How the JOBS Act May Keep Companies Private

The JOBS Act has been billed as an “IPO on-ramp” by the Obama Administration. But a key piece of the law, which substantially increases the number of pre-IPO shareholders a company can have, could have the opposite effect of encouraging startups to stay private longer.

In the months leading up to Facebook's now-infamous initial public offering on May 18, pundits suggested that the IPO was afoot because the company—by offering equity to attract workers—was bumping up against the 500-shareholder limit allowed under previous law. Until the JOBS Act was passed earlier this year, private companies passing that 500-shareholder threshold while trading on secondary markets were forced to register with the Securities and Exchange Commission and disclose financial information. In essence, federal securities law shoved startups in the direction of going public whether they wanted to or not.

That limit was also why, in 1986, cash-rich Microsoft decided to go public. More recently, employees of Twitter balked (and several resigned) over a company policy that sought to keep the threshold at bay by prohibiting employees from selling more than 20 percent of their awarded stock.

Seeking a work-around, booming social media companies like Twitter, Facebook, and Zynga won regulatory approval for issuing “restricted stock units,” shares that wouldn't count against the shareholder limit because they could only be redeemed following a future event, presumably when the company went public. At the same time, the tech lobby in Washington engaged in a full-court press to end the 500-shareholder limit.

They got their wish when the JOBS Act boosted the threshold to 2,000 shareholders, so long as the company has assets of less than $10 million.

The practical upshot, however, is that by raising the shareholder threshold, startups can now wait even longer before needing to go public.

Brian Hamilton, CEO and co-founder of Sageworks, a firm that collects financial data about private companies, says the market may see a “bumper crop of IPOs in the short term” since the JOBS Act also allows companies to file only two years of audited financial statements instead of three, and to submit confidential registration statements with the SEC before publishing them to the world.

“Several aspects of the JOBS Act will help companies that want to stay private do so, even if they previously were on the cusp of being forced to go public,” Hamilton says, adding that the legislation “as a whole, will probably continue the momentum away from companies going public.”

For example, the law allows small and medium-sized companies to gain access to new sources of capital (up to $1 million in a 12-month period through “crowdfunding”) without going to the public markets.

Hamilton says this would continue a trend that began in the late 1990s. The number of publicly listed companies on U.S. exchanges has fallen from 8,823 in 1997, at the height of the dot-com boom, to fewer than 5,000 at the end of 2011, according to the World Federation of Exchanges.

He explains that the burst of the tech bubble and subsequent recessions are part of the reason for that decline. Others also “blame Sarbanes-Oxley and other government regulations for becoming onerous,” resulting in public companies going private or being delisted, and dissuading smaller private firms from public offerings.

“Raising the shareholder limit does discourage IPOs in the short run, but it facilitates owners keeping their company private, and growing, and thus if they later wish to go public realizing larger rewards,” says Robert Litan, vice president for research and policy at the Kauffman Foundation in Kansas City, a non-profit foundation that awards grants to advance entrepreneurship and education. He also cites the JOBS Act's reform of Regulation A, which raises the threshold on private offerings from $5 million to $50 million.

“While all this JOBS Act stuff is great, and we really do think it is, another equally practical thing would be for underwriters to price these deals in a way that gives a high probability to strong aftermarket support and performance.”

—Timothy Keating,

Founder and CEO,

Keating Capital

Timothy Keating, founder and CEO of Keating Capital, a publicly traded business development company that specializes in pre-IPO investments, doesn't believe the threshold changes offered by the JOBS Act will have widespread effect.

“I think the rule was well intentioned, but practically of no value,” he says. “It applies to so few companies that I don't think it really matters … You can probably count on one hand the number of companies that this is a real issue for. It might, literally, affect one company a year.”

