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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.

Written by Antone Johnson

user Antone Johnson Founding Principal,
Bottom Line Law Group

Antone is a business lawyer and executive advising technology and media companies, entrepreneurs and investors in corporate, commercial and intellectual property matters. Johnson is Founding Principal of Bottom Line Law Group, a business and IP law firm and was the former VP and head of worldwide legal affairs at eHarmony.

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Comments

36 thoughts on “Probable and Improbable Lobbying Wins: The 1,000-stockholder Rule”

  1. Rhody says:

    The term “lifestyle business” is condescending and, quite frankly, it’s nonsense, and by using it the author has managed to insult a major percentage of the entrepreneurial population. Really, there’s no such thing as a “lifestyle business.” Hardly anyone goes into business with the intent of not eventually growing it and maximizing its value, including the owner of the concierge business he cites. The author takes the example of the designer who works from home and therefore insinuates that all talented professionals who start their own company from home aren’t interested in growth. The vast majority of entrepreneurs that I know who have started working from home only did so to keep fixed costs low – they weren’t interested in “lifestyle.” They were interested in working hard and making their companies as successful as possible. What about the partner from a big law firm who leaves to hangs out a shingle? What about the woman who opens a food cart in downtown, selling specialty salads and sandwiches? Or the home-based entrepreneur who starts a catalog selling imported furniture? Do you think these people are only interested in supporting a “lifestyle”?

    If the author has decided to overlook home-based entrepreneurs for investment than that is his prerogative. He is missing out on some remarkably talented, hard working and driven business owners. But what he shouldn’t do is insult them while declining to invest with them. Unfortunately he’s managed to do just that in this posting.

  2. Rhody,

    We are in no way slamming those entrepreneurs that decide to build what is referred to in the industry as a “lifestyle business.” In fact, MANY successful companies are indeed that – and those hardworking entrepreneurs should be commended.

    However, angels invest in companies to make a return on their own money, and are not doing it to help the entrepreneur build a business that does not have tremendous growth opportunity. So, while a hardworking woman might start a very successful clothing store and make a very nice living for herself, it wont generate a return for an angel that makes it worth their time and money. However, if she were to start a company which has explosive growth because of some amazing new idea that hasn’t been tried before – that’s something that is potentially of interest to angel investors and VCs.

    The question is not whether entrepreneurs should or should not create a lifestyle business – the title was “unfundable” and VCs and Angels will NOT invest in lifestyle businesses. These type of business should seek loans and other means of funding their business.

  3. evbart says:

    The term “lifestyle business” is definitely not a condescending term. Many entrepreneurs have built success businesses that have provided a comfortable lifestyle for them and all of their employees.

    The point Jason is trying to make, is that this is not the type of company an angel typically wants to invest in (or can afford to invest in) because the potential returns are often not high enough to justify the risk.

    If you look at some of the average stats on Angel investing you’ll see that typically 1 in 10 companies is a success, and this one success has to bring in enough return to cover the loss on the other 9 companies. Thats a huge responsibility, many times we’re talking 30x or 40x your original investment!

    To cover the responsibility Angel investors focus all of their efforts trying to find companies that can even come close to attaining that astronomical growth. Lifestyle companies typically don’t fall into this category.

    That’s why you see many Angels investing in scalable technologies (software, bio tech, cleantech, etc). When they have a successful technology on their hands (google, ebay, a new computer chip, etc) the sky is the limit on the returns, and it can happen very quickly.

    On the other hand retail stores, clothings lines, concierge services, or a variety of other businesses that could be a lifestyle business, typically can’t grow this fast this quickly.

    Its not a matter of putting those companies down or thinking bad of them (heck, the angel investor may have made their money doing a lifestyle business), its just a financial reality that the potential for massive returns needs to be there right from the start to justify the risk.

    That being said, given the diversity of angels out there, you might always be able to find one willing to invest in your lifestyle business, but you might just have to spend more time searching for the right match…

  4. OK, I’ll jump in here too (Rhody, it’s not that everyone is jumping ON you, but that you’ve raised some important points that deserve to be addressed.)

