Some background for this post: Facebook has recently been rumored to have raised money at a valuation of $100 billion; SecondMarket, a brokerage for private company stock, has grown as a place for robust trading of consumer web company stock, transacting over $150 million in the first quarter of 2011; interest in private or pre-IPO consumer web companies like Groupon/Facebook/Zynga are possibly at an all-time high; everybody is sure that we are either in a bubble, or not in a bubble. Also, I’m writing a paper for a class. 🙂
Now, looking at the information above, it’s not clear by any stretch that the market for private company stock needs to be regulated more than it is. In fact, the presumption is probably that government should stay the hell away from one of the few sectors of our economy that is experiencing some growth. Considering the general health of the industry, regulation seems to make little sense – But I would argue that the industry could benefit from regulation if and only if that regulation helped cure the one systemic ill that seems to serve as a detriment to the startup/tech world, the bubble cycle. As people in the tech world are acutely aware, tech seems to ebb and flow, with a bubble/crash/bubble/crash cycle. The system, unregulated trading and all, seems to work great in the boom years, and then in the bust years nobody is looking to put more restrictions on already rare funding rounds, so regulation seems unlikely to ever be advocated for by insiders. But if some regulation would soften the bubble by lowering the volatility of the market, that would be one scenario where regulation might be favorable.
Currently, private company funding is essentially unregulated. Public companies are forced to disclose a whole ton of information through various (expensive) public disclosures. On top of restrictions regarding insider trading, liability for false statements, and other shareholder protections, this is how public companies are regulated. Private companies are largely exempt from reporting most of these things, as they raise money from institutional investors or “accredited investors” through non-public offerings.
Why we don’t regulate private companies now –
The justification for the exemption of private companies usually falls into some combination of: “accredited investors” don’t need as much protection as the public and transaction costs associated with disclosure are too high for small companies to afford. The first justification, however, is slowly becoming less applicable, as the standard for who qualifies as an “accredited investor” has failed to keep pace with inflation, and sweeps in a much larger percentage of the population than Congress must have intended when they wrote the regulations in 1933. The second justification becomes less convincing when the companies seeing large markets for their stock are highly profitable and valued in the billions, as is the case with currently-private Facebook and Zynga. So maybe it is time to start considering whether some regulation for at least the upper-class of private companies could temper the boom and bust cycle without disrupting the markets for fundraising at the lower end of the private company spectrum.
Could regulation temper the bubble cycle? –
The most common form of securities regulation is probably mandatory disclosure. Public companies are asked to do this very consistently, as a way of providing their shareholders or potential shareholders with a broad view of the state of the company. Private companies don’t provide public disclosures – they get information to their smaller group of investors through other means, such as by granting those investors board seats or simply meeting with the investors frequently. Being a seed or angel investor in a private company surely grants that angel a more favorable position in terms of access to information than I have buying stock in Microsoft, thus the lack of formal disclosure has little practical significance for the institutional investor in the market for private companies.
But the issue I am most interested in, and the angle from which I believe regulation looks most desirable, arises when the successful private company files for an IPO. Focusing here makes sense – many use the IPO market as a proxy for whether there is a tech bubble, and bubbles seem to burst at the IPO level rather than at the level of, say, Series B or C investments. When a company files for an IPO, they are forced to make their first public disclosure, and likely the only disclosure they’ll make before shares of their company are put up for sale (unless they make Groupon-level mistakes and are forced to amend multiple times). This, and the newspaper articles describing the unbelievable valuations of the company, are all the public investor has to go on to make his or her judgment about the value of the company – and in reality, the public investor probably didn’t actually read the public filing anyway, but maybe skimmed a blog post on it. I’ve also noted elsewhere on this blog that usually VCs backing the IPO company are looking for a hasty exit, so the very group setting the earlier valuation now benefits from a public perception that the company is worth more than it actually is.
So the real question is, would forcing companies like Facebook or Zynga or Groupon to file more than one public disclosure before filing for an IPO make the market any more efficient? Would it effectively stem the tide of irrational investments into non-performing or underperforming companies, the canary in a mineshaft for a bursting bubble? Are there any other mechanisms or other forms of regulation available to fight the bubble problem? I’ll save looking into those answers for Part II.
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