Probable and Improbable Lobbying Wins: The 1,000-stockholder Rule

Talented entrepreneurs are nothing if not resilient in the face of change:  Market forces, competitive threats, technological shifts, you name it.  In recent years, government regulation has emerged as another such force to be reckoned with in the technology industry.  Startups and founders need to come to terms with the stark reality that the rules of the game may be changed mid-play.Nowhere is this more striking than in matters involving intellectual property and the rights of content owners.  At the height of “cyberspace exceptionalism” in the mid-1990s, Congress passed two key laws – the “notice-and-takedown” safe harbor in the Digital Millennium Copyright Act (DMCA), which became Section 512 of the Copyright Act, and a separate but equally critical safe harbor in Section 230 of the Communications Decency Act holding website operators immune from liability for a broad range of unlawful conduct by their users.  Without these two laws (or their equivalent), the social media revolution of the past decade would have been stillborn.  Mainstays of user-generated content (UGC) such as YouTube, MySpace and Facebook would have been sued into bankruptcy within days if they were held to traditional standards of liability as publishers of their users’ content.  (See this blog post for a full discussion.)

When a website has 100 million registered users and is adding a quarter million more per day, as was the case at MySpace when I left in 2006, the notion that the site can or should be held accountable for the actions of those users is about as nonsensical as suggesting that FedEx should be liable for every drug deal completed using its shipping services.  The sort of fact-checking and editorial judgment exercised by traditional publishers cannot conceivably be applied to a “publication” with 100 million “authors” adding and updating UGC to the tune of billions of page views per day. Yet the content industry (principally represented by RIAA and MPAA) has been relentless in pushing for UGC site operators to be deputized in a copyright police state in the interest of fighting piracy.  As I write this, Congress is teetering on the brink of passing the most disastrously ill-conceived law in the 18-year history of the commercial Internet, SOPA.  I will leave it to law professor Eric Goldman to articulate better than I could why “this law mortally threatens the entire UGC community.”  At the risk of beating a dead horse here, that includes everything from Amazon to Zynga, with sites like Facebook, Google, Twitter and Yelp in between.

I will skip the political diatribe about the influence of special interests and simply cite two key reasons Gust Blog readers should care about this issue:

  • UGC consumer Internet businesses account for arguably the largest creation of wealth by entrepreneurs in the shortest period of time in economic history.  Facebook, which did not exist in 2003, is now valued at nearly $100 billion.  Google, which incorporated in 1998, has a market cap of $200 billion and employs more than 30,000 people.
  • SOPA would disproportionately alter the risk profile for new startups, which are thinly capitalized compared to the giants like Google and Facebook.  In 2011, virtually every new consumer Internet startup incorporates a social/UGC element.  Increasing the associated risk would have a chilling effect on the entrepreneurs who found these companies and the investors who fund them, diverting startup activity (and value creation) away from what might otherwise be some of the most innovative new businesses in the “Web 3.0” era.

On a more positive note, the silver lining in a political system that is susceptible to influence is that occasionally common sense will prevail when legislators might otherwise miss a good opportunity to do the right thing.  This appears to be the case with a bill called the Private Company Flexibility and Growth Act, currently under consideration by the House of Representatives, which would amend the 1934 law containing the so-called “500 shareholder rule” to double the limit to 1,000 shareholders and make other significant changes.

What may appear to be a hypertechnical set of amendments to obscure code sections (Section 12(g)(1)(B) of the Securities Exchange Act of 1934, anyone?) targets the Exchange Act requirement that is reportedly forcing Facebook to go public in early 2012.  The law would have the effect of allowing companies to stay private longer, deferring the significant expense, management distraction and public disclosure of financial and operating data involved in the IPO process.  Principal beneficiaries would be the private secondary markets like Sharespost and SecondMarket, buyers and sellers that use them, and perhaps most importantly, companies like Facebook and Zynga that are generating plenty of cash flow, have no immediate need to raise capital for operations, yet find themselves forced to go public prematurely to comply with the ’34 Act.

As background, there are two principal legal requirements at play when a company goes public.  The Securities Act of 1933 requires that any type of securities offered to the public be registered with the SEC, involving a major undertaking to prepare and file a registration statement on Form S-1 – known to many as an IPO prospectus.  The Securities Exchange Act of 1934 requires any company with more than 500 shareholders, or with a class of securities registered under the ’33 Act, to file periodic reports with the SEC with ongoing financial results (most commonly annual and quarterly reports on Forms 10-K and 10-Q) and disclosure of material events (Form 8-K).  As it stands, a privately held company with more than 500 stockholders or optionholders can be forced to become such a “reporting company” under the ’34 Act, essentially incurring all of the obligations of being a public company with none of the capital-raising benefits.

To avoid this situation, a company like Facebook will choose to go public prematurely.  Technology companies in particular, which often grant stock or options to every employee, can easily pass the 500 mark if rapid growth results in rapid hiring.  Doubling the limit to 1,000 and exempting certain categories, as proposed in the new legislation, could keep these companies’ options open (pun intended), enabling them to choose the timing of an IPO based on legitimate business needs rather than regulatory technicalities.

This article is for general informational purposes only, not a substitute for professional legal advice. It does not result in the creation of an attorney-client relationship. All opinions expressed are those of the author, and do not necessarily represent those of Gust.

Antone Johnson , Founding Principal, Bottom Line Law Group
November 23rd, 2011