Structuring Secondary Sales of Private Company Stock

Description

Early-stage companies are generally closely or privately held, and underlying shares are neither registered with the SEC nor listed on a securities exchange. With companies remaining private longer, startup founders and employees may have equity securities of substantial value on paper and no easily accessible market in which to sell them. Properly structured, a secondary sale can provide private company shareholders with the desired liquidity without a public or private offering.

Company-sponsored transactions are often structured as a buyback of shares by the company. Alternatively, the transaction may be structured as a direct purchase of shares by a third party. The company will need to decide how involved to be in the sale, and if involved, the Company may want to direct which stockholders may sell their shares and what limits, if any, to place on those who sell and those who buy. It has become increasingly common for bylaws to require board approval of secondary transactions. A right of first refusal is also a useful device for controlling such transfers, to the extent that the company is willing and able to exercise it.

The transfer of securities must comply with applicable federal and state securities laws. It is essential that secondary sales not be viewed as an underwritten offering of securities by the company. Relevant to the analysis are such factors as how long the seller has held the stock, availability of pertinent information to a buyer, and whether the buyer is an "accredited investor." In addition, certain secondary sales could be subject to timing and disclosure requirements as a regulated tender offer.

A purchase of shares at a price above what the company's board of directors otherwise considers "fair market value" creates a 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 (and sometimes as if they were wages). As a result, the company may have withholding obligations. This risk is particularly acute if the company is the purchaser, but can apply even if the purchaser is a third party.

Listen as our authoritative panel discusses these and other issues associated with secondary sales of privately held stock.