Startups Should Move to Restrict Stock Transfers

The JOBS Act increases the limit on the number of investors a private company can have from 500 to 2000. As this change makes it easier for emerging growth companies to stay private longer, attorneys are encouraging hot startups to place additional transfer restrictions on company stock before the company makes it on secondary trading markets.

There are a number of benefits to placing transfer restrictions on stock. First and foremost is the ability to control who owns stock in the company. Tangentially related to that is the ability to stem employee departures in the event share prices spike on secondary markets and employees with options or restricted stock units cash out, as well as the ability to control public perception of the company which may be damaged if insiders sell stock, for whatever reason,that might foster the image that investors are not optimistic about the company.

However, another important benefit is reducing the likelihood that shares are traded on secondary markets on misinformation or in the absence of material information, which can open up companies to liability from unsatisfied investors, or inquiries and penalties from the Securities and Exchange Commission. Big emerging growth companies, such as Facebook and Zynga before they both went public, tried to restrict trading of their stock once it started on secondary markets by, for example, instituting insider trading restrictions except in permitted selling windows and charging fees to employees to cash out stock. As a result, in March 2011 the SEC initiated an investigation into secondary trading markets to establish whether private companies were complying with regulatory requirements.

This issue is important for all startups that issue equity, including restricted stock units and stock options, to founders, directors, officers, and employees — even if the company is nowhere near the level of a “hot startup” with vigorous trading on secondary markets, it is easier to waive restrictions that have been in place from the get-go rather than trying to put the proverbial genie back in the bottle once trading on secondary markets has begun.