The risk of insider trading for a shareholder of a private company is completely different from that for the shareholder of a public company. This is due to the fact that private companies do not report to the public.

Public companies by their nature periodically report information to the general investing public. This means that as a shareholder you have access to the same amount of information as anyone else of the investing public, whether they own shares or not. In such a situation, the risk of insider trading arises if, as a shareholder or otherwise, you possess so called ‘material non-public information’. Nonpublic information is information that is not available to members of the general investing public. Such information is a rare commodity in the context of public companies, and is usually obtained via conspiracies involving company insiders. The findings of the Gupta trial provides a good example of such a conspiracy.

If you own shares in a public company, bar exceptional circumstances where you have obtained nonpublic information, the risk of insider trading when selling your shares is low.

Private companies on the other hand do not disclose much to the general investing public. In fact, they almost never disclose anything to the public. The few people aside from senior executives with access to company information are the institutional shareholders such as VCs, who have access to information by way of privately negotiated information rights. Also employees in general will have had access to varying levels of corporate information.

This creates a particular set of problems for a shareholders wishing to sell shares: as a shareholder there is a good chance that you have had access to information that the general investing public will not have had access to, either because of your information rights, or because of your employment at the company. This means the risk of committing a de facto ‘insider trade’ when selling your shares to someone from the general investing public is much higher for shareholders of private companies than it is for shareholders of public companies. In the context of a private company, you might possess nonpublic information simply because you worked at the company.

While it seems that many in the tech industry think that insider trading does not apply to private company stock, this is a mistake that could cost dearly. If you wonder whether the SEC really is looking into insider trading at private companies, here is the proof that they do.

So what can private companies do to reduce the risk of insider trading for their shareholders who wish to sell shares? The answer seems to be that the company should make information available to the buyer of the shares, in order to reduce the risk of insider trading for the seller. Ideally this should be the same information to which the selling shareholder has had access.

To quote from The Facebook Effect: Secondary Markets and Insider Trading in Today’s Startup EnvironmentOnly the startup firm itself can effectively make available to counter-parties the kind of information that would ensure that a sale or purchase does not run afoul of the prohibition on insider trading. It is therefore prudent for the company itself to set the terms under which its employees, consultants, and advisors can trade in its securities.

So ideally shareholders of private companies should only attempt to sell shares to buyers who have had access to the same level of information as the seller themselves, which can practically only be achieved by having the company cooperate with the transaction.

So what do companies need to do to prevent their shareholders from selling outside of this scope? The companies could adopt an Insider Trading (IT) policy.

The above quoted article provides some cues as to what such a policy should entail:

  • Prepared by outside securities counsel, an IT Policy should make clear to all company employees that trading by insiders may in certain circumstances be illegal under federal securities laws
  • The IT Policy should establish a general principle that no employee should trade or cause someone else to trade the company’s securities while in possession of material nonpublic information.
  • The IT Policy itself should help educate rank and file employees, who are very likely not to have any familiarity with securities law, by providing clear examples of what material information means.
  • Examples of material information are financial information such as revenues, operating margins, or net income; risk factors such as potential environmental liabilities; and background information on key executives.

The article concludes that “although the founders of, and investors in, early-stage companies may chafe at the restrictions that an IT Policy places on liquidity, it is important that their counsel remind them of the far more catastrophic risk of facing liability for insider trading. ”

Further discussion on the topic can be found on Quora.


Today I saw and answered the following question on Quora:

“I’m working at one of the best post-IPO companies in Valley and have an offer from Square with 20% pay cut but stock options which at today’s valuation compensate for the pay cut over 4 years. However, I don’t have any savings and with this pay cut I don’t think I’ll save a lot. So I’m not sure if I’ll be able to exercise my options anyway. What are the alternatives for that?”

This question is a very good example of why private companies, especially in the tech sector where competition over talent is extremely high, should court prospective employees as  prospective common shareholders. The shares component is extremely important for such a prospective employee.

