Rudolph Libbe Cos. has put a shareholder agreement in place that allows for share redemption under only three circumstances: retirement, death, or disability. “So far, we’ve been successful in staying under the limit,” says Robert Pruger, CFO and treasurer at the private holding company, which contains 10 separate industrial subsidiaries. That’s good, because “we have no intention of becoming public,” he adds.
Tim Keating, CEO of Keating Capital, an investment advisory firm, also touts the use of such written restrictions. “It makes things pretty straightforward — you basically prohibit a secondary market in the shares from developing,” he says. The only drawback: such restrictions may work only for employees. When the shareholder is an institutional investor, “you have little leverage,” notes B2B CFO’s Gagnon.
Another useful restriction is to require that the company or existing shareholders be given the right of first refusal on buying shares, says Brad Mahaney, a partner at law firm Wicks Phillips Gould & Martin. “You want to ensure that you have some control over what shareholders are planning to do with their securities,” he says, in particular if one were to try to sell shares to a competitor.
Private companies can also protect themselves by issuing phantom stock rather than true equity. Phantom-stock plans require that a company adopt a mechanism for valuing itself and build in opportunities for employees to cash in their phantom shares at some point. The trigger can be based on a multiple of earnings or another performance criteria.
Yet another strategy is to apply for an exemption to the 500-shareholder limit of Section 12(g). The SEC, for example, allows exemptions for stock options issued under a written compensatory stock option plan. Companies can also appeal to the SEC for a “no-action” letter exempting them from providing information to prospective investors, which is required under the Securities Exchange Act’s provisions for formal registration of securities. Facebook did just that in 2008, and received the SEC’s blessing to issue unregistered restricted stock grants to employees and directors that were excluded from counting toward the 500-shareholder limit.
If all else fails, a private company can take comfort from the fact that it does not have to churn out a 10-K the minute the limit is breached — the SEC gives it 120 days after the end of its current fiscal year to register as a reporting company. But don’t rest too easy. “Regardless of whether or not a private company is aware that it has breached the limit, it is now a de facto public company with all the associated reporting and disclosure requirements,” says Gagnon. “Ignorance just isn’t an excuse.”
Russ Banham is a contributing editor of CFO.
I’ll Take Seconds
Alternative markets for private stock are proliferating. Should CFOs sign up?
One new, but possibly risky, way for private-company CFOs to curb shareholder growth is to sanction the use of a secondary exchange market, such as SecondMarket or SharesPost. These markets, which match buyers and sellers of nonpublic shares, are becoming popular with investors and employees alike, especially given the glacial path to initial public offerings these days. However, their popularity has also earned them the attention of the Securities and Exchange Commission, which is reportedly investigating trading of shares for hot private companies like Twitter, LinkedIn, and Zynga, among others.