- March 1, 2011
Facebook makes a fortune by coaxing users to post private information on a public website. But when it comes to its own affairs, Facebook stridently conceals financial and business information. Facebook’s recent private offering has become a roadmap for any company that is selling stock and wishes to avoid public scrutiny, governmental fines, and investor liability.
The Frenzy to Finance Facebook
In early 2011, a story of another spectacular round of private financing for Facebook exploded on the pages of national newspapers. The Wall Street Journal and wire services reported that Facebook tried to raise about $2 billion, but sidestepped the months-long process of filing an initial public offering. The deal would involve a $500 million investment from Goldman Sachs and some of its partners and affiliates, amounting to a reported $1.5 billion. The investment would complement an earlier $500 million sale of stock to a Russian-based investment fund.
Normally, internet or software companies would raise such vast sums through an initial public offering. Such an IPO for a newly “public” company would require that the company disclose sensitive details about its business and finances. After raising the money, the company would make public quarterly and annual financial statements; significant transactions become public record. Securities laws enacted about a decade ago impose newly public companies with additional accounting and bookkeeping procedures that add millions of dollars in expense. Therefore, the new crop of dot com stars are avoiding the public markets and the accompanying administrative headaches.
In less than two weeks following the spate of publicity surrounding the Facebook deal, the company retreated. It shifted the entire offering outside of the United States to avoid scrutiny and risk of liability for violating securities offering rules.
The following are among the rules that Facebook and any private company confront, as well as the legal techniques to overcome the obstacles to complete a successful, inexpensive, rapid, and private offering of capital.
It appears that Facebook limited its aborted offering to accredited investors only. These are investors that, among other things, have $1,000,000 in net worth (excluding their home), personal income greater than $200,000 annually, or combined annual income with the investor’s spouse of $300,000. By limiting an offering to only such accredited shareholders, companies dodge a variety of disclosure and procedural rules that can easily derail an offering and provide a technical defect to the process that investors can exploit to demand their money back.
Facebook ultimately raised the money off-shore, using an exemption to securities rules that permit raising money outside the United States, but using the funds domestically. Known as “Regulation S”, the rule outlines the procedures to raise funds in potentially huge amounts. As with most of the rules regarding stock and bond offerings, if companies attempt to be “cute”, and create foreign entities to slyly evade the letter of the law, investors can punch through the trick and demand that the company return the money.
Facebook tried to limit the number of shareholders to fewer than 500 to avoid triggering mandatory disclosures. Under the Federal securities statutes, companies with 500 or more shareholders, and with assets exceeding the statutory threshold, must disclose information periodically as if they were the largest company on the largest exchange. As Facebook tried to raise more than $1 billion, however, limiting the number of shareholders to less than 500 became a challenge. For smaller companies, especially those held by several generations of holders, the 500 shareholder number can present a genuine trap that must be avoided.
Whisper to Friends, Do Not Shout to Strangers
Another obstacle confronting Facebook was the publicity of its offering. For offerings to be exempt from the disclosure and filing rules applicable to jumbo public companies, firms cannot engage in a “public solicitation” for investors. No general advertisements, no appearances on Oprah, no web sites, no large-scale email blasts. Instead, companies raising funds must patiently contact persons they, or their investment banker, already know. The relationship could be just about anything – from coaching a soccer team to an occasional lunch companion. In the case of Facebook, the so-called private offering was reported by the New York Times, then the Wall Street Journal, and then John Stewart’s monologue on Comedy Central. As a result of this gusher of publicity, Facebook risked a serious challenge to its private offering, being vulnerable, fairly or not, to the accusation that it publicly promoted the stock.
Beware the Shell Game
Facebook initially tried to sell stock to a single-purpose company that would pool money from dozens or hundreds of investors. Presumably, this would have permitted the company to dodge the limits on 500 investors. As scrutiny and criticism of this sleight of hand grew, Facebook retreated to an off-shore offering. Any private company should similarly be wary of such a short-cut around the limit on the number of investors. In fact, securities statutes, regulations and rulings consistently dismiss semi-clever methods to conceal non-qualified shareholders under the ruse of an investment pool. Some of these devices work, but usually only if there is a compelling independent reason for the structure. Otherwise, companies should look for other less risky techniques to avoid the burdens of public company stock offering requirements.
For more information about the Facebook deal or securities law, please contact Craig McCrohon at 312-840-7006 or firstname.lastname@example.org
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