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Q17. What Do I Need to Know About Buying and Selling Shares of Private Company Stock?

Stockholders in many private companies are increasingly participating in “liquidity rounds,” also known as secondary sales, where they sell shares of stock for cash before the company goes public. There are many factors that a holder or a private company should consider when deciding if and how to structure this type of transaction. Will a liquidity transaction help a company retain key talent, or is it enabling its own demise by helping its key talent achieve an early exit? Is it fair to those who are participating and those who are not given access? There are also specific steps a company can take to control secondary transactions in its stock in the future.

The following is a brief legal guide to key considerations in buying and selling shares of private company stock in liquidity rounds.

Liquidity transactions can be structured as a buyback of shares by the company—funded by balance sheet cash or cash from an equity financing. Alternatively, the transaction might be structured as a direct purchase of shares by a third party, pairing the purchase with a company’s primary equity financing or even as a standalone transaction. In a company-sponsored transaction, the company must decide the limits and the stockholders that can sell shares.

Just like with any securities transaction, it’s wise to consult with the company’s legal and tax advisors to be sure that all required approvals are received, determine the appropriate tax, reporting, and withholding requirements, and prepare the right documentation. Other important legal considerations must be considered, including what disclosures are made by the seller to the buyer, and who knows what at that time. Will the information about the issuer leak to competitors or cause damage if learned by customers? These concerns can be accentuated in a tender offer by a company or a third party to holders. What will be said in a future S-1 filing about the transaction? How will the transaction impact a company’s prior or subsequent determination of the fair market value of its common stock for purposes of making future equity grants (e.g., the “409A value”)? What capital gains will be reported? How will such a transaction impact the federal tax-free status of the shares under Section 1202 of the Internal Revenue Code, commonly referred to as “QSBS rules?”

Just as with any transaction involving stock, the parties may be liable for disclosing relevant material and nonpublic information to the other parties (or for failing to make the disclosures). This is critically important when the sellers do not have board-level details about the company. Whether the company has liability exposure will depend on its involvement and the relevance of any undisclosed information. Making disclosures to potential buyers can trigger leaks to competitors, customers, suppliers, or other ecosystem players that could be dangerous to the issuer of the stock.

When secondary purchases are made via a “tender offer,” depending on the number of sellers, the transaction may need to be structured to comply with certain components of the SEC’s Regulation 14E.

Moreover, transactions occurring between the company, its officers, and others within the three years prior to the IPO must be disclosed as related-party transactions in the company’s IPO filing on Form S-1. A third-party purchase not involving the company could be required to be disclosed depending on its materiality. Some states, including Delaware and California, have statutory balance sheet tests limiting the amount of capital that a company can use to buy its shares.

The degree to which any transaction will impact the company’s 409A valuation depends on the terms of the transaction, the parties’ identities, the transaction size, and the valuation firm’s methods.

A purchase of shares priced above what the company’s board of directors otherwise considers “fair market value” of the common stock creates the risk that current or former employees or service providers selling shares won’t be able to claim capital gains treatment on 100 percent of the sale price. So, the difference may need to be taxed as regular income, and then the company may have a withholding obligation.

A company’s buyback of shares may impact whether the shares held by other stockholders qualify as QSBS for federal income tax. A third-party purchase will not have this impact, but the shares purchased won’t be eligible as QSBS. Therefore, consideration should be given to whether the transaction requires a “Hart-Scott-Rodino” antitrust filing, which involves much effort and a hefty fee.

How do you ensure your company has control over secondary transactions in shares in the future? It would help if you considered implementing a “right of first refusal” over your company’s stock transfers. Common stock can be subject to a right of first refusal, which provides the opportunity to purchase shares that a stockholder proposes to sell to a third party. The right of first refusal is usually contained in the company’s bylaws, so it automatically applies to all shares issued after the bylaws are adopted. This is a useful way to control stock ownership to the extent that the company or its assignee can spend the necessary funds to purchase the shares. If not, the shares can be sold to the proposed buyer.

A private company tends to feel pressure to provide liquidity to its stockholders as its value increases. So, whether you decide to engage in a liquidity transaction or permit your stockholders to sell while the company is private, setting your stockholder expectations both early and clearly can go far. Getting the details right will save you legal, accounting, HR, and tax headaches that are imminently avoidable.

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