Private companies who want to enhance their ability to attract talent need to build a relationship with their current common shareholders and option holder as well as prospective ones. Public companies build relationships within their shareholders and the wider investor community so that people end up buying and/or holding on to their shares, supporting the public stock price. Private companies equally need to build relationships with current and prospective holders of their common stock. They should be answering questions and having a dialogue with their (prospective)shareholders about issues related to the company itself and also the intricacies of private shares.

Here is the answer I provided on Quora:

I think the question you need to answer for yourself is whether equity based compensation from a private company like Square is an attractive proposition compared to that of a public company. I assume that you are also receiving equity based compensation in the public company where you currently work.

The benefit of equity based comp from a public company is that you have access to the same information about the company as every other shareholder or investor on the planet, and you have instant and cheap liquidity at your disposal in the form of the public stock market. You know a lot about the health and direction of the company, and if you don’t like what you are seeing or you simply need cash you can sell your vested shares easily and cheaply.

The drawback of a private company is that you do not have access to much information about the company, and also not as much as some other shareholders. The VCs, who are preferred shareholders, always negotiate for information rights and usually also a seat on the board, which gives them access to information beyond that which is provided to common shareholders.

In general private VC-backed companies provide very little information to their common shareholders as there isn’t much in the way of disclosure requirements that compels them to do so.  One such requirements that does exist is that under Rule 701 of the Securities Act, which compels companies to provide information under their employee stock compensation plan, however the execution of this requirement differs widely between companies.

Without getting into the specifics of the success of Square as a company, you should also realize that due to the low or non-existent liquidity of private stock, you are essentially tied to the long term success of the private company and an eventual exit for the preferred shareholders and yourself.
Preferred shareholders not only have access to more information, but they also have the benefit of various financial preference over common shareholders. One such benefit is the ‘liquidation preference’ that VCs commonly negotiate for.

This preference entails that a particular class of shareholders is entitled to receive an amount of money equal to their original investment and any ‘unpaid dividends’ that would have accrued over time, before anyone else is entitled to share in the spoils of an eventual exit. This could create problems for common shareholders such as current and former employees in the event that the ultimate valuation upon exit is disappointing.

Because these are the most innovative and fast growing companies out there where you could individually create much more value than you ever could at a more mature public company. You could be involved in the creation of an entirely new market or the disruption of an old and stodgy one. In the event of a successful exit by the company, the value of your share options is likely to have compounded over the years.

And the above mentioned problems can be easily overcome by companies themselves. While private companies are not subject to much in terms of disclosure requirements, most great CEOs will want to foster a sense of common ownership among employees and provide more information to share- or option-holders then is necessary. Liquidity for private shares can be created, as Facebook or Twitter did in the past by building relationships with secondary buyers who then provided liquidity to common shareholders.

Finally, I’d liked to quote Stephen Cohen, co-founder of Palantir:

“We tend to massively underestimate the compounding returns of intelligence. As humans, we need to solve big problems. If you graduate Stanford at 22 and Google recruits you, you’ll work a 9-to-5. It’s probably more like an 11-to-3 in terms of hard work. They’ll pay well. It’s relaxing. But what they are actually doing is paying you to accept a much lower intellectual growth rate. When you recognize that intelligence is compounding, the cost of that missing long-term compounding is enormous. They’re not giving you the best opportunity of your life. Then a scary thing can happen: You might realize one day that you’ve lost your competitive edge. You won’t be the best anymore. You won’t be able to fall in love with new stuff. Things are cushy where you are. You get complacent and stall. So, run your prospective engineering hires through that narrative. Then show them the alternative: working at your startup.”

Public companies do Investor Relations (IR) to attract investors to their stock, which will support their share price and aid any follow on public capital raising. Private VC backed companies have no public share price to worry about and will raise additional capital on the basis of close relationships with VC firms. They hardly need any IR it seems.

Well they do, because there is one group of people out there that they really need to attract: talented employees. While employees of these companies are usually attracted and retained on the basis of equity compensation, they are hardly ever courted in the same way as shareholders are by public companies.

