Dan Primack

The latest on private equity, M&A, deals and movements — from Wall Street to Silicon Valley

New private share rules could put VCs in a corner

April 8, 2011: 9:42 AM ET

The SEC may make it easier for hot private companies like Facebook to remain private. That may be a problem for the types of investors who backed Facebook in the first place.

The Wall Street Journal today reports that "federal securities regulators are moving toward easing decades-old constraints on share issues by private companies." Specifically, it is considering two moves:

  1. Raising the limit on the number of shareholders a private company may have before being required to publicly file financial statements. That threshold currently stands at 499.
  2. Relaxing the general solicitation rules on private placements.

My gut take here is to oppose the former and support the latter.

Once a company has more than 500 outside shareholders, it seems reasonable that they be provided with at least some basic financial information. I understand the counter-argument: "It's a private company, so why do they need to provide any public info?" Well, in that case you'd be talking about scrapping the limit entirely, rather than simply raising it (the ABA, for example, wants it put at 2,000). And, again, there is a public interest in protecting investors once they hit some sort of critical mass.

Remember, a company need not become publicly-traded if it trips the shareholder limit. It simply must report as if it were a public company. That may sound like a distinction without a difference, except that it means a Zuckerberg or Pincus would not be slaves to bank analysts, hedge funds, etc. All of this talk that Facebook and Zynga will be forced to go public in 2012 is simply untrue. It's still a choice.

On the latter, I've never really understood the purpose of general solicitation restrictions. You still need to be an accredited investor to participate in the transactions, so who cares if non-accredited investors are made aware of the "opportunity." After all, I know that a Tesla Roadster base price is $109k – but that doesn't change the fact that I can't afford to buy it (I know, not a perfect analogy).

But there is a larger issue here: These rules changes could put venture capitalists in the position of choosing between their own investors and their entrepreneurs.

Publicly, VCs may have to support the SEC's newfound flexibility. They cannot be seen by entrepreneurs as trying to force unwilling companies into the public markets, or hindering the ability of those companies to raise private capital. Today's VCs are desperate to appear buddy-buddy with the entrepreneurial community, because they believe that generates preferable deal-flow. Remember, John Doerr wore a hoodie to appear Zuckerberg-y.

Privately, however, VCs should be concerned. The relative dearth of VC-backed IPOs was a very hot topic at this past week's National Venture Capital Association annual meeting, with many investors privately grumbling that the lack of a mega-hit (i.e., Facebook) was holding back other, less well-known portfolio companies. "We need a giant marker of validation for our companies," one longtime VC told me. "Kind of like a market comp for our industry, rather than for Facebook or Zynga's industry. We need [the public markets] to trust us again."

Indeed, there were just 14 VC-backed IPOs last quarter, raising around $1.3 billion. Much better than during the 2008 or 2009 wastelands, but still sluggish in light of a bullish public market and a massive backlog of mature VC portfolio companies. That's why Tim Geithner convened a meeting to discuss this very topic last month. Got to wonder if he and Mary Shapiro ever talk…

Conventional wisdom is to blame Sarbanes-Oxley or public investors for the lack of VC-backed IPOs, but the reality is that many of the best entrepreneurs aren't taking their companies public because they have no interest in running a public company. If capital and founder/employee liquidity is available on the private markets, why deal with the public headaches?

Venture capitalists have nurtured this reticence, in part because they quietly believe it only can last for so long. At some point, regulation will compel companies to go public (even if it won't force them there). Google, for example, couldn't really remain private in 2004 because of difficulties raising capital or providing liquidity for option-laden employees. But this confidence has been shaken a bit by the advent of secondary trading exchanges, and would be obliterated by the SEC's potential action.

For VCs, the SEC's action may prompt a revelatory moment. They present themselves as working for their entrepreneurs (we're value-add, will do anything for you, have our interests aligned with yours, etc.). In reality, however, they work for their own investors, or limited partners. Soon, they may have to let their entrepreneurs in on that little secret.

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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