More on Facebook’s “Private IPO,” Securities Regs & Unintended Consequences

by on January 5, 2011 · 6 comments

In my essay yesterday, “How Federal Accounting & Securities Regs Screw Up Your Chance to Invest in Facebook,” I noted how America’s counter-productive accounting, disclosure, and governance regulations are increasingly thwarting the ability of average Americans to invest in some of the leading capitalist innovators of the Digital Age. In this case it’s Facebook, but there are plenty of other innovative companies out there sticking with private shareholders so as not to trigger burdensome securities and accounting regs.  In my essay, I also noted how this represented another prime example of well-intentioned regulation having profoundly unintended, anti-consumer, anti-competitive consequences.  America’s convoluted and onerous securities regulations are choking off capital infusions into innovative companies and denying average investors a chance to own a share a piece of the American dream.

So, what does the Securities and Exchange Commission (SEC) plan to do about this fine mess?  Regulate more, of course!  As The Wall Street Journal reports today:

The Securities and Exchange Commission has begun examining whether disclosure rules for privately held firms need to be rewritten as a result of recent deals allowing investors to buy shares in Internet companies such as Facebook Inc. and Twitter Inc., according to people familiar with the situation.  The review is at an early stage, these people cautioned, and SEC officials looking at the recent deals haven’t concluded that any of them run afoul of the 47-year-old rules governing private companies. The rules require firms with 500 or more shareholders of record in a given type of stock to publicly disclose certain financial information. The requirement is designed to protect investors from risking money on companies that say little about their operations and performance.

Yes, but that requirement can also trigger an onslaught of new regulatory burdens, as the Journal story continues on to note:

While SEC officials could decide the rules need to be updated in order to provide adequate protection for investors, the agency is trying to balance that with the demands of private companies that want to raise capital. As part of the investigation, SEC officials plan to scrutinize special-purpose vehicles like the one being created by Goldman and Facebook to determine if they are being designed primarily to circumvent the so-called 500-shareholder rule, according to people familiar with the matter.

Well of course Facebook is sticking under the 500-shareholder threshold to avoid triggering an avalanche of new regulation!  Wouldn’t you?  This isn’t shady business as some naively suggest, this is smart business.  Facebook wants to be able to continue to invest, innovate, and grow.  Going public in the current regulatory environment, however, might undermine those goals because of the new regulatory burdens that would accompany expanding the pool of shareholders.

America needs to get smart about its overly burdensome securities laws before more damage is done.  As Marc Morgenstern, a securities lawyer in San Francisco and the managing partner of Blue Mesa Partners, a venture capital firm told DealBook: “Companies forming today, like Facebook, are growing so quickly, and their stocks are being distributed so broadly, that they may not fit neatly within securities laws enacted decades ago.”  That’s exactly right. Even the 500-shareholder threshold is a relic of the 1960s.  But the newer regulatory burdens are the real killers. As Anupreeta Das and Amir Efrati explained in yesterday’s Wall Street Journal:

The [Facebook private offering] is the latest example of how Silicon Valley’s newest generation of Web companies is taking capital to stay private for longer. While as recently as a decade ago it was a status symbol in Silicon Valley to go public quickly, Facebook, Twitter Inc., Groupon Inc. and others are among the new crop of firms that have recently raised big money in private financing rounds that provides them a cash cushion to continue remaining private.

Across Silicon Valley, “the incentive for going public has lowered and the penalty for going public has increased,” said Ben Horowitz, a partner at venture-capital firm Andreessen Horowitz, which in November bought Facebook shares from venture-firm Accel Partners in a private transaction. “Compared to the 1990s when everybody went public as soon as possible at much lower revenues,” the regulatory environment and the rise of hedge funds has made it “dangerous” for start-ups go to public without a large cushion of cash, said Mr. Horowitz. “In general, we recommend that our companies be very careful about going public.”

Why should tech companies tread cautiously in this regard?  Why must they, as Mr. Horowitz suggests, “be careful about going public?”  Well, for starters, read this excerpt from a 2006 submission to the SEC by the Silicon Valley Leadership Group regarding the burdens imposed just by the Sarbanes-Oxley Act of 2002 (SOX):

SOX compliance brings with it a heavy burden that strains resources that could otherwise be used for critical research and development or other corporate initiatives to improve company management, expand into new markets and increase investor value.  Initially, the SEC suggested that the average company would have to spend $91,000 dollars annually.   However, in a recent survey of National Association of Manufacturers members about 50% of respondents reported spending more than $5 million in 2004 to comply.   More recently, a Financial Executives International (FEI) survey of 274 public companies indicated a 16.3 % reduction in SOX related costs in 2005 from the year previously, but that the total average cost for compliance was $3.8 million.