Imagine for a moment that the common stock of private VC backed companies would trade in a public and liquid market. Surely they would need to court their current and prospective common shareholders or face a falling market price and a resulting higher cost of equity based compensation. As private common stock is traded in an private and illiquid market this is not the case. However, it can be argued that a prospective employee will apply an implicit discount to the value of his offered option package, thereby raising the cost of compensation for the company. Such a discount would be applied in relation to the illiquidity of the stock and the reputation of the company in treating its common shareholders.

The publicity surrounding the secondary market in private stock also has changed the perception of equity based compensation for employees. Increasingly they wonder what their stock is worth, and how they could be able to access that value. Share options are no longer viewed as an all or nothing stake in the eventual success or failure of the company. They are rather starting to be looked at as an asset with a value that can be immediately determined.

There is also no good reason why an ex-employee owning shares in a private company should be almost entirely be left in the cold when it comes to information. A private company does not face any disclosure requirement to its common shareholders. It would however certainly add value for the ex-employee to receive some form of update from management, it could certainly reduce his need to sell the shares in the secondary market. Equally, current employees with share(options) receive information mainly due to the fact that they are employed by the company and interact as employees with management. Rarely do they get additional information or the possibility to ask questions to management ‘as shareholders’. Especially information related to the legal nature of private shares and their transfers should be supplied by the company to shareholding employees.

In a few cases, the secondary markets themselves pressured companies to adopt policies regarding transactions in their stock and inform employees about it. When a company became so well-known that secondary buyers are willing to pay top dollars for shares without receiving any information, employees have tend to follow and sell shares as they could. Companies reacted and attempted to limit and control the secondary market, and reduce the administrative burden and legal risks these entail.

Private companies should instead pro-actively engage with their common shareholder base and reap the HR benefits that will come from it. Don’t wait until you are so large and well known that the secondary markets drive you to do it. Instead start communicating with your common shareholders early on, provide them with a platform to ask questions and answer with the information you feel confortable with. This is not about creating additional reporting requirements for yourself, this is about building a relationship with your shareholders. This should also include your ex-employees. By treating them well you send out a clear message to prospective employees, none of whom will join you with the intent to stay forever(at least not if they represent the top entrepreneurial talent that you should be looking for), and whom might actually be tempted to stay much longer if they will treated as the shareholders that they are.

When you realize that the need for liquidity becomes a distraction for employees, it is time to start managing relationships with potential secondary buyers. There is no better way to do that then to include them in the same IR program as your common shareholder. By communicating with these two groups on an equal basis, you are ensuring that the risk of unwittingly trading on insider information is very limited for your shareholders, and you can effectively manage the secondary price of your stock(who wants shares trading sky high, resulting in a new and higher 409A valuation or disrupting carefully thought out IPO or M&A plans?). By including these two groups in the same platform, you are also allowing them to build direct relationships with each other, paving the way for commission-free transactions. This form of commission free liquidity would only further adds to the value represented by your shares to (prospective) employees.

While private companies don’t have a public stock price to worry about, the ‘price’ that prospective employees will put on their shares is something to be watched closely. An IR program adapted to the needs of private companies and their common shareholders is the best way to start doing that.

In 2011-12 the media focused on the trading of Facebook stock via brokers such as Secondmarket and Sharespost (who became a broker/dealer in early 2012, after settling with the SEC over allegations of operating as an unregistered broker). What received less attention was the fact that Facebook, as early as 2008, pioneered a form of engagement with common shareholders and outside secondary buyers that  resulted in liquidity for employees and presumably a huge HR benefit for the company itself.

A recent WSJ article reveals to us how the firm, as far back as 2008, through the efforts of its then CFO Gideon Yu, was actively courting sophisticated secondary investors to promote liquidity to its common shareholders (mainly current and former employees). This first resulted in $10m in common stock being acquired by Millenium Technology Value Partners from a dozen employees in 2008.

A year later, DST bought $100m worth of common stock form employees, in another deal orchestrated by the company.

It should be noted that both transactions were the direct result of Facebook reaching out to investors and building relationships with them, even though the transactions themselves were between shareholders and the outside investor. This can be seen from Mark Zuckerbergs comment on the deal at the time(emphasis is mine):

While individuals must make their own decisions about participating in this program, I’m pleased that the price DST is offering is much greater than the price originally considered last fall. This is recognition of Facebook’s growth and progress towards making the world more open and connected.”

