How to sell private shares in compliance with the Securities Act of 1933

Selling private shares is not the same as selling shares of public companies through the click of your mouse or tab of your finger via an online broker. The seller will have to ascertain for himself that he is complying with financial regulations when selling. The buyer will have to be an accredited investor. And both parties and the company involved will have to go through some paperwork to effectuate the transfer of shares from seller to buyer.

The below is going to involve going through some legal stuff, but don’t worry it’s actually quite simple.

When is a seller allowed to sell private shares?

Shares in private companies often qualify as so-called ‘restricted securities’, which means that they cannot be sold without registering the shares with the SEC, unless an exemption from registration is available. This is stated in the prohibition of  Section 5 of the Securities Act of 1933.

So what’s the exemption? It’s something called Section 4 (1) of the Securities Act of 1933. This section states that the prohibition of section 5 shall not apply to ‘transactions by any person other than an issuer, underwriter, or dealer‘. This means that if you are not an issuer, underwrite or dealer, you can sell your private shares without registering them.

As a employee, angel investor or founder of a private company, you are unlikely to qualify as an issuer(that’s the company itself) or an underwriter (a professional buyer and seller of securities).  However the risk exists that you will qualify as an underwriter when selling your shares if you are not careful. Why is that? Because an underwriter is anyone involved in the ‘public offer’ of securities. If you put in an AD in the WSJ that you are selling x amount of shares for x price, you are involved in a public offer and if you sell your shares you are likely to be doing so in violation of the Section 5 prohibition.

So how can a seller avoid being qualified as an underwriter? The answer to that is twofold: there is something called Rule 144, and another called Section 4 (1 1/2). If you want to sell your private shares,  whether on any of the established marketplaces or directly to your neighbor in Palo Alto, you will have to rely on either one of those.

Rule 144

Rule 144 was promulgated by the SEC to offer a ‘safe harbor’ for the resale of private securities under Section 4 (1). Essentially the SEC is saying “yes it can be tough to know for sure how to avoid the status of underwriter, so we are going to create an example for you of how to do it”. Rule 144 contains a set of requirements, and meeting those requirements can assure you that you are complying with Section 4(1). It is not exclusive, therefore there are other ways to comply, but it’s one clear way of doing so.

Rule 144 is especially useful for small shareholders that are not corporate officers or directors. This is because of the concept of company ‘affiliate’. An affiliate is someone who has a form of control over the company. Usually you can be an affiliate if you onw 10% or more of the shares, or if you are a director of officer.

Affiliates must comply with the requirements that adequate information about the company is available and must also file notice of sale with the SEC, among others. Non-affiliates only have to comply with the holding period requirements. That is in most cases 1 year. Yes, 1 year. That means after exercising your shares options, you must wait one year before being able to rely on Rule 144.

What if you want to sell your shares before having held them for one year? That is where Section 4 (1 1/2) comes in.

Section 4 (1 1/2)

First of all, there is no such thing as a Section 4 (1 1/2) in the Securities Act. It is something that was made up by lawyers. We discussed Section 4 (1) already above, and there is a section 4 (2). That is the section that grants exemptions to private companies that are raising capital in a private placement. Ever heard of Regulation D? If you have ever raised funds for a start-up using regulation D, you have used Section 4(2). In fact Regulation D is to Section 4(2) what Rule 144 is to section 4(1), a safe harbor.

So what’s this non-existent Section 4(1 1/2)? Well, lawyers have figured out that the best way to avoid the status of underwriter and comply with Section 4(1), without relying on Rule 144, is to avoid anything that could be qualified as a public offer. The opposite of a public offer is a private placement. Section 4(2) deals with private placements (primary deals), therefore if you want to make sure you are not making a public offer when selling your shares in the secondary market, then you should make sure you are doing something that resembles a private placement. Therefore for comply with Section 4(1) you should look at the requirements of Section 4(2) and comply with those that are appropriate for a secondary deal. This is what is referred to as a Section 4(1 1/2) transaction.

The Key requirements for a Section 4 (1 1/2) transaction is that no general solicitation should occur (only sell to people you have a pre-existing relationship with) and that the buyer should be an accredited investor.

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