Accidentally "Public" - Private Companies: Watch Out for the 500 Shareholder Rule

There has been a trend for domestic companies to remain private longer instead of rushing to an IPO (good recent example is Facebook). It is not surprising, given the high costs associated with legal and accounting compliance. Also, there is now a way to obtain financing and provide liquidity in the secondary market without being public. For example, this can be done through companies like SecondMarket, which provide a trading platform for resales of stock and other financial instruments issued by private companies.

There is a concern, however, that companies may accidentally become “public” by triggering the 500 shareholder rule. This may happen if, for example, shareholders grant or sell some of their shares to others, thus increasing the total number of shareholders. It may be difficult for a company to control, unless it imposes stringent buy-sell restrictions in its shareholders agreement.

The 500 shareholder rule comes from Section 12(g) of the Securities Exchange Act of 1934 that requires a company with a class of equity securities held by 500 or more holders of record and assets in excess of $10 million to register such securities with the Securities and Exchange Commission. Securities held in the name of a corporation, partnership or a trust are considered to be held by one person, except when the corporation’s purpose is primarily to circumvent this rule. If a company “triggers” the application of this rule, it becomes subject to the periodic reporting requirements of Section 15(d) of the 1934 Act (this means that it has to file annual, quarterly and periodic reports with the SEC). The count happens only once a year, at the end of each fiscal year.

Stock options are considered a separate class of equity securities separate from the class of securities into which such options are exercisable, so a company that has 500 or more of stock option holders is also subject to registration. There is an exemption for compensatory stock options (those granted to employees, directors, consultants, advisors of the company and their permitted transferees). Such options have very strict transfer restrictions. Option holders are not permitted to pledge, hypothecate such options or transfer them except to a family member by gift, to an executor upon death or disability, back to the company, or in a change of control transaction if options are no longer outstanding. The company must provide current risk and financial information to such option holders every six months.

In conclusion, private companies should be watchful of the number of their shareholders and keep in mind that option holders also count as a separate class. Imposing buy-sell restrictions on equity may be a way of controlling the number of shareholders in a company, but at an expense of lower price for such shares, as restrictions on transfer may be viewed negatively by the potential investors. Also, please remember that nothing in this blog constitutes legal advice. One should always consult with a securities lawyer before issuing any equity to investors.