Essentially, Facebook built relationships with outside investors, which paved the way for shareholders individually selling to those investors, without the need for a broker. It should also be noted that these secondary transactions were for the benefit of all common shareholders, not just the founders.
The Facebook deals were very different from limited secondary components of funding rounds which often allows founders to partially cash out. Such ‘secondary deals’ are often limited in scope and benefit only the founders, while being used as a sweetener by VC firms(Bill Gurley of Benchmark reportedly called these practices ‘bribes’).
Twitter’s massive secondary component of it’s 2011 funding round on the other hand clearly was orchestrated to provide broad access to liquidity to its shareholder base, similar to the preceding Facebook deals.

Secondary markets are often referred to by company management and boards as a pain and distraction that they wished would go away. It seems Facebook really was a pioneer in addressing and solving those problems, turning the private secondary market to its advantage.

This is best illustrated by a quote from a recent Millennium press release:

“Facebook solved one of the biggest problems facing emerging high-growth companies,” says Millennium’s Sam Schwerin. “Through the company’s unprecedented use of secondary purchase programs that allowed stakeholders to achieve early liquidity, Facebook was able to develop its business model in the relative calm of private company status. The company was able to avoid the inevitable pressures to go public too soon.”

Over time, Facebook developed ways of addressing some of the challenges and complexities of secondary market activity. Schwerin adds, “Facebook pioneered the trend of ‘taking control’ of the secondary process. Having learned from Facebook’s experience, leading companies are now selecting institutional partners for liquidity transactions, using secondary liquidity to attract and retain key talent, and aligning secondary activity with strategic goals, rather than allowing it to become a random or distracting process.”

What is most interesting is that Facebook achieved this without resorting to using one of the well-known online marketplaces for private stock such as Secondmarket or Sharespost. While its stock did trade on those platforms, this was through ad hoc transactions where shareholders sold to investors unknown to the company.(While Secondmarket as since shifted to offering company controlled ‘liquidity programs’, Facebook never signed on to those and its shares traded without the company’s involvement on the platform).
While the transactions on these marketplaces did get the bulk of media attention in 2011, they represented deals that went ‘through the cracks’ of Facebook’s control over its shareholder base. Perhaps Facebook’s focus shifted to the public markets in 2011, and the lack of a large orchestrated liquidity program resulted in so many shares being sold on the open market via Secondmarket and Sharespost.
One could argue that as Facebook became so well known by the general public, a market for its shares was created by buyers unknown to the company and with very little access to information about it. The only reason those buyers were willing to buy stock was the public reputation of the firm and the expectation that is was soon to go public in one of the most anticipated IPO. An unprecedented situation and probably the last time we will come across it.

The conclusion we can draw from the Facebook activities in 2008-09 is that when companies realize that the demand for liquidity becomes a distraction for their employees, it is best to address it directly by building long term relationships with selected outside investors. Such direct relationship between the company, its shareholders and those outside buyers pave the way for commission-free private transactions(no broker = no commission), while ensuring that those transactions are in full compliance with corporate policies and financial regulations.

In mid 2011, right in the middle of the private FB shares boom, the Fortune Brainstorm Tech conference in Aspen hosted a panel on secondary markets and private companies. Both venture capitalist and company CEOs expressed concerns about the pain the secondary markets were creating for private tech companies. This was discussed in a NYT blogpost

It’s a distraction,” said Dick Costolo, Twitter‘s chief executive. “We and Zynga and Facebook have retroactively had to put lots of policies in place to constrain that.”

New start-ups are writing bylaws that govern sales of shares on the secondary market, said Matt Cohler, a partner at Benchmark Capital. He encourages start-up founders to do so.

About a year later, at an April 2012 event organized by Wealthfront, Doug Leone from Sequoia was heard saying that “within Sequoia Capital companies, the door is getting shut on the secondary markets.” He further said that “companies are enforcing stricter trading rules on employees and “rights of first refusal all over the place,”

A company can prevent current employees from selling (but in doing so risks creating an incentive for people to leave), and hope to prevent any addition to its cap table by consistently exercising its right of first refusal when an ex-employee tries to sell to an outsider.

