direction.