Selling private Shares, part 1: Section 4 (1) of the Securities Act

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.

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.

A discussion of Rule 144 to follow in the next post…

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