Companies could do even better by engaging with shareholders through Investor Relations(IR). Two way communication with and the provision of information about a company’s prospect to common shareholders could reduce the demand for liquidity from (ex-) employees. It could also help companies gauge the need for liquidity and understand where it comes from.

At the 2011 Fortune panel, Frank Quattrone, the investment banker, said that whether private markets are beneficial depends on the employees’ motivation for selling their shares — cashing out, versus buying a house so they can concentrate at work.

If the need for liquidity proves to be a distraction for employees, companies could through their IR program reach out to pre-selected dedicated investors of their choosing, and work with them in setting up a liquidity program for common shareholders. Such deals are already being done, and a dedicated IR platform would make this more efficient.

At OpenShares we are building a shared platform for IR aimed at private companies and specifically tailored to meet their secondary market related needs. As we are not a broker, our goal is not to generate trading volume, it is rather fully aligned with the IR goals of the company. If a company wants to constrain the secondary market in their shares, then our platform could serve exactly such purpose. If companies do want to promote a form of limited and controlled liquidity, this could also be done through the platform by engaging with investors of their choosing. Companies, their shareholders and potential outside investors could build relationships directly with each other, paving the way for commission-free direct transactions between shareholders and company vetted outside investors. Companies could through communication manage the valuation and legal risks that arise from such secondary transactions, and ensure that transactions are in full compliance with both corporate polices and financial regulations.

In other words, OpenShares will allow companies to pro-actively address the needs of their common shareholders and manage their secondary market.

I believe private companies need to start building more meaningful relationships with their common shareholders. Why? For two reasons:

  1. an inexorable increase in common shareholder count. In the past, the 500 shareholder count limit forced companies from Google to Facebook to seek the public markets, as breaching the 500 limit would subject them to the oversight of a public company anyway. With the Jobs Act, that has now been increased to 2.000. This means private company will be able to ramp up their employee share ownership while staying private all the longer.
  2. the rise of the secondary market. This will further grow the number of shareholder, as each trade on average grows the shareholder base by one, assuming shareholders don’t sell their entire holding in one trade. Even if secondary markets have not reached the masses of private companies, their perceived benefits certainly have reached the masses of private company shareholders. This also creates pressure for companies to engage with their common shareholders and understand where the demand for liquidity comes from.

For companies, a rise in shareholder counts and secondary transactions create various headaches, which were very well summarized in this quora answer:

  • Increase in total number of investors (which causes securities law compliance issues and adds to administrative burden).
  • Inability to control the identity of shareholders. (Even if the company has a right of first refusal on transfers of shares, which is common, if the buyer offers a high enough price and/or the company doesn’t have the cash lying around to exercise the ROFR, the shares can end up in anyone’s hands.)
  • Leakage of financial and other proprietary information. Buyers understandably want to know as much as possible about the condition and prospects of a company before paying serious coin for a relatively risky, illiquid investment. The company is put in a tough position where it either cooperates and discloses financial information under Non-Disclosure Agreement to the potential buyer or refuses to cooperate, putting strain on some relationships and encouraging buyers and sellers to circumvent the NDA (tough to prove).
  • Messing up 409A Valuations, which the company pays real money for. By setting a new market price for the shares, secondary sales can force the company to price stock option grants higher than it would like going forward, undermining the incentive value of equity.
  • Inability to control the process. Most private companies would prefer no secondary sales be made at all before an Initial Public Offering (subject to some narrow exceptions), but as the lesser evil, the company is better off doing a controlled, structured process the way Facebook reportedly does.
  • Distraction and resentment among employees. There are always equity haves and have-nots, but it’s worse with private sales where investors usually don’t want to bother unless the block of shares is large enough. So generally top execs and founders have no trouble selling while rank-and-file employees may not have enough shares for anyone to bother, leaving them SOL.
  • Complex legal documentation and administrative burden. The standard documents used by a firm like SharesPost can run 30 pages. Selling shares in a publicly traded company requires only a couple pages in most cases. Everything has to be vetted by the company’s (inevitably overworked) legal and finance teams.

