Be Careful With Those Shares!

Source: Dan Shmalo, 360 Venture Law

In the early stages, growth companies often sell shares of stock (or units, or membership interests, or…) too readily. Raising money is probably the most difficult task for an early stage company, and it often leads entrepreneurs to ask “friends and family” for money. But, as they become successful, such companies will often layer on various classes of preferred stock. Growth companies and their investors should be wary of the pitfalls that may follow. Although these share issuances may comply with federal and state securities laws, a large number of shareholders can complicate an exit.

As time passes on the way to an exit event, stock issuances can add up. Investors may grow impatient for liquidity and may want to sell their shares. Employees may exercise options (if there is a very low strike price), and if there are no constraints imposed by the option plan and/or shareholder agreements, employees and investors may attempt to sell their shares. In today’s market, the path to liquidity for growth companies is fairly long (most studies show 7-10 years on average). Over that period of time, such companies can often find that their shareholder base has grown substantially and that many of their shareholders are nonaccredited.

What’s the Problem?

In a potential sale of a company, a large corporate buyer may prefer to use stock instead of cash to make the acquisition. Most buyers (whether privately held or publicly traded) will wish to consummate the acquisition quickly and cheaply, which, in the case of a stock-for-stock exchange or merger, means that the buyer will likely propose issuing its shares pursuant to a private placement exemption rather than in a registered offering (SEC registration).

This is the point where a company’s management (or lack of management) of its shareholder base can become critically important. The shares to be issued by the acquirer in a stock-for-stock acquisition will only qualify for a private placement exemption if the number and nature of the target’s stockholders make the private placement available — which for most transactions will require (under Rule 506) that there be no more than 35 nonaccredited target shareholders. In the event that the target company has not closely monitored its shareholder base, and if, at the time of the transaction, more than 35 of the target company’s shareholders are nonaccredited investors, the acquirer’s desired acquisition structure may become more complicated. This is the so-called “widely held private target problem.”

There are ways to ameliorate the widely held problem (e.g. registered shares as consideration, different compensation for unaccredited, fairness hearing), but the details of these solutions are beyond the scope of this article.

What Should a Growing Company Do?

There is no magic formula that will enable all growth companies to avoid road blocks, or speed bumps, at the exit event.  Even with the best planning and advice, certain things are outside of a company’s control, and financing needs and other considerations often override these potential issues. Nonetheless, here are a few pointers that growth companies and their investors should consider as they develop their capital-raising and equity incentive strategies.

Do not issue securities to unaccredited investors.

If possible and practical, growth companies should only sell securities to accredited investors. This is standard advice from an experienced corporate/securities lawyer, but the number of times in practice that this is ignored (out of ignorance or otherwise) or not heard (by lawyer-free entrepreneurs) by growth companies is staggering.

Restrict the transferability of equity in shareholder agreements. Growth companies should closely manage their shareholder agreement provisions that restrict the transfer of shares (for example, by providing a right of first refusal (see below) and by providing that investors cannot transfer shares except in compliance with applicable securities laws). Growth companies can significantly impede the expansion of their shareholder bases by including mandatory notice requirements in such provisions, and by closely monitoring all transfers to ensure they are made in compliance with securities laws. As typically drafted, these provisions give a private company some leeway in determining whether a proposed transfer is being made pursuant to a valid exemption and may provide a company with a legitimate basis to discourage transfers to unsophisticated (or nonaccredited) investors.

Adopt a detailed equity incentive plan and manage it closely.

To limit the risk that option exercises by departing employees will swell the ranks of unaccredited investors, growth companies should include in their equity plan documents a right to repurchase options or shares held by employees within a specified period of time following the termination of employment. The exercise of options in advance of a sale can also dramatically increase a company’s nonaccredited shareholder base. Equity incentive plans should include a mechanism that allows the board of directors, at its election, to provide for the conversion of options into options to purchase acquirer stock or to cash out options upon a change of control. In addition, as a part of the implementation of any equity incentive plan, growth companies should include in the equity incentive plan or a shareholder agreement a provision granting the company a right of first refusal to purchase any shares proposed to be transferred by employees.

About Scale Finance

Scale Finance LLC ( provides professional CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices in Charlotte, NC, the Triangle, the Triad, Southern Pines, and Wilmington with a team of more than 30 professionals serving more than 100 companies throughout the region.