In my last post, I discussed Facebook's new stock trading policy that restricts when and how employees can sell company stock. This raises the broader question of what private companies should do when employees sell stock. In this post, I discuss (1) why private companies and startups should be concerned when their employees sell company stock, and (2) what strategies private companies and startups should take to address this issue.
The Problems When Employees Trade Private Company Stock
Websites like Sharespost.com, SecondMarket.com, and StartupExchange.com provide markets for private company and venture capital backed equities that otherwise could not be easily traded. I explained that widespread trading of a company's stock could result in it violating the 500 shareholder rule, in which case the company would have to file a public registration statement for its stock.
Aside from that problem, other potential issues may emerge. Competitors can purchase shares through these online exchanges. Employees might lose their incentive to work hard when they cash out their shares.
Usually, when an employee sells shares in a privately held company, the employee engages in secondary market trading. However, secondary market trading is a burdensome process. The employee needs to hire an attorney to help with the transaction, and that can easily cost thousands of dollars.
More importantly, the employee needs to locate accredited investors to buy the shares. Under Rule 501 of Regulation D, an accredited investor is an individual whose income was at least $200,000 for each of the last two years (or at least $300,000 together with a spouse) and has the reasonable expectation of earning that much in the current year, or has a net worth of at least $1 million either individually or together with his/her at the time of the purchase. The employee has to convince friends or colleagues who are accredited investors to buy the shares and go through the legal process. These costly requirements have traditionally hampered secondary market trading and results in relatively depressed valuations for the stock of most private companies. However, online marketplaces make selling private company shares easier.
Strategies Your Company Can Take To Reduce The Risk Of Employees Selling Stock
1. Get the lawyers involved early.
Because securities laws are complicated, you need a good lawyer to advise on your company's policies and the communication of the policies to employees. Make sure the lawyer is involved early to avoid problems later on.
2. Limit how much stock an employee can sell.
Limit how much an employee can sell to some percentage of their holdings and/or a fixed dollar amount. You want to balance the employee's desire for liquidity while ensuring that he or she still has a significant stake in the company's performance.
3. Clearly communicate the policy.
Have a meeting or conference call with employees to explain your policy. You want to set clear expectations.
4. Use incentives wisely.
Employees will want to sell shares and turn a profit. Still, remind them that if them company goes public, the upside can be much higher. Remember that stock options are designed to keep employees with the company for the long term. Remind employees of that during the employee meeting.
5. Realize the risk that a competitor may buy your company's shares.
One risk of secondary market trading is that a competitor may acquire enough shares to force a vote on shareholder resolutions, gain board seats, or acquire sensitive company information.
The eBay/Craigslist situation presents an interesting variation on this theme. In 2008, eBay sued Craiglist, claiming that Craiglist used coercive and clandestine means to dilute eBay's share in Craigslist such that eBay lost its seat on Craiglist's board of directors. eBay's suit accuses Craigslist founder Craig Newmark and CEO Larry Buckmaster of "adopting poison-pill rules that inhibited eBay's ability to sell its Craigslist shares to anyone other than Newmark, Buckmaster, or their company." The case went on trial in December 2009.
Conclusion
Every private company and startup needs to understand the risks when their employees sell company stock, particularly through online exchanges. The key is not to overreact by attempting to prohibiting all stock trading. Instead, consider a more measured approach that optimizes the risk to the company's advantage by balancing your employees' need to cash out and your company's need to provide incentives to employees.
Twitter: @DougYPark
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