Keating, who praises the JOBS Act overall, says Facebook could have maneuvered around the threshold if it really wanted. He notes the private placement Facebook did last year with Goldman Sachs, where a special-purpose vehicle to put $1.5 billion into Facebook counted as only one stockholder. “I'm not sure how many investors were in Goldman's SPV, but let me put it this way: [the threshold] didn't seem to have any practical impediment on Facebook being able to do what they wanted to do.”

Why Expose Yourself?

For some companies, remaining a private entity could prove very beneficial.

“Being public is very expensive and requires non-value-added compliance infrastructure,” says Jason Malak, managing director of CBIZ Valuation Group, a valuation firm. “For the small companies we're talking about here, the return on investment is really not going to translate into excess cash flows. Generally, what that means for a smaller company is that you tend to encourage them not to go public, even when there are some CEOs that simply want the panache of being a public company, regardless of whether they need to.”

NO-ACTION LETTERS

Below are copies of the SEC's no-action letters to Fenwick & West and Twitter:

Re: Fenwick & West

Incoming letter dated February 7, 2012

Based on the facts presented, the Division will not object if a Company does not comply with the registration requirements of Section 12(g) of the Securities Exchange Act of 1934 with respect to restricted stock units granted and to be granted pursuant to a written compensatory equity incentive plan in the manner and subject to the terms and conditions set forth in your letter. This position will remain in effect until the Company otherwise becomes subject to Exchange Act registration or reporting requirements with respect to any other class of its securities.

This position is based on the representations made to the Division in your letter. Any different facts or conditions might require the Division to reach a different conclusion. Further, this response expresses the Division's position on enforcement action only and does not express any legal conclusion on the question presented.

Re: Twitter Inc.

Incoming letter dated August 23, 2011

Based on the facts presented, the Division will not object if Twitter does not comply with the registration requirements of Section 12(g) of the Securities Exchange Act of 1934 with respect to restricted stock units granted and to be granted pursuant to Twitter's 2007 Equity Incentive Plan in the manner and subject to the terms and conditions set forth in your letter. This position will remain in effect until the earlier of (1) the date that Twitter otherwise becomes subject to Exchange Act registration or reporting requirements with respect to any other class of its securities, or (2) the date of a Change of Control (as defined in your letter).

This position is based on the representations made to the Division in your letter. Any different facts or conditions might require the Division to reach a different conclusion. Further, this response expresses the Division's position on enforcement action only and does not express any legal conclusion on the question presented.

Sources: SEC Letter to Fenwick West.; SEC Letter to Twitter.

Though the JOBS Act means fewer hurdles to raising capital and fewer associated expenses as a registered public company, the effect of the threshold change is “probably going to be a blip,” Malak says, although it will allow some to “coast a bit further, raise a bit more capital, and not be burdened with the compliance and regulatory issues of being public.”

The $10 million threshold on assets may not always be clear-cut, Malak adds.

“A nuance is that some industries are asset-light, and others are asset-heavy,” he says. For example, a real estate holding company might hold prime pieces of property worth tens of millions of dollars, while a real estate management company might control an equally large number of assets—but actually own very few, and fall below the threshold.

“[The old threshold] is a hindrance to companies being able to provide equity to employees,” says Aishwarya Iyer, a spokesperson for SecondMarket, a marketplace for alternative investments that specializes in buying and selling shares of private companies. “If you're up against that limit, then you have to do what Facebook and other companies have done and issue restricted stock units. The fact that the SEC allows companies to even issue restricted stock units in the first place is a true indicator that this rule was completely antiquated and needed to be changed.”

Facebook—an investment that Keating says his firm passed up—reveals an “even simpler way to jumpstart the IPO market,” he says: Just do well when you finally go public.

“Think about the potential that Facebook could have had,” he says. “Imagine that if Facebook had been up 50 percent, what the halo effect that would have been on the IPO market. While all this JOBS Act stuff is great, and we really do think it is, another equally practical thing would be for underwriters to price these deals in a way that gives a high probability to strong aftermarket support and performance. Now we have to wait for the next company to price an IPO. And that's tragic.”