Over the years I have seen many business owners unwittingly break the law when they sold stock to key employees without getting experienced legal counsel involved. Many business owners are fortunate enough to have some extremely loyal employees who they want to reward by selling them stock in the company so they will have an equity interest and hopefully benefit when the company is sold or when they sell their stock back to the company at retirement. Sounds pretty simple, doesn’t it? It isn’t. If you are considering selling stock to some of your key managers keep the following in mind:

• Sell to only financially secure accredited investors. Securities laws carry severe penalties for business owners who sell stock to employees who are not “accredited investors”. What is an accredited investor in the eyes of the law? An accredited investor is a person who has a net worth of at least $1 million, $200,000 in annual income individually, or $300,000 of annual income including their spouse. These requirements are to protect investors from being taken advantage of by sellers. How many of your employees meet the definition of accredited investors? Probably not many, if any.
• Disclose information to the buyer. Providing detailed financial information about your company to the buyer is the best thing you can do to protect yourself from a suit alleging that you took advantage of the buyer. Disclose everything that you can think of. The more you disclose the less your potential future liability.
• Sell in large dollar increments. The larger amount of stock you sell, the smaller your risk of being sued. Courts view buyers of large amounts of stock as more sophisticated than one of your employees who may only have bought $25,000 worth of stock from you and then later claims to have been taken advantage of. If you want to take some cash off the table and you sell several million dollars’ worth of stock to, for example, a private equity fund, judges aren’t going to view those types of firms as unsophisticated.
• Require purchasers to hold shares for a year or longer. This protects you from someone who is simply speculating in your stock. You may even have an employee who has been in contact with a competitor and is buying stock to resell to a competitor.
• Require that purchasers can only sell their stock back to you. If you do this you don’t have to worry about your stock falling into unfriendly hands. Of course, you have to agree to buy the stock back at fair market value. Ascertaining fair market value can be tricky. One method I have seen that tends to be agreeable to most parties is that each party gets an independent appraisal by an appraiser of their choosing. If the appraisals are less than 10% apart the stock is bought back at the average of the two appraisal prices. If the appraisals are more than 10% apart a third appraiser is retained that is mutually agreed upon by both parties and the average of all three appraisals is used for the repurchase price.

Most business owners I talk with aren’t aware of the laws regarding selling private company stock. Keep the above points in mind if you are ever going to sell any of your company stock and these tips might just save you from an expensive legal settlement.

© Copyright 2011 by Jim Sobeck. All rights reserved. This information may be reproduced as long as full credit is given to the author.