Finance

Going Dark: The Explosive Growth Of Private Markets, And Other Thoughts On SEC Commissioner Lee’s Remarks

I am happy that folks are reading some of my musings here. As SEC Commissioner Allison Herren Lee delivered her remarks at the annual The SEC Speaks on Oct. 12—focusing on the rapid growth of private markets in the 21st century and the implication of this growth on investors and the economy at large—it was a vindicating moment for me as I have written on a number of the issues addressed.

As it turns out, I have not been simply flashing my proverbial high beams in vain. As you all know, I frequently examine how legal and regulatory structures influence the shift in U.S. equities from public markets to private markets. I have been—and remain concerned—with the increasing lack of transparency in the private equity markets. 

Commissioner Lee pointed out that the private market is growing rapidly, and she acknowledged that it may be time for Congress and the Commission to scrutinize the problems and consider action to address this reduced transparency without stifling economic growth.

Before considering what we should do about this situation, let’s remember three critical factors: the nature of the companies involved here, the number of investors, shareholders and stakeholders they have, and, perhaps most importantly, the way federal securities laws view these actors. 

The companies are growing in both size and frequency with more than 70% of new capital raised being done privately and the number of unicorns alone going from 40 to nearly 900 in less than eight years. As these companies grow, so do the number of their employees, investors, shareholders and stakeholders. 

Unicorns: A Commonplace Rarity

As unicorns are increasing in frequency and size, their influence and “transformational impacts on our way of life” begin to grow as well. However, as Lee rightly acknowledges, these companies are not required to provide almost any information to the public at large about their activities, current financial status, or operational capabilities. 

Despite the fact that these companies represent more than $3 trillion in value, they operate largely outside the realm of disclosures that we have come to expect from some of the largest companies in the world. Some unicorns exceed the market cap of publicly traded companies without being subject to the same rules. 

How to Lose Money Faster Than a New York Minute

The shareholders, both current and future, who invest in these companies are the ones who bare the most risk from the lack of transparency. For those with a few hundred million to throw in, you can simply buy a board seat to ensure access to information. The National Venture Capital Association’s model Investor Rights Agreement even points this out. They can also negotiate for aggressive redemption rights or anti-dilution provisions.

In my paper Alternative Venture Capital, I discuss the increasing number of players who have both the willingness and the ability to put this kind of money in. Mutual funds, sovereign wealth funds, private equity funds, corporate venture capital and hybrids of these are all jumping over each other to invest in these companies.

Given the lack of access to information publicly, board seats or significant investments used to guarantee information are the only way in, making investing akin to a high stakes game of musical chairs. This game is spilling over into the public sphere as an increasing amount of the capital at play here comes from indirect public investment via the savings and retirement assets of millions of Americans.

But for those of us mere mortals who don’t have the money to even play the game, the lack of information becomes even more difficult. And as I argued in my paper on Unicorn Stock Options, the largest group of shareholders at risk here are the employees of the firms themselves. Equity grants are common place in unicorns. But the employees who receive them are left in the dark when they purchase, as they hold, and when they decide to leave. As Lee said in her remarks: “Quitting can become an investment decision that must be made in the dark.”

Employees as Investors

Unicorns stay private longer for various reasons, including to avoid public disclosures that could reveal their true financial conditions and fair market value, including to their own employees. As noted correctly by Commissioner Lee, employees are “investors in these markets with much at stake and sometimes little to no negotiating power to obtain needed information.” 

In the past, prior to the JOBS Act, employees were protected as an investor group by our securities laws. Start-ups needed to count employees as investors and disclose material information accordingly.  The JOBS Act changed that—leaving employees vulnerable in their position as investors and minority common shareholders in their companies. Employees are left subject to the discretion of majority shareholders, founders, and their company’s legal counsel.

Unicorns are notorious for their exaggerated valuations. If you want to learn more, see the work of Gornall and Strabulaev on this. Employees are not privy to confidential information, including financial statements, shareholder lists, and other material non-public documents. Many unicorn firms leave employees holding potentially tens of millions of dollars of illiquid stock at the mercy of the majority shareholders, without access to detailed financial statements and adequate disclosures of risks and prospects to help guide their investment decisions. 

Moving the Goalpost

Federal securities laws are supposed to be designed with eventual tripwires to address this lack of transparency when it becomes too big of a problem for too many people. However, the rules have continued to change to move this tripwire further back. Section 12(g) of the ’33 Act requires companies to comply with periodic disclosure rules if they have 2,000 shareholders of record and at least $10 million (not billion) in assets. 

Employees receiving equity grants no longer count as investors, and the number of shareholders that necessitates certain public reporting is now set at 2,000.  While this may seem like a low threshold, consider that the limit on this number was increased from 500 to 2,000 in 2012 just as unicorns were first being discovered and equity ownership in the United States has shifted increasingly to indirect institutional ownership.

This has allowed companies to remain dark indefinitely while they grow and leave their smaller minority shareholders in the dark. While there is a lower threshold if the shareholders are unaccredited, the SEC has moved repeatedly in the last several years to make it easier to qualify as an accredited investor, moving the tripwire even further back.

Shining the Light in the Dark

I advocate for stronger disclosures by these unicorns to their employee shareholders on the financial status of the company and the corporate governance structure. Such disclosures would allow these employees to not be making investment decisions in the dark, the exact purpose of our securities laws. 

On the other end of the spectrum, many industry-side attorneys are advocating for doing away with any financial statement disclosures, instead providing fair-market-value statements to shareholders once per year. If you want to find out more on the different approaches to disclosure, check out my paper and the work of Yifat Aran.

Commissioner Lee and I both agree that it is also time for the SEC to consider whether or not to re-examine the method for classifying shareholders as shareholders of record. We have been joined by the North American Securities Administrators Association, academics like Ann Lipton and current SEC Director of Corporate Finance Renee Jones, and former SEC Chair Mary Schapiro

While this debate is likely just getting started, I’m glad that I have found someone to lead us with lights on in the darkness of the private market. I may simply have to keep flashing my high beams to ensure we keep turning more lights on.

If you have any comments, suggestions or feedback, please send them to my research assistant John Livingstone [email protected] or to me [email protected].


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