In an effort to limit the number of stockholders, web companies Twitter, LivingSocial and Square Inc., are taking measures to restrict investors from selling shares in secondary exchanges.
Twitter asked investors in its recent funding round to refrain from sales on exchanges, according to two people familiar with the matter, who asked not to be identified because the agreement is private. Square sent a contract to investors that would prohibit sales, two other people said. LivingSocial?is considering similar restrictions, according to two people.
The startups aim to stanch the trading of stock on?SecondMarket Inc.?and SharesPost Inc. — open online marketplaces that process share sales of companies such as Facebook Inc., Zynga Inc. and Twitter. The transactions spread private financial information and bring in new investors who may not understand the company and the risks involved, said Hans Swildens, a managing director of Industry Ventures LLC.
?Board members and companies are getting more proactive, putting in procedures to manage the whole process,? said Swildens, whose?San Francisco-based firm?has been buying secondary shares for almost 12 years. ?They want to keep the shares in the family. They don?t want it to be the Wild West.?
Matt Graves, a spokesman for Twitter inSan Francisco, declined to comment. Katie Baynes, a spokeswoman for San Francisco-based Square, also declined to comment, as did Brendan Lewis at?Washington, D.C.-based LivingSocial.
Private companies already have greater control over their stock than public corporations. They typically have the ability to see proposed transactions of their shares on exchanges before they take place and buy them at the agreed-upon price, a process called the right of first refusal. In some cases, companies hand that right to specific investment firms, Swildens said.
Twitter, the leading microblogging service, is raising $800 million in financing and plans to about half of that to buy back shares from employees and early backers. The funding round was led by Yuri Milner?s DST Global, the Russian investment group that has purchased secondary shares of Facebook, Zynga and Groupon Inc.
?It?s in everyone?s interest to let the company conduct an effective and organized offering of the shares, as opposed to having ?ad hoc leakage of the shares,? said Ted Hollifield, a partner at law firm?Dorsey & Whitney LLP?in?Palo Alto,?California.
Twitter was valued at $8 billion in its latest round, and daily-deal site LivingSocial raised money in April at a $3.5 billion valuation, according to people familiar with the deals. Square, a mobile-payment startup, was valued at more than $1 billion in its fundraising in June, a person said. Square Chief Executive Officer Jack Dorsey also serves as executive chairman of Twitter, a company he co-founded.
The move to restrict share sales comes a year after Zynga and Facebook began charging at least $2,500 for such transactions, fees that legal experts say were geared toward discouraging the practice. U.S.regulators also are considering limits on secondary markets. In January, SecondMarket said it received a request for information from the U.S. Securities and Exchange Commission.
Giuseppe Zocco, a partner at Index Ventures, said his firm is buying shares of portfolio companies from some early investors. The firm invested in ad network?Adconion Media Groupthis year, and it used a portion of the funding to purchase stock from angel investors, Zocco said. Handling secondary sales internally lets the company avoid the disruption of dealing with exchanges, he said.
?It makes the focus and execution sharper because you don?t have to think about all this other stuff,? said Zocco, who?s based in Geneva. ?These other things are a distraction.?
Having too many shareholders also presents a regulatory challenge because the SEC requires companies with 500 or more investors to disclose financial results. Facebook, the world?s largest social network, said earlier this year it plans to start reporting results by April 2012, even if it hasn?t held an initial public offering by then.
San Bruno, California-based SharesPost and New York-based SecondMarket have taken measures to work with companies, rather than get cut out of transactions altogether. Attorneys for top technology startups have recently met with representatives of SecondMarket to discuss ways to limit private share sales from happening without a company?s involvement, said Adam Oliveri, head of the private-company market at SecondMarket.
?Ad Hoc Consortium?
?We kept getting requests from companies asking, ?What do we put in our bylaws to make sure secondary trading doesn?t happen before we?re ready for it??? he said.
The ?ad hoc consortium? of lawyers is working to draft standard contractual language restricting secondary sales until enabled by a company, said Oliveri, who would not name the attorneys present.
Before, LinkedIn Corp. held its IPO earlier this year, the company worked with SharesPost to set up controls on the site, limiting the sale of stock only to other existing shareholders.
Prohibiting stock sales through secondary markets could land companies in legal trouble with shareholders who want to cash out, said Greg Brogger, president at SharesPost.
Last year,Abu Dhabi investment group Alpha Investments sued Zynga for restricting a share sale on SecondMarket. After former Zynga employee Andrew Trader attempted to sell $12.9 million in the company?s stock to Alpha, Zynga said it would only allow the transaction if the firm agreed not to sell the shares until 180 days after a Zynga IPO. In June, the attorney for Alpha filed to dismiss the case.
?Judges don?t like it when companies tell their shareholders that they can?t sell the shares they have bought and paid for,? Brogger said. ?The more draconian and the more unreasonable the prohibitions are, the more these companies are inviting lawsuits.?
Twitter has more than 300 million registered users who?publish more than 200 million tweets a day. Valued?at $3.7 billion after its most recent round of funding in December, Twitter makes $200 million each year, according to analysts.
While Twitter is incredibly popular, it has had some trouble finding effective ways to monetize the service. The company introduced ?promoted tweets? last year in an effort to make money and it also runs promoted trending topics.
Sources: Bloomberg, venturebeat