    “Lifestyle business” is NOT a pejorative term. Rather, it is a well-known and generally accepted expression (see and .

    It describes the perfectly valid goal of creating a business that is fulfilling economically and spiritually for the entrepreneur and his/her family. I know dozens, if not hundreds of lifestyle entrepreneurs who would not change their jobs if you offered them ten million bucks: the homebuilder who loves being out on the job and creating a hand-crafted, perfect house; the picture framer who works six hours a day at a relaxed pace and knows every one of his customers by name; the personal shopping consultant who delights in finding just the right outfit for the perfect occasion…even the top VC who quit his job at Accel partners to move to Maine and start a mail order business specializing in a cappella music.

    All of these businesses comfortably support the entrepreneur, each of the entrepreneurs receives great personal satisfaction from his or her business, and each is contributing to society…but not a single one of those enterprises is “venture (or angel) fundable”. The point that Jason and the others are making is NOT that there is anything ‘wrong’ or ‘tacky’ or ‘less desirable’ about a lifestyle business, simply that the economics of it mean that it needs to be financed in some way other than risk equity. That can mean bootstrapping (usually the best option), personal savings, friends & family loans, or personal debt.

    The fact is, because early stage, high-growth businesses are so incredibly risky (to expand on Evan’s point, only 1 out of 100 businesses looking for venture/angel funding actually gets it, and five out of ten of those go bankrupt), seed and early stage investors need to maximize the potential return. I recently led a seminary discussing the somewhat complicated math involved (see for a look at the key slide), but what it boils down to is that EVERY deal into which a smart angel invests money needs to have the POTENTIAL to deliver a 20:1 or 30:1 return on the invested capital.

    To run through a bit more of the math (and to make clear just how unbelievably tough that is), take an entrepreneur who comes to New York Angels seeing a $1 million investment and valuing his or her company at $4 million (this is a pretty typical profile for the kinds of businesses we see.) In order for the angel investor who contributes, say, $25,000 to the round to end up with an annual return of about 25% (which is about twice what you would hope to get from a hedge fund, and is commensurate with the risk being taken; remember the odds are 1000:1 that this will be “the one”!) that little startup company needs to be sold within six years for [I hope you’re sitting down] ONE HUNDRED FIFTY MILLION DOLLARS.

    And since there simply is no way from now to the end of the universe that this is going to happen to a sole proprietor home builder, or a local picture framer, or a personal shopper or even a mail-order a cappella music label, THAT is why those perfectly valid, great businesses, run by wonderful, smart, entrepreneurs (all of whom happen to be friends of mine, by the way) are “lifestyle” businesses and not appropriate for angel or VC financing.

    So that is why it is really, really important to figure out at the beginning exactly what one;s personal goals are in starting a business, and what kind of financing (from bootstrapping to venture capital) is appropriate to support that goal.

  5. Rhody says:

    Thanks for all the responses. Taking into account all that you’ve said about risk, investing in early stage cos., etc. all of which I believe, isn’t it worth considering a slight change to the angel/VC investing approach? Why try to swing for the fences every time out, if you know that a huge percentage of those deals will fall flat on their face? What’s wrong with hitting singles and doubles? One of the problems I have encountered with VCs (and I suppose this applies to some angel groups too) is that they generally back technology companies that have sustainable differentiators with regards to their intellectual property. Though I understand the reasoning, it seems like that filter is way too stringent. Call them lifestyle businesses, or call them whatever you’d like, but it seems like the VCs are missing out in investing in some really good companies.

  6. Anonymous says:

    Another way to tick off the average entreprenuer is to ask him when he feels he may need to step aside for a more seasoned executive to take charge. Most entreprenuers have a limit on how far they can go, whether it be to even get it off the ground floor, to 1 million, or to 10 million, etc. All of this is critical to the mindset of being a successful businessperson versus being a sucessful investor. In my case, I know I am capable of growing the company specifically towards its target to be acquired or merged with a larger firm.

