- July 29, 2011
Tips to Sell Private Company Stock without Violating Securities Laws
Buying a minority stock interest in a small company can be as easy as singing happy birthday; selling the stock can be as difficult as performing a four-hour opera.
Stock owners holding a passive investment in a private company must first convince someone to buy shares with no market, little corporate information, almost no verified financial statements, and uncertain prospects for future returns. Adding insult to injury, sellers who violate state and Federal laws regarding stock re-sales risk lawsuits demanding at least the return of all the money paid for the stock.
In contrast, for publicly traded securities, sellers need only check the stock quote on the internet, contact a stockbroker, and clear the trade. No time, no risk, no problem.
The market for shares of private company stock differs completely. The private market has no exchanges, no annual reports to shareholders mandated by the SEC, no brokers to facilitate buying and selling shares. It is as different as selling a downtown condominium versus a farm in Siberia.
As a result of these very different markets for private versus public stock, the laws impose separate rules on sellers of investments in private companies. The Federal Securities Act governs issuance of shares by companies, and state court-made law establishes the legal standards for garden-variety fraud. If a disgruntled buyer can pass the laugh test before a judge, then both the seller of the stock and the company that has issued the shares are at risk for the return of the buyer’s money—and substantially more.
The Seven Pillars
1. Disclose Information to the Buyer. Providing information about the company is among the best inoculations against buyer claims of fraud. Sellers should provide possible buyers with reasonable information regarding the company. Though a private company usually lacks a formal annual report, the seller should share information about the company. To avoid claims that the seller blurted out company secrets, the buyer should execute a non-disclosure agreement. If the seller has a company offering memorandum in the files, it usually would be provided to the prospective buyer. The goal is to preempt claims that the seller either withheld information or made false statements to close the sale of the shares.
2. Comply with Company Shareholder Agreements. Detailed shareholder agreements, buy-sell agreements, and corporate documents such as bylaws often govern shareholders’ rights when selling stock. These restrictions range from virtual prohibitions on sales, to limited rights of first refusal. These agreements often require the seller to protect confidential company information that is disclosed to potential buyers. In addition, agreements commonly require that buyers satisfy the tax requirements for S corporation treatment for the company, which allows all company shareholders to avoid double taxation on corporate earnings. Sounds simple—however, these rules prevent most corporations, limited liability companies, many trusts, and even some individuals from holding shares. If a seller does not follow the rules, the unfortunate individual might be liable to both the company for breaching its agreement, and to the buyer for failing to deliver stock free and clear of any claims.
3. After the Initial Purchase, Wait Until Next Year. Securities laws frown upon quick sales of shares of private companies. Securities statutes and the court cases interpreting them strongly recommend that shareholders hold stock long enough to demonstrate an intent to hold the investment without an immediate interest to re-sell the shares. If a court finds that the original purchaser was merely a conduit for further share sales, the shareholder and the issuing company may suffer financial and other penalties. The general rule-of-thumb is that shareholders should hold stock of a private company for at least a year, which reduces the risk of accusations of simply being a conduit for inappropriate re-sales by the issuing company.
4. Find Purchasers Interested in Non-Cash Benefits of Buying the Stock. In the case of the stock of a Fortune 500 publicly-traded corporation, owners may re-sell the shares like any other highly liquid financial instrument. It is about returns on investment, dividends, and cashing out. However, given the extreme illiquidity of private company stock, potential buyers often must derive non-financial benefits as well. Sellers should seek buyers desiring non-cash rewards for holding shares, such as influencing a supplier or customer; or keeping the stock away from a competitor; or helping a friend of the company; or getting a chance to coach the management of the company; or buying the bragging rights of “ownership” or “partnership” in the venture. For example, buyers often enjoy boasting about owning part of a restaurant, sports team, entertainment firm, or bank.
5. Sell to Only Financially Secure Accredited Investors. Securities laws exact a harsh penalty from sellers who prey on unsophisticated widows and orphans as purchasers. Court cases and administrative policies encourage stock owners to re-sell shares to higher-net-worth “accredited” investors. These include persons who have a $1,000,000 net worth (excluding their home), $200,000 in annual income individually, or $300,000 of annual income with the purchaser’s spouse. In addition, buyers should certify their financial experience and sophistication. While hardly a standard befitting Bill Gates, this minimum threshold protects sellers from claims that they duped an unsophisticated and unqualified amateur into buying low-value stock.
6. Sell in Larger Dollar Increments. Sellers face smaller risks when selling in larger amounts. Securities laws frown upon a stockholder who subdivides investments into low-dollar increments for many buyers. In securities law, perception is reality. Even if a stockholder’s intent is pure, if actions appear otherwise, the investor may be cited for violating state or Federal statutes. For the selling stockholder, this means avoiding parceling out the investment in small low-dollar increments to unsophisticated investors. As a rule-of-thumb, sales below $25,000 are a huge red flag. Sales of more than $50,000 are better, but raise questions. A safer floor would be $100,000, which is an amount of money that few ordinary investors would not take seriously when purchasing a speculative illiquid investment. By selling in larger increments, the buyer cannot complain later that the re-sale was simply a ruse to subdivide a larger block of shares into small increments to pawn off to unsuspecting innocents with little money and less investing experience. In the hands of a plaintiff’s lawyer, such a re-sale would be an attempt to circumvent limits on private company sales to a large number of purchasers. As a result, a successful claim in court might entitle the purchasers to their money back, with interest and sometimes other fees.
7. Require Purchasers to Hold Shares and Keep Quiet. The investor reselling shares should require the purchaser to sign contracts similar to shareholder agreements in a private offering. Also, confidentiality agreements protect sellers from accusations that they recklessly endangered company secrets. Covenants should restrict re-sales of shares and require holding the stock as a long-term investment, with no intent of short-term flipping. The fine print of securities laws also requires some effort by the sellers to ensure that the purchaser is not an “underwriter”—be it a Wall Street investment bank or a neighbor who unwittingly resells shares too quickly and bursts open a piñata of securities liabilities. These restrictions need not last forever, but usually at least a year to prevent sales that trigger legal problems for the buyer, the seller and the company.
Selling with Safety
No checklist can bulletproof a securities deal from a complaint and accusation of legal non-compliance. However, by following these basic rules, holders of stock in a private company can significantly reduce the legal risks when disposing of the investment. In the end, the stockholder should focus on the business risks of the investment, not the legal risks and fine print of securities laws.
For more information on venture capital or securities law, please contact Craig McCrohon at 312/840-7006 or email@example.com.