If you are considering the sale of private company shares, the following seven tips are important.
Selling publicly traded securities requires only a call to a stockbroker or the click of a mouse. In contrast, private company shares have no exchanges, no SEC annual reports, and no brokers to facilitate buying and selling shares. If considering the sale of private company shares, the following seven tips are important:
1. Disclose Information to the Buyer. Providing information about the company is among the best inoculations against buyer claims of fraud. Sellers should provide buyers with information regarding the company in lieu of an often unavailable annual report. To avoid claims that the seller released company secrets, the buyer should execute a non-disclosure agreement to preempt claims that the seller either withheld information or made false claims to close the sale of the shares.
2. Comply with Company Shareholder Agreements. An assortment of detailed agreements and bylaws often govern shareholders’ rights when selling stock. 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 company shareholders to avoid double-taxation on corporate earnings. However, these rules can also prevent many types of investors from holding shares. If a seller does not follow the rules, they might be liable for breaching company agreement and for failing to deliver claim-free stock.
3. After the Initial Purchase, Wait Until Next Year. Securities statutes strongly recommend that shareholders hold stock long enough to demonstrate intent to hold the investment without an immediate interest to re-sell. The general guideline 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 corporation, owners may re-sell the shares like any other highly liquid financial instrument. 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, keeping the stock away from a competitor, or getting a chance to coach the management of the company.
5. Sell to Only Financially Secure Accredited Investors. Securities laws exact harsh penalties from sellers who prey on unsophisticated investors. 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, $200,000 in annual income individually or $300,000 of annual income with their spouse. Additionally, buyers should certify their financial experience and sophistication. This minimum threshold protects sellers from claims that they sold low-value stock to an unsophisticated investor.
6. Sell In Larger Dollar Increments. Sellers face smaller risks when selling in larger amounts. Securities laws penalize a stockholder who subdivides investments into low-dollar increments As a result, a successful claim in court might entitle the purchasers to their money back.
7. Require Purchasers to Hold Shares and Keep Quiet. The investor reselling shares should require the purchaser to sign agreements similar to shareholder agreements in a private offering. These 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. The fine print of securities laws also requires some effort by the sellers to ensure that the purchaser is not an “underwriter”. These restrictions should last at least a year to prevent sales that trigger legal problems for the buyer, the seller, and the company.
Craig McCrohon specializes in corporate, securities, and mergers and acquisitions law at Burke, Warren, MacKay & Serritella in Chicago. He advises companies and investment funds regarding mergers and acquisitions, corporate transactions, director and officer liability, corporate finance, and financial institution regulatory and acquisition matters. His work has included bank organization and acquisitions; venture capital; securities offerings; and domestic, European, and Asian joint ventures. For more information, contact McCrohon at 312/840-7006 or [email protected].