Killing the 500-shareholder rule

The 500-shareholder rule is heading for the scrapyard.

Senators Pat Toomey (R-Pa.) and Tom Carper (D-Del.) today introduced legislation that would effectively eliminate a rule that many have cited as the reason Facebook may go public next year. It's called the 500-shareholder rule, and basically means that a private company must publicly disclose financial data once it has at least 500 shareholders. In fact, it's so similar to going public that most private companies opt to do just that once they trip the limit. For example, the 500-shareholder rule is regularly cited as one of the main drivers of Google's (GOOG) initial public offering in 2004.

Today's proposal would increase the limit from 500 to 2,000. It also would exempt employees from counting toward the cap. Under current rules, employee stock options are exempted but any actual stock received as compensation is counted.

Accredited investors would continue to count toward the 2,000 limit. An earlier House proposal would have exempted them as well -- a move that would have made even a 50-shareholder rule virtually irrelevant -- but a subsequent House proposal returned accredited investors to the scorecard (the newer bill passed committee last week, and is expected to be voted on by the full House before year-end).

It is unclear how fast the Senate may act on this proposal, particularly in light of Facebook's looming deadline. The social network giant could ask the SEC for an extension if it believes legislation is close to passing, but that's a few steps ahead of where we are right now. Another company said to be near its 500-shareholder limit is Zynga, which already has filed for an IPO and reportedly will price just after Thanksgiving.

Also unclear is why the Senators picked 2,000 as the new magic number. Seems just as arbitrary as 500. If a private company is okay having a ridiculously-complicated cap table, then so be it. Why put any limit at all? Is it somehow more elitist if 2,000 accredited (read: rich) investors can have a piece of Facebook than if only 500 can?

Anyway, brief rant over. Below is draft language of the Senate bill: