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Why Facebook may prefer to retain private status

Denver Business JournalOn the Money
From the  February 4, 2011 print edition

It’s hard to go anywhere these days and not hear the word “Facebook,” the social media website that dominates the Internet. Often the discussion is about users’ “privacy settings” and how individual privacy is becoming harder to maintain.

Facebook recently raised $1.5 billion by selling stock, drawing the attention of the Securities and Exchange Commission and many members of the investment community. The reason for all the attention was Facebook’s own financial privacy setting – namely “private.”

Why is this an important concern? Let’s examine the basics of what it means to be “private” or “public” when selling stock to raise money for any company.

In the frenzied (and sometimes dishonest) securities markets of the 1920s, companies often sold stocks based on glitzy charismatic promises, but without any meaningful information, to investors. So the U.S. Congress created the SEC and enacted the two primary sets of federal laws that govern what a company can do when it wants to offer and sell its securities to the public: the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act).

The Securities Act generally requires companies to give investors “full and fair disclosure” of all “material facts,” the facts investors would find important in making an investment decision. The Exchange Act requires publicly held companies to continually disclose information about their business operations, financial condition and management.

In an ideal situation, all companies that sold stock to raise money would be subject to both acts, and therefore would be public companies.

This, of course, is very impractical, so exemptions were created to allow the sale of stock under certain conditions without complying with the acts.

Having fewer than 500 shareholders is one of the exemptions that Facebook relies on.

A great deal of work (and many pages of paper) is involved when complying with the two acts. Additionally, audit fees and attorney fees can be extremely costly. For the smaller company, relying on the exemptions saves a great of money and time while also keeping the details of its operations private. This is where the term “private placement” came from – selling stock to investors under one of the exemptions from the acts and therefore avoiding becoming public.

Making a case against going public

It’s often thought that becoming public is a noble and positive goal. While being a public company has many advantages, it also carries a whole new set of obligations. For example:

  • Keeping shareholders informed about the company’s business operations, financial condition and management.
  • Incurring additional audit costs and new legal obligations.
  • Officers of the company may be liable if these new legal obligations aren’t fulfilled.

When a company intentionally sets out to become public, the primary document is called a “Registration Statement.” In it, a company must reveal and disclose many things, including:

  • Its business, properties and competition.
  • The identity of its officers and directors, and their compensation.
  • Material transactions between the company and its officers and directors.
  • Material legal proceedings involving the company or its officers and directors.

Even more than just the information contained in a single registration statement, ongoing reporting obligations for the company are substantial, and in some cases also include the company’s officers, directors and significant shareholders.

Once a company is public, the Ex-change Act requires the filing of reports with the SEC. This obligation continues unless the following thresholds are satisfied. In other words, a company does not have to file SEC reports if:

  • The company has fewer than 300 shareholders of the class of securities.
  • Or the company has fewer than 500 shareholders of the class of securities offered and less than $10 million in total assets for each of its last three fiscal years. This is the threshold Facebook relied on.

However, U.S. securities regulations require companies with more than 499 shareholders to disclose financial information whether or not they’re publicly traded. Facebook expects to exceed that number some time this year.

When that happens, the company must disclose and file information with the SEC regarding:

  • Its operations.
  • Its officers, directors and certain shareholders, including salary, various fringe benefits, and transactions between the company and management.
  • The financial condition of the business, including financial statements audited by an independent certified public accountant.
  • Its competitive position and material terms of contracts or lease agreements.

All of this information about the company becomes publicly available, along with information about the company’s directors and officers, as well as shareholders who own more than 10 percent of the stock.

This is the essence of reporting requirements for public companies. Maybe it provides a glimpse into why a financial privacy setting of “private” has some advantages.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.