In years past, a private company stockholder would have expected to wait until the company went public or was acquired to receive any return on investment. However, over the last several years, stockholders in many private companies have been able to sell their shares in so-called secondary sales, in which they sold all or a portion of their shares for cash, long before (and regardless of whether) the company ever goes public or is acquired. Sometimes these secondary 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 people, often in connection with a company financing. We refer to this sort of company-sponsored transaction as a “liquidity transaction” in this article.
This article discusses several considerations that a private company should take into account when deciding whether to engage in, and how to structure, a liquidity transaction. In addition, long before a private company is at the point when such a transaction is feasible, there are steps that should be considered in order to enable the company to have some degree of control over secondary sales occurring outside of company-sponsored transactions down the road. These topics are summarized in turn below.
How is a liquidity transaction structured?
Company-sponsored liquidity 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 standalone 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 liquidity transaction to current employees of the company, to provide a reward for their years of effort and value creation. 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 liquidity transaction?
As with any securities transaction, you should consult with the company’s legal and tax advisors in advance, to ensure that all required approvals are obtained, to determine the appropriate tax, reporting and withholding requirements and to prepare documentation appropriate for the transaction structure. The following table summarizes some of the legal considerations that a U.S company considering a liquidity transaction should take into account.
|Disclosure: As with any transaction involving stock, the parties may have liability for failure to disclose relevant material, nonpublic information to the other parties. This is particularly important when the sellers do not have board-level information about the company. Whether the company has any liability exposure will depend on the degree of company involvement and the relevance of any undisclosed information.
|Tender offer: Depending on the number of sellers and other factors, the transaction may need to be structured according to the SEC’s Regulation 14E (e.g., offer kept open for 20 business days).
|S-1 disclosure: Transactions occurring between the company and its officers, directors and other affiliates within the three years prior to the IPO must be disclosed in the related-party transactions section of the company’s 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 and California) 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.
|409A: The degree to which any transaction, regardless of structure, will have an impact on the company’s 409A valuation will depend on the terms of the transaction, 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, but give them a fairly low weighting as compared to the other valuation methodologies they employ.
|Capital Gains: 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 price. The difference may need to be taxed as ordinary income (i.e., as if they were 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, depending on the facts. In addition, depending on the facts, a company buyback may need to be taxed and reported as a dividend. If the selling stockholders are not in the U.S., special tax withholding and reporting obligations may apply.
|QSBS: A company’s buyback of shares may impact whether or not 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. To learn more about QSBS, click here.
|Consideration should be given to whether or not the transaction requires a “Hart-Scott-Rodino” antitrust filing, which involves significant time and effort and a large filing fee, but substantial penalties if missed. This comes up most often in a third party purchase by an investor that already holds a substantial amount of shares in the company.
|If any of the purchasers are non-U.S. parties (or have non-U.S. owners or shareholders), and as part of the transaction may be afforded certain information or governance rights (e.g., board representation or observer rights, or access to company decision-makers or sensitive company information), it is possible that a “CFIUS” filing could be required. For more information on CFIUS, click here.
|If you will be having non-U.S. employees selling shares in the transaction, the transaction will need to comply with the 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 secondary transactions in my company’s shares down the road?
- 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.
- 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.
- Set Stockholder Expectations. In a company’s early years, it is unlikely that employees and investors will be clamoring to sell their shares. A private company tends to feel pressure to provide liquidity to its stockholders as the company increases in value or if the company ends up remaining private for many years. Whether you decide to engage in a liquidity transaction or 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.