  7. Has read with the pleasure, very interesting post, write still, good luck to you!

  8. Anonymous says:

    I was going through this article and I guess I can get an answer to a question that is bothering me for quite a while. I was wondering as to why wouldn’t anyone invest in a’ lifestyle’ business where in he or she can get a continuous stream of income as a cut from the profits(possibly for the lifetime) which potentially could have the same NPV as one obtained by selling a ‘VC friendly’ business after 7 years. What makes a potential one off success better than continuous streams of income from a ‘lifestyle’ business considering that these businesses have a high success rate and more often than not a high growth potential.

  9. Home Remedy says:

    I completely agree to you concerning the lifestyle business, it may not be so easy to convince VCs to get the funds, the most important thing is to believe in yourself have a gameplan and look for a business loan, the loan can be financial institutions or from a trusted individual..
    There is nothing to blame the investors as it is fair on their part to look handsome returns for their investments and specially when there are options for them to opt for…

  10. I went and got my residential real estate license to help bring in income while I get my business going. That has really helped me.

  11. Rick Schultz says:

    I’ve also been surprised at the typical angel approach. If I knew that the standard approach to investing had a 1 in 10 chance of making money, I’d likely look to change my investment strategy. To me, 1 in 10 is not investing, it’s gambling.

    I originally pitched my business to a group of angels; no bites. I then looked for someone to partner with, someone who knew the kind of product I was building, and found a development partner to share the risks. We’re finalizing the product now, and were just approached by a customer who said, “we’ve looked, and nobody does what you do.” Having 10 years in the industry, I knew that was the case – no-one had touched this niche. But trying to convince angels, who are looking for the next Google (and good luck with that!) is next to impossible.

    A while ago I was told the story about a professor who brought a jar to class. He put a bunch of rocks in, and asked, “is it full?”. The class says, “Yes”. He then takes a bucket of pebbles, fills up a bunch of spaces left by the rocks, and says, “is it full?”. Now the class is sure he’s made his point, so they say, again, “Yes”. So the prof pulls out a bag of sand, and empties the entire bag into the apparently-full jar. Smiling, he asks, “How about now?”. No takers in the class, so he takes the jar over to a sink and starts to fill it with water…

    The Googles of the world were the rocks. The jar is pretty much full of the rocks. But there are a whole breed of pebbles coming on stream and, while looking for the rocks, I think a lot of investors will find they missed out on a great set of opportunities with the pebbles.

  12. OrientPoker says:

    Maintaining ones lifestyle while starting an online poker business is certainly not easy. You can try supplement your income by playing online poker yourself, but this require a mastery of the game that very few people reach. Plus such income has a lot of variance. So if you just focus on you core business of developing a gaming website with a lot of quality strategy articles and room reviews, it make take time to build and it may take time to get traffic. As they say in the Orient, if you want to make a long journey, you need to start with the first step. Patience is the key rule.

  13. Good insight on curve of any business to become a magnet of big hitters.One thing we miss as entrepreneurs is foresight of what we would like after business succeeds.Most entrepreneurs just want the business to take off,without retrospect of 5-10 yrs down the line when the business growth phase changes.

    Though i have to admit,If you are starting a lifestyle or non-attractive business to the Angels and like,but it fulfills your needs while enjoying it,that’s the hall mark of business.Indepedence,satisfaction while having fun at it.

    As it is said.Try not to become a man of success but of value.

    Best of luck to all business entrepreneurs.

  14. Armani Jeans says:

    The author takes the example of the designer who works from home and therefore insinuates that all talented professionals who start their own company from home aren’t interested in growth. The vast majority of entrepreneurs that I know who have started working from home only did so to keep fixed costs low – they weren’t interested in “lifestyle.” They were interested in working hard and making their companies as successful as possible.

  15. i had to save up for years before i was able to start my own busines.. stunk.. wish i had investors.

  16. I’ve also been surprised at the typical angel approach. If I knew that the standard approach to investing had a 1 in 10 chance of making money, I’d likely look to change my investment strategy. To me, 1 in 10 is not investing, it’s gambling.

