Share Rules Could Push Offering by Facebook

 Noah Berger/Bloomberg NewsMark Zuckerberg, Facebook’s founder and chief executive, rings a gong during the launch of the Places feature. Facebook likes big numbers — it now has more than 500 million users, each one of whom can have as many as 5,000 friends. Yet as a privately held company, its ownership base must remain small, or it will have to disclose publicly its financial results.

A surging shadow market in the privately held shares of Facebook is making such restraint difficult and could spur the company to go public — even as its executives try to tamp down speculation about an initial public offering — much as similar pressure helped push Microsoft and Google toward their own initial public offerings. The frenzied trading in Facebook, as well as in Twitter, Zynga and LinkedIn, has caught the eye of the Securities and Exchange Commission. The New York Times DealBook first reported on Tuesday that the agency had asked for information about trading in all four companies.

While it is unclear what exactly the S.E.C. is focusing on, legal experts say that one clear area of inquiry relates to a federal law that establishes a limit for private companies of fewer than 500 shareholders. Once a company has 500 shareholders, it must register its private shares with the S.E.C. and publicly disclose its financial results.
Facebook is well aware of this issue. In 2008, the S.E.C. allowed Facebook to issue restricted stock to employees without having to register the securities, a move that would have required the company to publicly disclose financial information.

A spokesman for Facebook declined to comment.

The company has also tried to limit the number of employees selling shares. This year, it put into effect an insider trading policy that bars current employees from selling stock.

But the pace of trading in Facebook shares, as well as trading in other social network companies, has accelerated nonetheless. Over the last year, several private exchanges have formed to match the buyers and sellers of these companies, which have spiked in value. Facebook is now valued at $42.37 billion, more than tripling in value over the last 12 months, according to SharesPost, an online marketplace for private investments.

The selling shareholders in the companies are former employees and early-stage venture capital investors who are already sitting on huge profits. Buyers are wealthy speculators, many of them pooling their money into investment vehicles sponsored by Wall Street firms.

One potential legal issue is whether the investment pools formed by a group of investors are a way to sidestep the 500-shareholder restrictions.

These private transactions do not always go smoothly, as evidenced by a seven-year-old lawsuit involving a private sale of Google shares. The soured deal serves as a cautionary tale of the risks inherent in these types of transactions.

In 2003, Scott Epstein, a former Google consultant and interim vice president for marketing at the company, struck a deal to sell about $700,000 of pre-initial public offering Google stock to a group of investors who had pooled their money to buy the stock at $19.75 a share. In late 2003, around the time that Google announced it was pursuing an initial public offering, the investors claimed that Mr. Epstein had reneged on the agreement. Mr. Epstein, in turn, claimed that Google had improperly refused to transfer his shares, despite his having complied with various requirements.

The investors filed a breach of contract lawsuit against him in California state court.

On the eve of the trial in May 2005, after 18 months of litigation — Google had already gone public by then — the parties settled the case. Mr. Epstein paid the investors roughly $100 a share in cash, or about $3.5 million, according to two people with knowledge of the settlement who requested anonymity because they were unauthorized to discuss it.

Mr. Epstein declined to comment, citing a confidentiality provision in the settlement.

Although the investor group made about five times its original investment, the agreement was bittersweet not only because of the bruising litigation but also because Google shares were trading at more than $200 a share at the time.

Google’s founders, Larry Page and Sergey Brin, had not been keen to take their company public. But they had widely distributed stock options to employees. In 2003, five years after they founded the company, Google crossed the 500-shareholder threshold — a rule that is part of a 1934 securities law. The company went public the next year. That initial offering created hundreds of Google millionaires.

Microsoft, founded in 1975, had been around for more than a decade when it sold shares in an initial public offering in 1986. Because venture capitalists owned very little of Microsoft, its founder, Bill Gates, controlled the company and had little interest in a public offering. Microsoft was so profitable that it also had little need for capital. But Mr. Gates had also been handing out shares to company executives and recruiting programmers with stock options. So in 1985, he reluctantly agreed to a public offering, which made Mr. Gates one of America’s wealthiest individuals. Like the Google founders and Mr. Gates before him, Facebook’s iconoclastic founder, 26-year-old Mark Zuckerberg, insists he is a reluctant seller. He and his fellow executives have sought to dispel expectations of a Facebook public offering any time soon. But as the company grows, it risks exceeding the 499 shareholder limit.