IPO Market Decline Spurring Secondary Private Markets: SEC Considers Relaxing 500-Shareholder Rule

In the past few years, the number of venture-capital backed IPOs has dropped to 50 or fewer, and total IPOs now are about 100 per year, down from about 500 in the 1990s. Many IPOs are not startup companies, but companies that are being spun off from established companies. The average company completing an IPO is also much larger than was the case a decade ago. While the numbers are on an upward trend so far this year, a still-uncertain economy is having a dampening effect. More important, there is a greater reticence among entrepreneurs to go public given the stronger regulatory requirements of the Sarbanes-Oxley Act and the expectations of public shareholders for quarter-to-quarter results.

The rise of secondary markets has made that reluctance easier to sustain. These markets provide a way for investors and employees to get liquidity for their shares absent an IPO. Companies such as SharesPost and SecondMarket allow investors to buy and sell shares in private transactions. SecondMarket lists 140 companies whose stock it has created markets for on its Web site; SharesPost says it has brokered $500 million in transactions.

The rules for these markets mean that only "accredited investors," primarily meaning people and institutions rich and/or sophisticated enough to take the risks, can buy shares on them. So the enormous wealth these companies may create may be largely captured by a very small number of people.

Many, but not all, of the firms whose shares are traded on these markets limit sales of exercised equity awards for current employees, or restrict them altogether. A few large private companies like Facebook and Zynga charge employees hefty fees when they sell their shares on private markets. Still, the markets make it possible for employees in these companies who do end up with shares when they leave to cash them in rather than wait for an uncertain IPO or eventual sale of the company. Most of the companies on the SecondMarket list are believed to make equity awards broadly available to employees.

Earlier this year, Goldman Sachs withdrew an effort to attract U.S. investors to buy Facebook stock through these markets after media and SEC scrutiny questioned whether the approach they were taking was a way to get around the current rules that any company with 500 or more shareholders and more than $10 in assets is a de facto public company and must register its stock. Goldman then limited the offer to less-regulated foreign investors.

Now the SEC is looking into whether the 500-shareholder rule should be changed to some larger number and whether the rules for who is allowed to invest in such transactions should be changed as well (it is not clear if this would ease or restrict the kinds of investors who would be eligible). The idea behind the existing rules is to protect unsophisticated investors from poor investments. Presumably, the SEC will look into whether and how that should change. For an interesting column questioning the need for the change, go to this link.