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Selling Restricted Stock of Private Companies

Anyone who holds restricted stock of a non-public company, such as Twitter, Box, or Palantir among others, probably has discovered it is possible to find buyers for their stock by contacting Second Market or Shares Post or other broker-dealers who specialize in assisting in the purchase and sale of restricted stock of companies experiencing rapid growth and share appreciation. Although such companies may go public at some point, it seems that more companies are choosing to wait longer before doing so. Examples from the not too distant past include Facebook, Zynga, and LinkedIn.

For many employees, investors, and former employees, restricted stock holdings may constitute the most significant portion of their personal net worth. As a result, they may decide to liquidate at least a portion of their stock holdings to diversity their assets. However, because the restricted stock they hold is not freely tradable, there are a number of issues that a potential seller should be aware of before proceeding with a sale.

First, many companies require, as a condition of exercising stock options or purchasing stock under a company stock plan, that their employees agree in writing to very specific requirements that must be strictly followed in order to resell their stock. The contractual restrictions may include a right of first purchase or refusal (ROFR) in favor of the company and/or a co-sale right. The company's bylaws may also prohibit any transfer of shares without first obtaining the written consent of the company.

In any case, to move forward with a potential stock sale under either or both of those restrictions, a written notice of the proposed sale must be given to the company well in advance of the consummation of the contemplated transaction. The content of that notice, and to whom and how it must be given, are often specified in detail. These notice requirements must be satisfied in all respects or else the entire process may have to be repeated to remedy any non-compliance or other shortcomings.

As alluded to above, the required notice must be sent out in advance, making it uncertain as to whether the proposed sale will be approved. Therefore, the potential seller should to have a written agreement with the buyer making the seller's obligation to sell subject to (i) the company not exercising the ROFR and (ii) the company authorizing the seller to move forward with the stock sale transaction.

Besides complying with any ROFR and prior written consent conditions, the company will likely require the seller and buyer to enter into a stock transfer agreement containing specific investment intent and sophistication representations, and obligating the buyer to abide by the same restrictions on any future transfers of the stock. In addition, the company will likely require the buyer's agreement to be bound by a lock-up provision that is triggered if the company undertakes an initial public offering (IPO) of its stock. The company-required stock transfer documentation usually does not adequately protect the seller's interest in connection with the sale to the buyer (its primary intent is not to be used for that purpose), so a separate written agreement should be used for that purpose. However, the separate agreement will need to be coordinated with the company's documentation.

The company also will likely impose other conditions on the sale and transfer of the seller's shares, including requiring that the seller provide an opinion from an attorney that the proposed sale of restricted stock is exempt from the registration requirements under Federal and state securities laws and sign (along with the seller's spouse, if applicable) stock assignment documents, and that the buyer sign stock assignment documents "in blank."

Often other items must be addressed, including the possible use of an escrow where the purchase price will be deposited by the buyer and held pending the satisfaction of the ROFR period and the other conditions of the sale. An escrow may be advisable to ensure that the buyer has the requisite funds available to complete the purchase and to reduce the risk of the buyer not completing the purchase if something unexpected occurs, including that the value of the stock decreases between the time the parties agree to the terms of the share sale and the closing of the transaction, which may take 45 days, or longer.

Using an experienced intermediary such as Second Market or Shares Post to facilitate the share sale can be beneficial, especially if the seller is not able to find a qualified buyer for the shares. Intermediaries charge commissions, which can range from 5% to 8% depending on the total selling price of the shares.

Even in transactions where an experienced intermediary is involved, a seller should consider engaging an attorney. While intermediaries are helpful in shepherding the share transfer process to completion, they are not able to provide legal advice to the seller. Because their compensation is based on closing the transaction, they may not be in the best position, or have the same motivation, to protect the seller's interest through the use of a separate purchase and sale agreement alluded to above.

A seller should not hesitate to inform the intermediary that the she or he would feel more comfortable engaging independent counsel to prepare (or at least review before signing) the separate purchase and sale agreement and provide advice during the process, as well as the requisite opinion letter. Experienced intermediaries will understand such request and will agree to reimburse the seller for the legal fees incurred by the seller out of the intermediary's commission from the sale transaction. The intermediary also may agree to pay the company's transfer fee out of the intermediary's commission.

The sale of restricted stock of an emerging growth company that has decided to delay its IPO can be highly beneficial to former employees and early investors holding stock in the company, but strict attention must be paid to the detailed transfer requirements and other potential issues for a successful transaction to occur.

Terrence P. Conner, Business Group