And there’s plenty more red tape to contend with when companies go public.  Again, this hurts not merely the companies but also those average investors who’d like a chance to buy in to hold a small share of the American Dream. As Albert Wenger of Union Square Ventures correctly notes in his essay, “The Private IPO“:

These deals should really be a wake-up call to politicians and regulators.  They are a great example of how well-intentioned regulations can backfire.  The net result of the Wall Street research settlement, SARBOX and other protections for small investors has been: small investors now have no access to the most interesting investment opportunities.  Instead, these companies are going to be more or less fully developed by the time they eventually come to the public markets, with most of the upside having been captured by private investors.  That’s especially annoying when it seems that with the Internet we should be seeing IPO 2.0 — direct to small investors without the historic flip opportunity for well connected investors.

How incredibly sad. And how incredibly frightening for the future of American competitiveness.

Let’s be clear, cleaning up this mess doesn’t mean the SEC would be devoid of any role in policing capital markets for fraud.  A certain amount of transparency is essential for good corporate governance.  But the path we are now is instead wrapping companies and capital markets in layers of red tape that suffocate investment and innovation.  Moreover, as today’s news from the SEC proves, regulatory intervention in these cases simply begets more and more intervention to correct the inevitable failures of, or dissatisfaction with, previous interventions.

In that regard, I’m reminded of what Austrian economist Ludwig von Mises had to say about government intervention in his 1949 classic, Human Action:

All varieties of interference with the market phenomena not only fail to achieve the ends aimed at by their authors and supporters, but bring about a state of affairs which — from the point of view of their authors’ and advocates’ valuations — is less desirable than the previous state affairs which they were designed to alter. If one wants to correct their manifest unsuitableness and preposterousness by supplementing the first acts of intervention with more and more of such acts, one must go farther and farther until the market economy has been entirely destroyed and socialism has been substituted for it.”  at 858 (3rd ed. 1963) (1949).

No, I do not believe we are headed into a socialist hell-hole any time soon.  Nonetheless, the SEC appears poised to dig us into an even deeper ditch before thinking about an escape plan to get us out of this mess.

  • Chris Ioakimedes

    Reading the article More on Facebook’s “Private IPO,” Securities Regs & Unintended Consequences by Adam Thierer on January 5, 2011 and reflecting on other recent financial news, reinforces my opinion that investors should intimately know what they are investing in. Many of the recent problems in the economy have been a result of investors not knowing enough about, and failing to keep up to date with what they invest in; as well as the people who sell these investments taking advantage of ignorant investors. The article that I cited above explains how the government is trying to protect investors, and the results of these actions. Almost as if the government and industry wants or needs ignorant investors. The article equates the American Dream with the ability to invest and profit from business. I have always thought that the American Dream was the ability to be in an environment in which an individual can create products or services that the same individual can profit from, not ignorantly investing in, and depending upon the products and or services created by another individual. What I think we need more of is people who create and produce, not people who live off of others creations. I believe that investment is necessary and good, and not every can be a creator or producer, but that we should educate all of our citizens so that they have a better understanding of economy and business, so that if they want to invest they can be wise investors, not ignorant ones. Macro and Micro Economics should be required classes in high school, so that all citizens have a better working knowledge of the economy.

  • Clarence

    I thought Adam’s zany free market libertarian like opinion from his essay illustrated the Governments efforts to protect us from ourselves with regulation begets regulations loophole after loophole pretty well. I personally see the current U.S. Banks, Treasury and Federal Reserve as the most ignorant investors of all time. Though I guess individuals are to blame. Despite that, I try to deliver to my best ability a ROI and from my perspective it’s a coop.
    And, I don’t think you would disagree with Jefferson when he said “I think myself that we have more machinery of government than is necessary, too many parasites living on the labor of the industrious”.

  • Gary

    Adam let’s talk about the end of your bio, fast cars, fine cigars, and good beer. Because I’m getting sick of all the issues that you here about with raising capital. In order for a company to grow it will need a capital infusion at some point and time. Why can’t there be some way of staging the laws with the capital?

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  • Adam Thierer

    Update: Wall Street Journal columnist Gordon Crovitz wrote more about this issue in his 1/10/11 column, “How Washington Defriended Investors,” and concluded:

    “The goal of securities regulation should simply be to ensure that accurate information gets to the market as quickly as possible. By this measure, the regulations of the past decade have undermined public stock markets and their vibrant flow of information about companies. Now that Washington has defriended investors, the would-be investing public should defriend the politicians who took away their markets.”

  • Adam Thierer

    UPDATE 1/20 … Make sure to read Jonathan Macey’s WSJ op-ed on “The SEC’s Facebook Fiasco.”

    “The SEC’s fundamental approach to regulation involves depriving investors of opportunities in order to protect them,” he notes.

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