Companies can resolve these problems with IR tools. Its all about communication with your common shareholders really. First of all, employees and other common shareholders might be clamoring for secondary liquidity, but the real reason might simply be a lack of engagement and information coming from companies. An ex-employee might want to cash out on his shares simply because he now feels disconnected from the company. An IR campaign aimed at common shareholders could do a great deal to reduce demand for liquidity in the first place.

Shareholders might also feel the need for liquidity due to their personal financial situation. When they reach 30 and get their first child, the need for cash for a deposit on a house might be greater then that for an ownership stake in a risky venture. If the need for liquidity becomes a distraction for current employees, or prevents the company from competing with publicly traded rivals over talent, a private company might consider pro-actively enhancing the liquidity of its common stock.

Again, such liquidity can be achieved through IR tools as well. Back in the days that ‘secondary market’ was not yet a buzzword, transaction were occasional and conducted with outside buyers with a long standing relationship with the company. the following quote from John Glynn is telling:

“These were very occasional transactions, and it was done the old-fashioned way. You earned the respect and trust of the company, and they ended up wanting you as a shareholder.”

Another example is the leading role played by Millennium Technology Partners, a pioneer secondary investor in VC backed companies. Here is an excerpt from the same business week article

Millennium Technology Value Partners was among the first such investment funds, founded by two veterans of buyout firm Blackstone (BX). The fund spent the early part of the decade buying shares in startups from executives and investors that needed cash. In one of its first organized, companywide “liquidity programs” in 2006, Millennium bought shares from employees, executives, and investors of TellMe Networks, a Silicon Valley voice recognition company. Microsoft acquired the startup the following year, reaping Millennium bounteous profits. These transactions were still tame, well-orchestrated, and carefully negotiated affairs, always conducted with the imprimatur of the company in question. And then Facebook changed everything.

The frenzy that followed to acquire FB shares did not represent the dawn of a new era, which would see the private secondary market virtually replacing the public markets. It was just a blip, albeit a very big one, in the history of the secondary market.

Companies wishing to pro-actively enhance the liquidity of their common stock for the benefit of their shareholders should do so the ‘old fashioned’ way: by building relationships with one or several sophisticated secondary buyer such as Millemium.

By communicating with existing common shareholder and selected outside potential secondary buyers on an equal footing, private companies can assert control over their secondary share price, their shareholder base and the information used as the basis for transactions. This would effectively deal with the above mentioned problems, as well as with the risk of insider trading arising every time a shareholder with some corporate information sells to an outsider with none.

This is taken from a recent Quora answer which I felt was material enough to warrant a blog post as well 😉

If you want to sell shares of a private company you will have to take applicable financial regulations into account, as well as the contractual rights of the company and other shareholders (Right of First Refusal). I won’t go into the rarely exercised Right of Co-sale.

Regarding the contractual rights: The contractual rights (ROFR) entail that the company whose shares you hold and/or your fellow shareholders have a right but not an obligation to preemptively purchase the shares that you want to sell to an outsider. So in fact you should usually first find a willing buyer at a particular price, then go to the company and give them notice of your intent to sell. Then the company will go through the procedure and notify you out its outcome. ROFR usually have to be exercised at the same price as whatever the outside buyer is willing to pay. So in case the ROFR are exercised you don’t really lose out, however the outside buyer does not get to purchase the shares he wanted.

These are the usual steps to go through:

  • Best thing for you to do is first sign an Stock Purchase Agreement(SPA) with the buyer. The SPA should take the existence of the ROFR into account of course (you can’t really promise to sell shares until you know the outcome of the ROFR). So it should be a contract were you and the buyer agree to transact subject to the outcome of the ROFR procedure.
  • Next you need to notify the company of your intent to sell. The company usually has up to a month to go through the procedure, and will then notify you of its outcome.
  • At this point you know how many shares you can sell to the outside buyers, and it would be best to retain a lawyer and get a legal opinion about the compliance of this prospective transaction with applicable financial regulations. The company is likely to request such an opinion before transferring the shares.
  • You should then sign a Stock Power directing the company to transfer your shares in the name of the buyer, and send it along with the legal opinion to the company. You should also send a copy of those to the buyer, along with a copy of your stock certificate.
  • I would say that at this point the buyer should wire you the funds.
  • Once the company has received the Stock power and legal opinion and is satisfied of the legality of the transfer, they will change the name of the shareholder in their registry and issue a new stock certificate in the name of the buyer.

