Limiting the Number of Shareholders in Private Companies
The US Securities Exchange Act of 1934, section 12(g), generally limits a privately held company to fewer than 500 shareholders. The assumption has been that companies with 500 investors are quasi-public anyway, and for disclosure and other reasons should be forced to go public when the shareholder number approaches this limit.
Since the IPO market has been in the doldrums for most of the past decade, high-profile private companies have chosen (or been forced) to stay private while raising huge sums of money from VCs and other private equity sources. But, this SEC limit has created some problems for these high-tech phenoms, both in raising additional capital and in private sales through secondary markets in which early investors resell shares to a large number of smaller US buyers. This shareholder limitation has made it difficult for companies like Facebook to stay private, even if the shareholders and management team were not inclined to go public.
Most recently, the number of shareholders issue has arisen as Congress considers legalizing crowdfunding which may allow hundreds or even thousands of smaller investors to make equity investments in startups. Raising $1000 each from 1000 investors would surely seem to violate current SEC regulations.
We have heard that SEC chairman Mary Schapiro “recently instructed the staff to review the impact of our regulations on capital formation” (according to CNN Money). It would appear that Congress and the SEC are both considering raising the limit to at least 1,000 shareholders.
However, the SEC limit on the number of shareholders is not the only issue entrepreneurs should consider. If large amounts of capital are required for startup companies to dominate a market, then the preferences of larger investors, such as angels and venture capitalists should be paramount in importance to entrepreneurs. Let’s be frank: neither angels nor VCs choose to invest alongside large numbers of less-than-sophisticated investors. Why? Because shareholder votes are required for numerous corporate actions and marshaling the approval of large numbers of shareholders is difficult, sometimes impossible without shareholder lawsuits. Consider the following two examples (and assuming new SEC limits are not exceeded):
- Company A raises $500,000 from 1200 investors using a crowdsourcing website (average investment: $417). The company proves to be in a really hot space and, to grow rapidly and stay ahead of the competition, must raise $6 million.
- Company B raises $40,000 from five friends and family members and then $460,000 from twelve angels who are members of a single angel group. The angel group has one member of the board of directors. The company proves to be in a really hot space and, to grow rapidly and stay ahead of the competition, must raise $6 million.
If a venture capitalist was evaluating these two opportunities and both were equally exciting, which do you think the VCs would fund? Clearly, the company with fewer shareholders would be the first choice of sophisticated investors. Angels and VCs generally choose not to invest in startup companies alongside larger numbers of investors with little or no experience. This is not a new rule of thumb. This has been the case for decades.
Raising capital from large numbers of investors, through crowdsourcing or elsewhere, may work well for companies that can achieve all their milestones without raising large amounts of additional capital from angels or VCs. However, SEC limits on the number of shareholders in privately-held companies may not the primary issue for entrepreneurs. If entrepreneurs need to raise significant subsequent funding from sophisticated investors, crowdfunding is not the most favorable source for early-stage capital.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.