What is the ‘500 Stockholder Rule’?

Co-author, Kate Nichols

Late-stage private companies sometimes ask us about the “500 stockholder rule” (or the “2,000 stockholder rule”) and whether they should be concerned about it. Companies subject to US securities laws may have special obligations if they exceed certain numbers of stockholders. However, these requirements typically do not apply to private companies – even those with a large stockholder base. Below is an overview of the rule and why it does not affect most private companies.

Background: Public versus private company reporting requirements

Under the US Securities Exchange Act of 1934 (1934 Act), public companies must file quarterly and annual reports, as well as reports of certain corporate events, with the Securities and Exchange Commission (SEC). These filings are publicly available and represent a significant ongoing compliance obligation. Generally, a company only begins making these filings after an initial public offering (IPO), special purpose acquisition company (SPAC) transaction or direct listing, when it has consciously decided that the benefits of going public outweigh the costs. Private companies are generally not subject to these reporting requirements, with an exception covered below.

Section 12(g) of the 1934 Act

Section 12(g) of the 1934 Act requires a company to register its equity securities with the SEC – and thereby become subject to public company reporting requirements – if, at the end of its fiscal year, it has: Total assets exceeding $10,000,000 and a class of equity securities held of record by either 2,000 or more persons in total or 500 or more persons who are not accredited investors under US securities law.

If a private company crosses both the asset threshold and either of these equity holder thresholds, it must comply with public company reporting obligations, even if it has not undergone an IPO, SPAC transaction or direct listing.

Key exceptions and qualifications

Thankfully for many late-stage private companies, there are important exceptions and qualifications to the thresholds in Section 12(g). In particular:

• Employee compensation plans: The 2,000- and 500-person limits generally exclude holders who received securities under an employee compensation plan. This means that service providers who receive shares and options granted under standard equity incentive plans generally do not count toward these limits. This exception is particularly important for late-stage private companies that may have issued options to hundreds or even thousands of employees, advisors and consultants under such plans. Note, however, that transferees/buyers who acquire securities that were originally issued under such plans in a secondary transaction (e.g., a tender offer or sale/transfer of shares) will likely count toward the limits – notwithstanding the fact that the transferor/seller themself did not count against the limits.
• Separate counting of stock classes: Different classes of capital stock are counted separately for purposes of the limits. For example, preferred stock is not combined with common stock for this purpose – each class is subject to its own 500- and 2,000-person limits, making it less likely that the company will exceed the threshold for any individual class of its equity securities. Of course, if a company undertakes a recapitalization or other transaction that causes all of its preferred stock to convert into common stock, then it would need to analyze its new “recapped” cap table to understand how the resulting class of common stockholders would stack up against the limits of Section 12(g).

Practical implications for private companies

Even though the requirements of Section 12(g) do not apply to most private companies, the consequences of inadvertently triggering public company reporting requirements would be severe. Companies with a large stockholder base should monitor their cap table and consult with legal counsel to ensure they do not unintentionally cross these thresholds.