At some point in time you will have investors divest part or all of their securities. As you probably know, there is a great deal of momentum building toward enabling secondary markets for private securities and we will soon see listing services, venture exchanges, trading desks and a variety of firms helping investors buy and sell private securities.

This can be good for you. And it can be very bad for you.

Reasons an investor may want to liquidate their ownership in your company include:
* emergency need for cash
* estate planning or divorce
* desire to take profits or simply reallocate their capital
* disengagement from the company
* attempt to exert influence and pressure on the company (e.g. by threatening to distribute their shares to a large number of people unless you do something they want)
* a competitor who wants to wreck havoc (e.g. by acquiring shares and then distributing them to enough people to force you into 12g, thereby causing you to spend all your time and money in legal rather than on your primary business)

What happens if…
A shareholder sells or distributes their 506-D securities and you are faced with one of the following situations?

=> SPV – if you are operating a Special Purpose Vehicle that isn’t registered under the ’40 Act then you’re limited to 100 shareholders in the fund, and this event will put you over that number. This can occur in Reg D offerings where a fund structure is permissible, and where resales generally occur under Rule 144.  Hedge funds have been limiting resales for years in order to protect their exemption.
=> 12g – Section 12(g) of the Exchange Act requires businesses to register when they exceed 2,000 non-employee shareholders (of which no more than 500 may be non-accredited). 12g registration is incredibly expensive in terms of both money and time, and complying with ongoing requirements is practically impossible for small and medium sized businesses. So what happens if the shareholder divests shares to 3,000 people in order to try and force the company into a full SEC registration. Or to 501 non-accredited persons.
=> Reg A, Tier 2 consideration – lets say you only sold to 300 people so you can opt out of annual filings, and a distribution to more people could take you above that limit

You say “that can’t happen“? Why not? Have you disclosed that to investors? Have they agreed to that? It may seem unreasonable as logically you’d assume that securities regulations would give you some protection, but there are no regulatory rules that prevent it, so it comes down to what you have put in the contract your investors signed when you originally sold the securities. And has your transfer agent put automated systems in place to prevent mistakes from happening?

Point: You need to be cognizant of how a secondary trading market can impact you as an issuer. Remember, 506-D (both b & c) securities are not overly restricted by regulation and thus may be freely tradable securities by your investors. So you should expect that your investors will at times divest and trade, and that those will impact you.

The best way to protect your company is to ensure that your operating agreement, your investor doc’s, and your transfer agent have incorporated whatever transfer restrictions and legends that you want for your securities.

– The above screenshot is from the FundAmerica security setup wizard & registered transfer agent integration –

Secondary transactions will happen. Both because market forces are coming into place that will reduce friction and make it easy…and because it’s just a fact of life that from time to time people will divest and transfer their ownership. Make sure you’ve thought about this and prepared before it happens.


Legal Disclaimer:
These materials are my personal opinions and for informational purposes only and not for the purpose of providing legal or tax advice. You should contact your attorney or tax professionals to obtain advice with respect to any particular issue or problem.