Facebook, Twitter, Groupon -- hot Internet startups are using private financing to grow like never before. Why do they trust the social graph to be the backbone of their business model but not of their statement of ownership?
By Kevin Kelleher, contributor
The web is nothing if not a democratizing force. It has turned us into active investors with low-cost commissions from online accounts and free access to vast amounts of financial data. It lets us compare flight fares and gadget prices; and sites like eBay have helped turn us into retailers. It has humbled media giants by letting readers respond with comments and publish their own thoughts on blogs. Most recently, thanks to Facebook and Twitter, that self-publishing phenomenon was an important tool in bringing democracy to countries like Tunisia and Egypt.
But there is one area where democratic impulses of the web still aren’t welcome, where the playing fields are still unfairly uneven, and where an elite group of entrenched interests still reap benefits while the rest of us are excluded. Perversely, it’s an area at the very heart of the web industry: the ability to buy and sell shares in the hottest web startups like Facebook, Twitter and Groupon.
These private companies will go public, but they are taking their sweet time about it. A Groupon IPO “may happen this year,” Bloomberg reported Wednesday, citing unnamed sources. When it does, it could be worth $25 billion. Facebook, mulling an IPO in 2012, could trade at a few times that value. Both companies could offer some of the best investment opportunities to come around in years. But small investors — and the vast majority of Facebook and Groupon’s customers — are being shut out.
That’s too bad because there is a huge demand for ownership in these web 2.0 leaders, from large and small investors alike. But even as hedge funds and wealthy investors line up to buy into Facebook in private rounds or on secondary exchanges like Sharespost, the small investors remain excluded for two main reasons.
The first is that the SEC bars ownership in privately held companies to accredited investors — those who make more than $200,000 in salary or have a net worth above $1 million. The rule is both well-intentioned and sound, limiting retail investors to publicly traded companies that are required to disclose data on their finances and operations.
Which brings us to the second reason. Successful and profitable companies that are ripe for trading on public stock exchanges are fighting against an initial public offering, selling round after round of venture investment so they can stay under private control. It’s Silicon Valley’s version of prolonged adolescence, the supposed trend of young people living with their parents into adulthood.
The SEC has another sound, well-intentioned rule for private startups: once a company has more than 499 shareholders it needs to publicly disclose its financial results. Although the rule doesn’t require a company to trade publicly, it’s ends up prompting many companies who’d just as soon stay private to file for IPOs.
Because web companies use stock and option packages to lure in top engineering and management talent, they tend to get to 500 employees fairly quickly. Google GOOG held off on filing for an IPO, but took the plunge in April 2004 once it had more than 500 shareholders. Being public meant disclosing data and holding quarterly calls where analysts grilled the co-founders, who were clearly uncomfortable with the new exposure. And it opened Google to intense pressure to jump through new hoops like meeting targets for its net profit or preventing margins from declining. But it also allowed Google’s users to share in its financial success.
Two and a half years ago, when Facebook was nearing that 500-shareholder threshold, it asked the SEC for an exemption to the securities law. The SEC granted its wish. Had Facebook ended 2008 with 500 shareholders, it would have had to file for an IPO or disclose financial results four months later. But thanks to the exemption, Facebook’s employees — and insider shareholders — have grown, while its stock is traded only on secondary exchanges.
And so instead of IPOs, we are seeing huge private investment rounds. Facebook raised $500 million in January from Goldman Sachs GS and others, on top of the $678 million it had raised previously. Such large rounds are usually seen in capital expenditure-intensive industries like solar manufacturing, pharmaceuticals and IT networks, not in the web, where startups tend to launch cheaply.
Increasingly, these mega-rounds of private money are becoming common. Groupon, which employs 3,000, raised $500 million in late December. Zynga, with 1,500 employees, is reportedly close to a $500 million round. So is Groupon-rival LivingSocial. There are, of course, good reasons to stay private. Facebook, like Google and many startups before it, faces keen competition and doesn’t want to open up its financial books for competitors to see. Moreover, no company relishes the quarterly earnings game, which often requires companies to cut back on investments in long-term projects in the name of boosting short-term profits.
But there are just as many complications when companies raise money privately for too long. Public companies must disclose carefully vetted data, which private investors of late rounds might not enjoy. Individual investors clamor for private shares, leading to elaborate and questionable schemes like Goldman’s aborted plan to allow prized clients to invest in Facebook. This week, the Financial Industry Regulatory Authority warned of a wave of scams targeting would-be investors in private web companies.
Facebook, Groupon and other web companies staying private during their growth years aren’t affected directly by these problems, but their image could be. Alongside all the financial considerations behind an IPO, there used to be another consideration rooted in principle: Companies went public to share their success with customers. Sadly, the fastest-growing web companies today don’t want to share their success with us. Only Facebook users who make more than $200,000 a year can buy Facebook stock -– and that’s if they’re lucky.
At the core of this widespread insistence to stay private is a whiff of hypocrisy. The web companies that champion democratic ideals through their technology — and that profit richly from them -– are refusing to embrace those same ideals when it comes to their stock.
More from Fortune: