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Historically, private company stockholders would be expected to wait until the company went public or was acquired to receive any return on their investment. Over the last several years, however, stockholders in many private companies have been able to sell all or a portion of their shares for cash before (and regardless of whether) the company goes public or is acquired. Sometimes these sales are part of company-sponsored transactions in which the company or one or more investors offers to purchase shares from a broad group of equity holders, often in connection with an equity financing. We refer to this sort of company-sponsored transaction – regardless of the identity of the buyers – as a “secondary transaction” in this article. Sometimes people will refer to these transactions as “private company tender offers,” or just “tender offers,” but that is a bit of a misnomer. “Tender offer” captures many sorts of transactions not discussed in this article (in particular, certain types of M&A transactions), and not all private company secondary transactions need to be treated as tender offers under the federal securities laws.
This article discusses several items that a private company should consider when deciding whether to engage in – and how to structure – a secondary transaction. In addition, long before a private company is at the point when a secondary transaction is feasible, there are actions that it should consider to enable the company to have some degree of control over secondary sales occurring outside of company-sponsored transactions. These topics are summarized in turn below.
How is a secondary transaction structured?
Company-sponsored secondary transactions are often structured as a direct purchase of shares by one or more investors, either paired with a primary equity financing of the company or as a stand-alone transaction. Alternatively, these transactions may be structured as a buyback of shares by the company, funded with cash on hand, often provided from a recent equity financing.
In a company-sponsored transaction, the company will need to decide which stockholders may sell their shares and what limits, if any, to place on those sales. For example, it is not uncommon to limit a secondary transaction to current employees of the company and to limit the offer to those employees who have sufficient vested holdings to make the offer worthwhile. This has the added benefit of providing employees who have helped with company value creation with some opportunity for liquidity for their efforts. In that scenario, it is fairly typical to limit the amount any one employee may sell to a small percentage of their vested shares (e.g., 10%) to ensure that the employee continues to have meaningful equity incentives going forward.
What are the legal issues a company should consider when structuring a secondary transaction?
As with any securities transaction, companies should consult with their legal and tax advisers in advance to ensure that all required approvals are obtained, determine the appropriate tax, reporting and withholding requirements, and prepare documentation appropriate for the transaction structure. The following table summarizes some of the legal considerations that a US company considering a secondary transaction should take into account.
| Securities law | Disclosure: As with any securities transaction, companies should consult with their legal and tax advisers in advance to ensure that all required approvals are obtained, determine the appropriate tax, reporting and withholding requirements, and prepare documentation appropriate for the transaction structure. The following table summarizes some of the legal considerations that a US company considering a secondary transaction should take into account. |
| Tender offer: Depending on the number of sellers and other factors, the transaction may need to be structured according to the Securities and Exchange Commission’s Regulation 14E (e.g., offer kept open for 20 business days). | |
| S-1 disclosure: In an initial public offering (IPO), transactions occurring between the company and its officers, directors and other affiliates from the beginning of the three most recently completed fiscal years until the time of the IPO must be disclosed in the related-party transactions section of the company’s registration statement on Form S-1. Whether a third-party purchase not involving the company will need to be disclosed will depend on its materiality. | |
| Corporate balance sheet tests | Many states – including Delaware – have statutory balance sheet tests limiting the amount of capital that a company may use to buy its own shares. These restrictions would not apply in a third-party purchase. |
| Tax |
Secondary transactions bring with them many tax-related issues and risks. It is critical to bring in the company’s tax advisers early in the process of designing any secondary transaction to mitigate these risks and ensure the transaction has the company’s desired tax treatment. Some of these issues include:
409A: The degree to which any transaction, regardless of structure, will have an impact on the valuation of the company’s common stock will depend on the terms of the transaction, the securities being purchased, the identity of the parties, the size of the transaction and the methodologies used by the company’s valuation firm. Typically, valuation firms will take such transactions into account when determining the value of the company’s common stock, but how much weight to give the transaction will vary based on a number of factors – in particular, the number of secondary transactions in which the company has previously been engaged. |
| Tax Treatment: A purchase of shares at a price above what the company’s board of directors otherwise considers “fair market value” of the common stock creates risk that current or former employees or service providers selling shares will not be able to claim capital gains treatment on 100% of the sale proceeds. Some portion may need to be taxed as ordinary income (i.e., as if it constituted wages), and as a result the company may have a withholding obligation. This risk is particularly acute if the company is the purchaser, but can apply even if the purchaser is a third party. In addition, a company buyback of shares may need to be taxed and reported as a dividend. If the selling stockholders are not in the US, special tax withholding and reporting obligations also may apply. | |
| QSBS: A company’s buyback of shares may impact whether the shares held by other stockholders qualify as qualified small business stock (QSBS) for federal income tax purposes. A third-party purchase will not have this impact, but the shares purchased will not qualify as QSBS. Learn more about QSBS. | |
| Inclusion of private company RSUs: It is common in secondary transactions to include some shares that may be issued upon exercise of employee stock options. If a company has shifted its equity compensation program from options to restricted stock units (RSUs), it may wish to begin including shares issuable upon settlement of these RSUs as well. Private company RSUs are often structured with two conditions (time and liquidity) – both of which must be satisfied for the RSUs to vest and the shares to be delivered. The “liquidity event” condition typically includes a change in control or IPO to ensure employees are incentivized to help the company achieve a liquidity event, which results in employees not being taxed before there is a liquidity opportunity for those shares. Thus, in order for RSUs with a liquidity event vesting condition to participate in a secondary transaction, the company’s board of directors must waive all or a portion of the liquidity event condition. Waiving the liquidity event condition typically results in vesting of the RSUs and triggers the obligation to deliver shares in respect of vested RSUs, leading to immediate income taxation and withholding requirements with regard to the shares delivered. It also is important to keep in mind that under current federal income tax laws and existing market practice, there is a lack of clarity as to whether waiving the liquidity event condition may jeopardize the company’s ability to rely on the occurrence of a liquidity event as a “substantial risk of forfeiture” for federal income tax purposes going forward. Many practitioners are skeptical a company can engage in this sort of waiver more than one time. | |
| Antitrust | Consideration should be given to whether the transaction requires a Hart-Scott-Rodino antitrust filing, which involves significant time and effort and a large filing fee – and substantial penalties if missed. This comes up most often in a third-party purchase by an investor that already holds a substantial number of shares in the company. For more information on antitrust considerations in secondary sales, see this Cooley Go article. |
| Committee on Foreign Investment in the United States (CFIUS) | If any of the purchasers are non-US parties (or have non-US owners or shareholders), and as part of the transaction may be afforded certain information or governance rights (e.g., board representation, observer rights, or access to company decision-makers or sensitive company information), it is possible that a CFIUS filing could be required. Learn more about CFIUS. |
| Non-US laws | If non-US employees will be selling shares in the transaction, the transaction will need to comply with applicable tax withholding, tax reporting, employment law, securities law and other legal requirements of the jurisdictions in which the employees reside. |
What should I do to ensure my company has some control over stock sales outside of company-sponsored transactions?
1. Right of first refusal
First, you should consider whether to implement a “right of first refusal” over transfers of your company’s stock (if one is not already in place). A private company’s common stock is often subject to a right of first refusal, which gives the company the opportunity to purchase shares that a stockholder proposes to sell to a third party. The right of first refusal is sometimes contained in the company’s bylaws, in which case it automatically applies to all shares issued after the bylaws are adopted. Alternatively, or in addition to this, a right of first refusal can be included in the company’s option award agreements or other contracts.
2. Board approval right
A right of first refusal is a useful device for controlling ownership of stock only to the extent that the company or its assignee is willing and able to spend the necessary funds to purchase the shares. Otherwise, the shares can be sold to the proposed buyer. As secondary transactions have increased in popularity, and valuations have grown, it has become increasingly common for bylaws to have a separate requirement for board of directors’ approval of any transfer – with only limited exceptions, such as estate-planning transactions. Board decisions to permit or not permit transfers based on such bylaw provisions should be informed and determined in good faith to be in the best interest of the company’s stockholders.
3. Set stockholder expectations
In a company’s early years, it is unlikely that employees and investors will have an expectation or desire to sell their shares. A private company tends to feel pressure to provide liquidity to its stockholders as the company increases in value – and the longer the company remains privately held. Whether you decide to engage in a secondary transaction, permit your stockholders to sell while the company is private, or instead require them to wait it out until an IPO or M&A event, setting your stockholder expectations early, clearly and consistently can go a long way.
Last reviewed: August 23, 2024
