Unicorns, Delaware, and Private Company Financial Disclosure: When Should Companies Disclose Valuation Information to Their Owners?

Z. Christopher Mercer, ASA, CFA, ABAR, Founder and CEO of Mercer Capital, maintains a business valuation-themed blog at ChrisMercer.net.  This guest post first appeared on Chris’s blog on May 26, 2016.

What if every private company had to disclose its financial statements, stockholder list, and other information relevant to valuation to any of its shareholders upon their written request?

The Wall Street Journal reported (subscription required) yesterday that under an “obscure law,” shareholders of Delaware corporations can do just that, according to Section 220 of the Delaware Code, titled “Inspection of Books and Records.” The WSJ article discusses a number of startups with billion dollar plus valuations (called “unicorns”) who are having to open their books to small shareholders as result of their requests under Section 220.

(For more information on “unicorns” and their valuation issues, see “Unicorn Valuations: What’s Obvious Isn’t Real and What’s Real Isn’t Obvious” from Mercer Capital’s Financial Reporting Blog.)

Implications of Delaware Section 220

At issue for the smaller shareholders of the unicorns is transparency over valuation. Valuations are in question for many of these private tech companies. Many have had round after round of cash investments from venture investors, raising valuations to stratospheric heights. I wrote about the valuation of Uber recently, where, based on a financing round in October 2015, Uber’s implied equity capitalization of $51 billion exceeded that of Federal Express.

However, the market for continuing investments is tightening, with investors redirecting their managements to focus on profitability instead of just growth. The IPO market for tech IPOs is virtually shut down now, so there is continuing pressure on unicorn valuations. The WSJ noted that many mutual firms have marked down their stakes in some startups. Smaller shareholders are trying to find out what is going on.

The companies desire to keep their information private from all but major stockholders. The explanation:

Companies say keeping their financial information private, even from some stockholders, prevents it from falling into rival hands. The lack of public scrutiny also gives them freedom to invest for the long-term.

However, that game may be up for many of the tech privates domiciled in Delaware. Delaware Section 220 says, in part:

(b) Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose, and to make copies and extracts from:

(1) The corporation’s stock ledger, a list of its stockholders, and its other books and records; and

(2) A subsidiary’s books and records…(emphasis added)

The books and records of a company would certainly include its internal financial statements, audits, documentation re the pricing of financing rounds and more, including financial projections.

Delaware has always been known as a corporation-friendly domicile. According to the WSJ, the unicorns are realizing that Delaware may not be friendly for private companies that raise lots of capital, issue stock options, and end up having numerous stockholders.

All public companies must file their financial statements with the Securities and Exchange Commission quarterly (Forms 10-Q each quarter and Form 10-K at each fiscal year-end). Their rivals can certainly obtain their financial statements and all public disclosures. The required enclosures include key management compensation, customer and other concentrations, and more. There are many purposes for public company disclosure, but investor understanding, management and board accountability and more.  Perhaps the Delaware unicorns need to begin a regular quarterly reporting process, as well.

What About Private Companies Elsewhere?

Private companies are often reluctant to share their financials with all of their owners. Why is that? Do they want to keep their financials out of rival hands, as noted above? Or sometimes, do they just not want to be held accountable to all of the owners?

I’m not aware of state statutes in other states like Section 220 in Delaware. But I am an advocate of reasonable disclosure for private company owners in general. Failure to disclose reasonable financial information to all shareholders can create distrust and more. It can lead to lawsuits complaining of oppression or seeking other remedies. These litigations are expensive and disruptive for companies and shareholders. We have been involved on one side or the other in many of these lawsuits over the years.

A couple of thoughts for private business owners and for their counsel:

• Business owners. If you are not providing basic financial information to your shareholders on at least an annual basis, think about why you don’t. Your shareholders are your shareholders. Regardless of how they obtained their shares (by purchase, gift, inheritance…), your company is running based on their capital as well as yours. What rate of return are you delivering to all of your owners? What dividends are you providing? These are good questions for every business owner to address.
• Attorneys. Some of the staunchest advocates for keeping the muzzle on shareholder disclosure have been, in my experience, attorneys for companies. They often represent the corporation, and forget, sometimes, that their client corporations are owned by all of its owners, not just the one(s) in control. Why do you advocate little or not disclosure, if you do? Is it good for the company and all of its owners? Are your client companies doing a good job of delivering reasonable returns to their owners?

The unicorns domiciled in Delaware are finding that they may have to provide reasonable disclosure to all to their stockholders. I think they will find that it is good business to do so. What about other private companies with no legal requirement to disclose books and records. It might be a good idea to develop a reasonable and regular form of disclosure for all shareholders. They should appreciate it. And perhaps your company can benefit, as well, with better owner relationships.