Among the most important trends evident in today’s U.S. economy is the fact that private companies are choosing to remain private longer. This is primarily due to legislation enacted through the bi-partisan JOBS Act of 2012, which increased the number of shareholders that triggered the need to publicly register with the Securities and Exchange Commission from 500 to 2,000 (excluding employee shareholders).
The idea was to give emerging growth companies the ability to grow revenue and more fully develop before entering the capital markets. That’s good for entrepreneurs. And although it means a longer on-ramp to a potential IPO, it also means that more proven, long-term focused companies are eventually listed on the public exchanges. That’s good for investors, and for capital markets.
But the flip side of companies choosing to stay private longer is that employees and investors of private companies find it increasingly challenging to obtain any meaningful liquidity before the company chooses to go public. New legislation before Congress, H.R. 1839 authored by North Carolina Representative Patrick McHenry, called the RAISE Act (Reforming Access for Investments in Startup Enterprises Act), would help address this problem by adopting a new federal exemption from registration for resales of private company securities, a key way to drive widespread economic growth. The legislation also contains important investor protections, including that the shares only be resold to accredited investors and remain restricted after the resale.
Current federal law only provides a workable safe harbor and state securities law preemption for private company share resales where the seller has held their shares for at least 12 months. And, except for New York State, existing state blue-sky laws preclude a registered broker dealer from contacting existing accredited investor clients to assess investment interest. This restriction is inconsistent with SEC and FINRA guidelines, which allow a broker dealer to discuss potential investments with clients with whom they have a preexisting relationship.
Why is the current law a problem? Well, to start, most private company employees receive a significant amount of overall compensation in the form of restricted option equity grants that vest over a four-year period. Exercise of employee options requires that the employee pay the option exercise price and income taxes at the time of exercise. Typical startup employees simply do not exercise options and hold common shares because they cannot afford to fund these costs out of pocket. As a result, a substantial amount of private company employees’ options may end up not being exercised in cases where a private company delays an IPO or the employee leaves the company and, instead, expire, resulting in economic loss and income reduction unless they can structure a transaction that allows for the immediate resale of a portion of their common shares to cover these costs, something existing federal and state laws don’t allow.
The proposed legislation before Congress would provide a clear exemption for these types of transactions, allowing employees to monetize a portion of their equity compensation and realize discretionary income that will be spent in their communities to pay for life’s necessities, including paying off college loans or buying a house. Making equity compensation more attractive to prospective employees facilitates prospects for job creation and employee retention. In addition, the proposed legislation would facilitate pre-IPO liquidity for founders and early investors, who often use those funds to make important investments in new startups.
What’s more, private companies, including not just those in the high-growth tech and biotech industries, but also private community banks, find it much easier to raise primary capital when prospective investors understand that some degree of secondary liquidity will be available. Private companies use that capital to grow their businesses and hire and retain new employees. Private community banks use that capital to increase loans to local businesses.
All of this amounts to good growth: more startups able to conserve their resources, employ new and retain talented employees, raise and expend capital, and time their public offering on their terms. In addition, the proposed legislation will result in increased income and capital gains tax paid at the state and federal levels as options are exercised and shares are sold.
For these reasons, the RAISE Act deserves the kind of bipartisan support the JOBS Act received in 2012. That landmark bill has already proven good for the U.S. capital markets and the economy at large with over 630 companies using provisions of the JOBS Act in conjunction with their IPOs, which raised approximately $90 billion in total proceeds.
The proposed new changes — by eliminating unnecessary impediments to small business capital formation imposed through antiquated limitations on shareholder liquidity — offer a sensible way to fully unlock American ingenuity and potential.
Nelson Griggs is Executive Vice President of Listing Services at Nasdaq and a board member of Nasdaq Private Market LLC.
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