'Facebook Rule' Would Delay IPOs, Open Door to Secondary Market Excesses

You may not yet have heard of the "Facebook Rule," but it's cause for concern.

Its formal name is the Private Company Flexibility and Growth Act (HR 2167), and it was introduced to the House of Representatives on Tuesday by Rep. David Schweikert, R-AZ.

Officially, the bill aims to increase from 500 to 1,000 the number of investors a company can have before it is required to publish its financial information. But in reality, it would simply delay companies from going public – thereby encouraging trading in secondary markets that are rife with questionable practices and shutting out the average investor.

It has been dubbed the "Facebook Rule" because the social media giant would be a primary beneficiary. Facebook Inc. has sought to stay private but intense interest from private investors has pushed it to the threshold of the Securities and Exchange Commission's (SEC) 500-shareholder rule.

Schweikert says that's unacceptable, and that his bill would make it so companies like Facebook don't have to go public until they're ready.

But there would also be side effects.

Delaying the IPOs of many companies – particularly tech companies that tend to be popular among private investors – would also drive up valuations in the secondary markets, which exclude all but the wealthiest "accredited" investors (people who have $1 million in assets or make at least $200,000 a year).

And although those secondary markets – which so far have remained unregulated – would clearly benefit from the higher investor threshold, dubious behavior among some participants suggests the extra cushion easily could be abused.

So-called "middlemen" such as Felix Investments already have been using a workaround for the "500 rule" by pooling money into funds and then investing the fund into the target company. The fund then counts as just one investor, even though hundreds or even thousands of investors may own shares in the fund.

In January Goldman Sachs Group Inc. (NYSE: GS) launched a similar $1.5 billion fund for those wishing to invest in Facebook, which pushed its valuation to $50 billion.

And that's not the only questionable way "connected" investors are acquiring stakes in private companies.

Employees of many companies, especially tech start-ups, are given shares in their company, which private investors want to buy in the secondary markets. So the middlemen act as a go-between, finding accredited investors for employees willing to sell their shares.

Indeed, raising the threshold of shareholders to 1,000 for companies to disclose financial information carries the risk of fostering more such unregulated investing.

Even some private investment firms are questioning the wisdom of Schweikert's bill.

"Private companies that are successful and able to attract ‘real funding' never have an issue with the 500 shareholder rule hurting future funding efforts," Giles Somerville, managing partner with private investment firm Clearview Capital Partners wrote in a comment on the Private Equity Hub Web site.

"This rule is completely for the benefit of shareholders and secondary market participants," Somerville continued. "The extra liquidity that will be provided by an expansion of the allowable shareholder base will all go to shareholders, internal and external, not the actual company itself. As an investor in the secondary market I am all for the expansion; I just find it a little bit frightening that once again the governing bodies are so completely clueless."

Others worry about the lack of transparency in the secondary markets, and the possibility of more investors putting money into companies they know very little about. That's why the rule exists in the first place.

"We need more transparency – not less," Lawrence Aragon, an editor of Venture Capital Journal and Private Equity Week, wrote on Private Equity Hub. "This will only encourage more companies to stay private and trade on secondary exchanges, where they can keep their shareholders in the dark."

There's also the concern that the average investor will be left out of early gains of desirable companies, because a hot company's IPO price will be much higher by the time it goes public.

Still, the bill most likely will become law, since it has bipartisan support and few opponents.

Schweikert argues that the SEC rule, imposed in 1934, is out of date and impedes the early development of companies that need capital but aren't ready for an IPO.

"Our goal is simple-to create another path for capitalizing a business instead of business owners going straight to venture capitalists or saying, let's go public even though we're not ready," Schweikert told The Wall Street Journal.

Yet the trade group that represents the venture capital industry, the National Venture Capital Association (NVCA), reacted less than enthusiastically to the proposed change

"The implied need for even a limited number of companies to remain private longer, or indefinitely, is indicative of a much larger problem in the U.S. capital markets," Mark Heesen, president of the NVCA, said in a statement. "It must once again be compelling for our country's most promising companies to enter the public markets and continue on their growth trajectory as public companies."

News and Related Story Links:

• Money Morning:
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• PE Hub:
  What to Do with the 500 Shareholder Rule
• Business Insider:
  EXPOSED: The Sleazy Tactics Brokerage Firms Are Using To Make Silicon Valley Employees Rich
• The New York Times:
  Facebook and the 500-Person Threshold
• Fortune:
  Everyone into the pool: How to invest inTwitter
• Washington Post:
  Secondary markets and the next big fraud
• Financial Times:
  Proposed SEC rule changes could delay tech IPOs