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 participated in so-called “liquidity rounds”, sometimes referred to as 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.
There are several considerations that a private company should take into account when deciding whether to engage in, and how to structure, such a 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 transactions in its stock 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 buyback of shares by the company, funded either with balance sheet cash or cash provided from a recent equity financing. Alternatively, the transaction may be structured as a direct purchase of shares by a third party, either paired with a primary equity financing of the company or as a standalone transaction.
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 sell. 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 his or her 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 company considering a liquidity transaction should take into account.
Click here to view table.
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 often 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.
- 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.