As Private Market Booms, SEC Considers Private Firm Reporting Requirements

While the dust settles on the recent trial of Elizabeth Holmes, former CEO of Silicon Valley startup Theranos, attention is building around the Securities and Exchange Commission’s current and future role in regulating private firms.

Under existing federal law, private firms with less than 2,000 shareholders are not required to register with the SEC nor provide routine disclosures, unlike their public counterparts. [1]

While exemption from such regulatory requirements may provide private startup companies with the freedom to develop their business unimpeded by government, thus encouraging valuable innovation, the rapid growth of the private capital market has experts questioning whether some degree of SEC oversight may be warranted.

In fact, during her remarks at the “SEC Speaks in 2021” event held in October 2021, SEC Commissioner Allison Herren Lee signaled that the regulatory body is in the beginning stages of evaluating whether they may indeed have an obligation to consider “address[ing] the reduced transparency in U.S. equity markets” brought on by private market growth. [2]

So, what exactly does recent growth in the private market look like? To start, over two thirds of the capital currently being raised is being raised privately, in essence dwarfing that which is raised publicly. [3] What’s more, the number of “unicorns,” or private companies with valuations of more than $1 billion dollars, has skyrocketed from just 40 in 2013 to over 900 today. [1],[4]

But why does this explosive growth matter to the SEC, or even to the average investor?

According to Commissioner Allison Herren Lee, the shift of capital from public to private markets is akin to a large swath of the market, and thus the economy, “going dark.” [2] As private companies continue to raise billions of dollars from investors without any true pressure to go public, the rest of the world, and even the company’s investors themselves, remain largely in the dark about the company’s true operations and financial position. [2]

This lack of transparency poses risks not only to wealthy individual investors and employees who hold equity in the private firms for which they work. There are also risks to those whose retirement assets are invested indirectly in private markets through institutional investors. [2]

Furthermore, the sheer size of the private market and its continued growth poses other systemic issues, including the possibility of obscuring climate change or other Environmental, Social, and Governance (ESG) risks that these companies face or perpetuate. [2]

The Theranos saga is illustrative of some of the myriad risks posed by unicorn companies in the absence of regulatory requirements from the SEC. Theranos was a company which purported to have produced a “portable blood analyzer” which would “revolutionize the blood testing industry,” though in actuality the product did not function as was represented. [5]

Ultimately, Theranos and its management were charged by the SEC for making false statements about their business and technology in violation of the anti-fraud provisions of federal securities laws. [5] Theranos had raised more than $700 million from private investors and venture capitalists, and while its value topped $10 billion in 2015, it was completely liquidated, and worthless, by 2018. [6]

The lesson here is evident – as capital continues to shift from public to private markets, investors are at greater risk of falling prey to a fraudulent scheme like that of Theranos, and the broader economy may well feel the aftershocks. When private startups raise large sums of money in the absence of mandated SEC disclosures, their value may well be inflated, and investors may not find out until their money is already lost.

While the SEC is still in the early stages of considering new reporting requirements for large private firms, this is a key area for investors to keep their eyes on in the coming months.

Sources: [1] https://www.wsj.com/articles/sec-pushes-for-more-transparency-from-private-companies-11641752489 [2] https://www.sec.gov/news/speech/lee-sec-speaks-2021-10-12#_ftnref20 [3] https://www.forbes.com/sites/anatalonbeck/2021/10/15/going-dark-the-explosive-growth-of-private-markets-and-other-thoughts-on-sec-commissioner-lees-remarks/?sh=63ed2b9d21c0 [4] https://www.cbinsights.com/research-unicorn-companies [5] https://www.sec.gov/news/press-release/2018-41 [6] https://www.investopedia.com/articles/investing/020116/theranos-fallen-unicorn.asp#:~:text=the%20same%20day.-,Theranos%20Inc.%2C%20a%20consumer%20healthcare%20technology%20startup%2C%20was%20once,venture%20capitalists%20and%20private%20investors.