Venture capitalists could be stifled by SEC share sale review

April 8, 2011

By Richard Beales
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Facebook could wind up changing the way people invest as much as the way they interact. A fundraising round led by Goldman Sachs for the social networking giant earlier this year has put the rules surrounding the way private companies raise capital into sharp focus. One of them requires any firm with 500 or more shareholders to disclose information as though it’s publicly traded. The Securities and Exchange Commission is now reviewing the issue. It could be bad news for venture capital firms and investment banks.

Today’s varied regulations are intertwined. Forcing companies with more than 499 holders to reveal lots of information came about in 1964 to extend to over-the-counter investors the kind of information already available about companies traded on exchanges. Yet many private placements, including Goldman’s effort for Facebook, are only aimed at investors deemed sophisticated, and thereby in less need  — if any — of such protection.

For the same reason, there’s little danger of investors being misled if news of a private placement becomes public, as the Facebook deal did, leading Goldman to limit it to non-U.S. investors for fear of being on the wrong side of current U.S. laws about marketing private deals.

The publicity issue aside, the incentive to keep the shareholder count below 500 to avoid a hefty reporting burden creates its own distortions. Private firms may give employees options, ownership of which the SEC has decided doesn’t count, rather than shares. And until they are ready to go public and suddenly add thousands of new shareholders, bosses may court cash from funds, which usually count as only one investor, rather than directly from individual sources.

Fund managers benefit by collecting fees from investors. But many investors in funds might well prefer direct ownership. The SEC has floated options that include increasing the current shareholder limit, excluding sophisticated investors from the count and looking through some types of fund vehicles to count all their investors separately.

Those options might have different implications for companies seeking capital, but they would all tend to encourage more direct investments and fewer through funds. The collective record of VCs hasn’t been stellar of late anyway. They, along with other fund managers, could lose influence and income if the SEC proceeds with its rethink.

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