The US secondary market for private company stock has exploded nearly 3,200% in the last several years!  Longer lead times to an IPO, more companies becoming profitable faster and the weakness of the public equity markets are all touted as reasons why (See the FT’s recent article on “The New Stock on the Block” - The article reports that the number of venture backed IPOs from a decade ago have shrunk nearly 93.7% ,whoa!). 

The article makes for excellent reading, and I will not rehash its contents.  Rather, I’m going to focus on the efforts by lawyers like myself to curb the ability of holders of stock of emerging companies to resell their founder’s stock or vested options to third parties in a private transaction before the company’s stock is available on the public market.  Why do we do this?   To control your shareholder base, after all, as an emerging company the last thing you want (as the founding/executive team) is to be dealing with a belligerent activist shareholder.  There are some other side benefits to this as well.  Keep reading for more...

Putting aside securities laws and requirements aside for purposes of this discussion, almost every agreement granting stock or stock options I have ever drawn up for a client has involved some sort of restriction on transfer.  One of them in particular is the “Right of First Refusal” which applies to the restricted stock, and the stock granted under stock options until the company’s shares are registered on the public market. 

A right of first refusal gives the company the ability to buy back the shares that a seller is contemplating selling to a third party.  The process usually involves the seller of the private stock approaching the company once he/she has received a good faith offer for his/her shares from a third party.  The potential seller must divulge the identity of the third party, the number of shares offered for sale and the price offered for such shares.  The company then has a set period to decide if it wants to purchase the shares at the price offered.  The company also has additional time to raise/arrange for the funds if it does decide to make the repurchase.  To top it all off, the shares that are transferred to the third party might STILL subject to the right of first refusal and potentially even further restrictions that the original shares might have been subject to, for example if the stock was initially granted subject to a voting rights agreement. 

It might be an understatement to say that all of this has a chilling effect on any transactions in the private company stock market.  For one, any potential outside buyer would have to be aware, or would quickly be aware of the company’s right of refusal and right to match any offer made by them.  Imagine for a second you make an offer on interesting stock only to be told that not only does the company  have the right to match that offer once all the particulars of your offer have been divulged but also that they have 30 days to consider if they want to match such an offer.  Unless we are talking about a Facebook or Zynga, chances are most suitors would probably say, “Forget I ever made an offer.”

Why make this process of selling the company’s private stock so difficult?  As hinted before, we don’t want the company to lose its ability to control its stockholder base while the stock is not publicly listed.  Sure, the stock was offered in consideration of work or investments of some sort, but they still have strings attached.  Directors answer to shareholders and in effect shareholders (in the majority) influence the direction of the company.  Activist shareholders, even those with minority stakes, that have goals for the company that are at odds with those of the founding team can be a giant pain to deal with (read: expensive in terms of time, money and distraction).  The right of first refusalin effect gives the company some control on whom its shareholders are.  Equally important, it allows the company to control the number of shareholders it has since having more than 500 shareholders might require registration as a Public company under the 1934 Securities Act.  The rights of first refusal also facilitates two signaling factors that might be valuable to the company: a) the identity of a potential suitor (you want to know who is interested in purchasing stock in your company) and b) the perceived value of the shares of the company in the market (and hence by some extrapolation the perceived value of the company, though only in the eyes of one potential suitor).  As the old adage goes – “something is only worth what someone else is willing to pay for it.”  Having someone make a bid for the private stock of a company can help determine what the value of the company to an external player, which can be invaluable when considering corporate strategy decisions (read: expansion, mergers, acquisitions etc.)

The right of first refusal, one could argue, helps balance the desire of stockholders for liquidity with the company’s desire to control its stockholder base, while still delivering some fringe benefits to the company.