  17. If you look at some of the average stats on Angel investing you’ll see that typically 1 in 10 companies is a success, and this one success has to bring in enough return to cover the loss on the other 9 companies. Thats a huge responsibility, many times we’re talking 30x or 40x your original investment!

  18. Most entreprenuers have a limit on how far they can go, whether it be to even get it off the ground floor, to 1 million, or to 10 million, etc. All of this is critical to the mindset of being a successful businessperson versus being a sucessful investor. In my case, I know I am capable of growing the company specifically towards its target to be acquired or merged with a larger firm.

  19. Guest says:

    I like your article but i want to say something more.
    For the building of company person needs good capital, Risk taking attitude burning desire over all important liking for that business. If you have good liking for your work then you are able to create the miracle in your field. And risk taking attitude is also such important if you want to take up your business at new height.

  20. I originally pitched my business to a group of angels; no bites. I then looked for someone to partner with, someone who knew the kind of product I was building, and found a development partner to share the risks. We’re finalizing the product now, and were just approached by a customer who said, “we’ve looked, and nobody does what you do.” Having 10 years in the industry, I knew that was the case – no-one had touched this niche. But trying to convince angels, who are looking for the next Google (and good luck with that!) is next to impossible.

  21. your blog is good i like your blog. blog is giving the good information about the many things. your blog is good for the business starting

  22. bingo gratis says:

    Your article is good. But for the business devleopment not only the the finance but the quality of person is also nedded in the business development. Which is not shown in this article

  23. Writing Jobs says:

    So how do you start a lifestyle business without investors? If you’re going to start one, make sure you can bootstrap your way to revenue. Use income from another job, raise money from friends and family, or take out a business loan. If you can’t, then you may want to reconsider your business.

  24. i like your post, for becoming the good businessmen you should be connected to the market. you should know what is going in the market. what are new products comming in the market. If you will not able to cop up with the market you will be thrown out from market

  25. I know dozens, if not hundreds of lifestyle entrepreneurs who would not change their jobs if you offered them ten million bucks: the homebuilder who loves being out on the job and creating a hand-crafted, perfect house; the picture framer who works six hours a day at a relaxed pace and knows every one of his customers by name; the personal shopping consultant who delights in finding just the right outfit for the perfect occasion…even the top VC who quit his job at Accel partners to move to Maine and start a mail order business specializing in a cappella music.

  26. Guest says:

    If you look at some of the average stats on Angel investing you’ll see that typically 1 in 10 companies is a success, and this one success has to bring in enough return to cover the loss on the other 9 companies. Thats a huge responsibility, many times we’re talking 30x or 40x your original investment!

  27. The author takes the example of the designer who works from home and therefore insinuates that all talented professionals who start their own company from home aren’t interested in growth. The vast majority of entrepreneurs that I know who have started working from home only did so to keep fixed costs low – they weren’t interested in “lifestyle.” They were interested in working hard and making their companies as successful as possible.

  28. Either way, entrepreneurial spirit helps achieve success in the long run. Coupled with discipline, you can never go wrong.

  29. fish tanks says:

    Starting any kind of business is mostly not easy and especially if the investors will not corporate. The advent of the internet as well as different life issues such as raising children has ed man people to want to have their own lifestyle business and since there is not much scalability in these kinds of businesses many investors are shying away from them. This should not dishearten the entrepreneur as all they have to do is to get support from their well-wishers. Although it might seem unlikely, you can be surprised at how many people are willing are willing to help.

  30. Very good post. I appreciate the work you guys put in to make this world a better place for the disabled. Thanks…

  31. What you think you can do best should be the starting point of your entrepreneurial spirit. You can express yourself more in things that you know you are effective. Study your thoughts and be honest.

  32. The vast majority of entrepreneurs that I know who have started working from home only did so to keep fixed costs low – they weren’t interested in “lifestyle.” They were interested in working hard and making their companies as successful as possible.

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  35. Bangkok Paul says:

    Steve Jobs and Steve Wozniak sold some of their possessions, raised $1,300, and assembled the first prototypes in Jobs’s bedroom and later (when there was no space left) in Jobs’s garage.

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