The cost of the above is likely to run into the hundreds of dollars, mainly to obtain the legal opinion. If you go through Secondmarket or Sharespost or another broker you will have to pay them a fee as well, I believe its around 3% of the transaction. If you go through a broker, then obviously the above process will be slightly different as you will be assisted by the broker, but the steps will still have to be walked through.

Regarding financial regulations:
I can’t tell you everything on this topic, as it will also involve complying with State ‘blue sky’ laws and also with insider trading laws, but here are the main points:

  • private shares are likely to qualify as ‘restricted’ or ‘control’ securities (control securities are the same as restricted, but are called control securies when in the hands of an affiliate of the company, i.e. someone with a form of control of company management). This means that they can’t be sold without first being registered with the SEC, unless an exemption from registration is found.
  • Such an exemption is found in Section 4 (1) of the Securities Act of 1933 ( see here). It is available to anyone who is not an issuer, a dealer or an underwriter.
  • You are unlikely to qualify as an issuer(the company itself) or a dealer(a professional involved in the buying and selling of securities).
  • The main risk is to act as an Underwriter. This is because the definition is very broad and includes anyone involved in the ‘public offer’ of securities.There are two ways to avoid the status of underwrite, one is Rule 144, the other is the so-called Section 4 (1 1/2) type of transaction.
  • Rule 144 is a rule promulgated by the SEC to provide a ‘safe harbor’ for compliance under Section 4(1). It’s not exclusive and you should see it as one concrete example of avoiding the status of underwriter. If you are an affiliate, you will need to comply with quite a few requirements, however if you are not an affiliate you will only need to comply with the holding requirements. This is in most cases one year, meaning that you should have held the actual shares(not the options) for one year before being able to rely on Rule 144. If you did held your shares for one year and are not an affiliate, then it’s relatively simple to sell you shares relying on this rule. If you do not fufill with the requirements of Rule 144, you could still try to do a Section 4 (1 1/2) transaction.
  • Section 4 (1 1/2) type of transactions are an invention of lawyer to allow people to sell private shares without having to rely on Rule 144. It’s useful if you didn’t hold your shares for long enough or if you otherwise are unsure of complying with the requirements of Rule 144. There is no Section 4 and a half in the Securities Act, there is only Section 4 (1) and (2). (1) deals with secondary transactions and we discussed it above, (2) deals with private placements by companies (primary transactions). The thinking goes that since an underwriter is someone involved in the public offer of securities, to comply with 4 (1) you need to avoid doing anything that could be a public offer. Since a private placement is the opposite of a public offer, the best way to do avoid the underwriter status is to make sure that you comply with the appropriate requirements of 4 (2), even though these are in fact meant for primary offerings. This is what people refer to as a Section 4 and a half type of transaction, as you are relying on the requirements of 4(2) to secure compliance under 4(1). So essentially you need to take the same precautions as a company when doing a private placement, even though you are not a company and are actually doing a secondary transaction.

So that’s it. I’m not a lawyer so I hope this is all close to the facts as it can be. If any lawyer could help correct any mistakes or elaborate it would be greatly appreciated. I still haven’t covered compliance with State ‘blue sky’ securities law or with the potential risk of insider trading. For that last point you can look at this quora answer.

Regarding a company’s involvement in the process: Brokers such as Secondmarket have started offering tailored ‘liquidity programs’ which gives a company control over and involvement in the trading of their shares via the Secondmarket platform. I would however argue that companies need to start thinking of adopting investor relations(IR) programs independently of brokers, as this will best ensure that they meet their own IR goals, which not necessarily match that of the broker. If companies really want to promote liquidity in their stock, they can also provide an infrastructure to their shareholders and selected investors without necessarily relying on a broker either.

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