Paul Boutin on Reforming Rule 501

by Reihan Salam

The latest issue of Wired contains a brilliant and perhaps unintentional defense of the free market from Paul Boutin, one of my favorite technology writers. As Boutin explains, companies that haven’t gone public can engage in pre-IPO equity sales. But, rather perversely, only the very wealthy can take part. The number of shareholders is limited to 500, yet employees can be granted restricted stock units that serve as a proxy for shares. The restricted stock units can then be traded privately. 


Pre-IPO sales are limited to “accredited investors,” people with a demonstrated net worth of $1 million or a yearly income of $200,000. It’s been that way since 1982, when Rule 501 of Regulation D of the Securities Act went into effect. The measure was intended to protect less-informed investors—widows and orphans, in Wall Street parlance—from gambling away their savings. So who hasbought pre-IPO Facebook stock? A reported 10 percent of the company went to the Russian investment group Digital Sky Technologies, whose backers include one of that country’s richest oligarchs. In other words, the extremely wealthy.

Today, Rule 501 does less to protect widows and orphans than it does to prevent risk-savvy investors from playing the secondary market. 

Congress tried to make the requirements even more restrictive in the new financial reform bill, but the plan was abandoned after the Angel Capital Association denounced the plan, which would have devastated their ability to raise start-up capital. Boutin ends with the following:

It’s time to lower the bar: The pre-IPO market should let everyone in. Today’s Internet stock rockets are social networks built by the active participation of their members. Preventing Facebook users from buying a stake in the company they helped create is an injustice. These millions of people should be able to take part in the financial ups and downs of Facebook, Zynga, and whatever comes next. I’m not saying it will reverse the recession. But at least the masses could once again play a role in America’s thrillingly adventurous startup economy without having to land a job at Twitter.

My only objection is that Boutin frames his argument too narrowly. He is right to wonder why a person with $800,000 in assets, or for that matter $60,000 in assets, shouldn’t be allowed to make a bet on Zynga. But this logic should extend well beyond investing in firms with a participatory bent. If you have the money, you should be allowed to take the rest. The case for insisting that homeowners make a substantial down payment before receiving a government-backed mortgage, in contrast, is about protecting the interests of taxpayers.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.