The trigger that pushes private companies public
Issue
The Securities and Exchange Commission is contemplating changes to the way it implements Section 12(g) of the Securities Exchange Act of 1934 (Exchange Act). These changes could force more companies into the public markets before they’re ready to make the transition.
Section 12(g) of the Exchange Act establishes thresholds at which an issuer (company) must register its securities with the SEC and become subject to periodic reporting and disclosure requirements.
Section 12(g) requires an issuer to register its equity securities if:
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The issuer has total assets greater than $10 million; and
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The issuer exceeds 2000 “holders of record,” or if there are 500 or more non-accredited investors among the holders of record (Employee compensation-related holders are not included in this count, and collective investment vehicles are counted as one holder, as are securities held in street name.)
Why it matters: Section 12(g) is the trigger that pushes private companies into a public reporting regime. The reporting obligations that come with 12(g) registration are similar to those in public markets: filing quarterly reports, an annual report, and periodic updates on Form 8-K when certain material events occur. As companies approach the 12(g) threshold, the more onerous reporting regime pushes many to go public—often before they’re ready.
Background
Original intent: Section 12(g) was not initially directed at private companies, but rather public companies that traded in the over-the-counter market. As companies stayed private longer and became more widely held, the same “holders of record” standard applied, and they increasingly encroached on the original 500-holder trigger. The most striking examples of this were when Section 12(g) essentially forced Google and Facebook to go public.
Current law: As part of the JOBS Act of 2012, Congress raised the threshold to 2000 (500 non-accredited) holders of record and excluded employee compensation-related holders from the count.
Possible reforms
Skeptics of the private-market growth enabled by the 2012 reforms to 12(g) believe that this growth has come at the expense of public investment opportunities. To constrain private-market growth, some policymakers have proposed reforms:
Congress
Progressive lawmakers in Congress have attempted to amend 12(g) since the passage of the JOBS Act without success. While any legislative changes will not have enough support to move forward in the current divided Congress, even partisan support for narrowing 12(g) could help bolster SEC action.
SEC
The SEC has included possible reforms to Section 12(g) on its rulemaking agenda. The SEC does not have the power to adjust the actual 12(g) threshold because Congress set that number (2,000) in statute. However, SEC commissioners and academics have contemplated alternatives that would have the effect of lowering the 12(g) thresholds, including:
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Changing how holders of record are counted: The SEC could “look through” an investment vehicle (such as a special purpose vehicle or other entity) to count all of its beneficial owners as “holders of record.” As a matter of precedent, only the investment vehicle is counted as a holder of record.
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Adding new triggers: The SEC could create additional triggers that are based on company valuation, capital raised, revenues, number of employees, or other metrics that would force the company to register its securities.
Consequences
Policy changes that would lower the 12(g) registration threshold would have a number of impacts, whether or not they are intended:
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Premature IPOs: Establishing additional triggers that would potentially be hit prior to the existing 12(g) threshold would force private companies to go public earlier in their life cycle, perhaps before they are ready.
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Increased cost: Public markets impose extensive costs on companies, in the form of compliance, disclosures, and reporting. This can disadvantage early-stage and growing companies without the infrastructure of economies of scale to handle such a burden.
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Short-termism: Private companies invest in long-term projects and initiatives that yield results down the line, not necessarily next quarter. This longer time horizon enables innovation. Forcing companies to go public earlier would subject these innovators to shortened timelines and limit their ambitions—as well as any resulting innovations.
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Increased cost of capital: Creating earlier triggers based on valuations or revenues would undermine growth companies’ ability to raise capital.
Private companies raise capital from private funds that invest for longer durations and the potential for larger return profile. If a growth company is raising a second or third round to continue to build, its investors will now know the return is capped—meaning the risk-reward profile is limited to the extent stipulated by valuation or revenue limits. As a result, fewer funds will allocate capital to later-stage companies, making funding less available and more costly.
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Reduced competition: Many growth-stage companies will be acquired by competitors as they approach triggers, rather than go public too early in their life cycle.
Forcing companies to go public based on regulation rather than what is right for the business, its owners, and its employees would undermine their growth and constrain innovation. The cost, burdens, and operational impact of going public in today’s market are significant. Larger competitors may leverage a foreseeable threshold and use it as a way to purchase competition, further consolidating markets.
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Constrained investor access: Looking through investment vehicles penalizes less affluent investors, further concentrating returns and wealth accumulation to larger investors.
Investors who do not have the means to make large investments on their own often invest through investment vehicles, which provide them access to growth-stage returns and diversification. If those vehicles are opened up for purposes of the shareholder count, companies will be incentivized to exclude them to make room for larger investors. This will be especially true for high-performing companies, where more and often larger investors will want to own equity.
Bottom line
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Section 12(g) threshold and application should remain unchanged
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Changing Section 12(g) would force private companies to go public earlier in their lifecycle, impairing their development, making it harder for companies to raise capital, and ultimately undermining competition.
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If the goal is to create more public companies, we should not make private markets less hospitable, and we should focus on creating more companies. Fostering an environment for more entrepreneurs to start and grow companies. Building a private market framework that supports companies throughout their lifecycle will help them grow, mature, and transition to public markets.
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Make public markets more hospitable, not force companies public by making private markets worse.
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