Thoughts on startups by investors that
fund them & entrepreneurs that run them

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):

  1. 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.
  2. 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.

 

All opinions expressed are those of the author, and do not necessarily represent those of Gust.

Written by Bill Payne

user Bill Payne Angel Investor ,
Frontier Angel Fund

Bill Payne has been actively involved in angel investing since 1980. He has funded over 50 companies and mentored over 100. He is a founding member of four angel organizations: Aztec Venture Network, Tech Coast Angels, Vegas Valley Angels, and Frontier Angel Fund.

prev next

You might also be interested in

The UrbanTech Movement is Transforming Cities

Urbanization is a defining process of modern life.

More than half of the world’s population now lives in cities, and the number of urban citizens around the world is projected to rise to 66% by 2050.

In the US, over 80% of the population lives in urban areas with 1 in 7 Americans living in New York, Los Angeles and

Read more >

Angel Investors Spotlight: An Inside Look at Hudson Valley Startup Fund’s Investment Process & Advice for Founders

Hudson Valley Startup Fund brings together a network of the region’s successful business and community leaders to give back, supporting the launch of the next Hudson Valley visionaries. We sat down with fund managers Chad Gomes, Johnny LeHane and Paul Hakim as they shared insights into their investment process, what they look for in both group members and startups, and

Read more >

The Right Startup Advisors Are As Valuable As Money

If you are a new entrepreneur, or entering a new business area, it’s always worth your time to assemble an Advisory Board of two or three executives who have travelled that road before. You need them before you need funding, and if you select the wrong people, or use them incorrectly, no amount of money will likely save your startup.

Read more >

How do I get in touch with investors/funds with just an idea and no product?

There are many wonderful ideas, and they are not necessarily easy to come up with. So congratulations on having thought of one!

However…

“Having value” and “Being fundable” are two completely different things. What the more experienced responders here are saying is completely accurate: while a good idea is usually a necessary ingredient for the formation of a good company, it is

Read more >

Is there an incubator for aspiring Angel Investors or VCs?

No, but there are several sets of courses on angel investing that can provide a good base from which to start. The most comprehensive and best known is the Power of Angel Investing seminar series developed by the Angel Resource Institute (formerly known as the Angel Capital Education Foundation, and prior to that part of the Angel Capital Association). It

Read more >

Comments

2 thoughts on “Limiting the Number of Shareholders in Private Companies”

  1. Excellent point, Bill. I also think there are downsides for entrepreneurs as well. Even without crowdfunding, for a late-stage startup with a few dozen angels and other investors, any time a significant corporate event occurs, it can be a drain on resources of senior management (as well as significant legal expense) to round up the necessary consents and answer myriad questions from stockholders. Multiply by 10 or 100 and it becomes an administrative nightmare. The probability of shareholder class action litigation also increases, which in turn should cause D&O premiums to rise… And so on. I think there are many unintended consequences that crowdfunding advocates tend to overlook.

  2. patarcher says:

    This is a key issue, and with a great wave of momentum being crowd funding, enabling new and exciting ideas, we need to make sure it works and people understand long term consequences.

    The CF concept works very well for more “donation” type sites like Kickstarter as you do not expect much in return, but as soon as legal documentation needs to be involved, it can cause issues.

    Loan and Equity financing done through crowdfunding are the trend at moment, but I wonder if it may not unravel in a few months/ years.
    – If you provided a loan, how do you enforce security, agree various agreements and manage interest payment (basically you will need full syndicate function which is costly).
    – If you provided equity, if business goes down you are clearly left with nothing, but if it gets sold for top dollars, how do you ensure as one of the 1000+ people that got equity in a start up that you get paid? If (hypothetically) Instagram had raised $100,000 1 year ago for 10% equity via crowd funding, a $10 stake would have been worth $10,000 when Facebook bought it… you’d certainly want to make sure you could get your hands on that!