Whether or not to sell shares in a privately held corporation is often hotly debated among shareholders. In most cases, the shareholders are seeking a necessary cash infusion either because initial funding has run out before the company could reach its full potential or because the shareholders desire expansion. The shareholders, however, are simultaneously reluctant to share equity, profit and control. After investing significant personal time and resources in development, they feel as though they have poured their heart and soul into the company. With so much invested and so much at stake, it’s not surprising that shareholders have disagreements about funding and expansion. Funding and expansion aren’t the only reasons shareholders may want to issue new stock. In smaller closely held corporations, it may be that the shareholders (typically fewer in number) desire to issue new stock to someone with a particular expertise even if that person has no money to invest. In other cases, issuing new stock is a way to ease into a full transfer of ownership over time so that tax liabilities are spread out.
In addition, there are important practical considerations not the least of which is whether or not those wishing to sell corporate stock have the authority to do so under the corporate by-laws. If the by-laws require a unanimous decision of the shareholders for the issuance of new stock, then even a one-percent owner with little involvement in the company’s operations can veto the sale. If the total authorized shares under the Articles of Incorporation are already outstanding, then either the Articles need amending or the shareholders will have to relinquish some of their existing shares.
Finding Investors: Once the corporation’s directors decide to issue new corporate stock, the first step becomes the difficult task of finding an investor. In some cases, the call for issuing new stock in the corporation arises because the board of directors has already found (or been approached by) a prospective investor. In such cases, the investor has already been vetted and the directors go straight to a vote. In other cases, the directors consult with the shareholders about the need for investment and after satisfying themselves that the shareholders are on board, seek out investors.
The first targets are often people the directors already know – people who are familiar with the business and who may have an interest in participating in its growth. There are also resources on the internet that cater to connecting businesses with investors. Either way, it’s important that those offering to sell stock in a corporation comply with state and federal securities regulations. Full compliance with securities regulations is beyond the scope of this article. It’s enough to understand that securities regulations are designed to deter fraud and ensure full disclosure. See “Exemptions to Registering Federal Securities with the SEC“. Typically, a Private Placement Memorandum (PPM) or Offering Memorandum is used to fully inform prospective investors. Because of the complexities of securities regulations, it is particularly important to consult with a corporate attorney before offering shares of stock to the general public.
The corporation will also need to convince prospective investors that the company is worth investing in. This means proving to investors that the business is, or shows signs that it will be, profitable. A business plan with financial projections and a well thought out marketing plan are key factors. Investors will want to know how their money will be spent. They will also want to know what current assets, revenue, profits and cash flow look like. Investors like to see a well oiled machine including actual inspection of the business in operation, current financial records and prior tax filings. It’s also important that the shareholders are able to work with the new investors, especially if they will have a say in how the business will be operated. Shareholders will have the ultimate approval rights (in most cases) and they’ll want to bring on investors who share their vision and more importantly that they can trust.
Determining the Stock Price: The price of the shares offered will have a direct impact on the corporation’s ability to attract investors. In some cases, shareholders enter into buy-sell agreements upon forming the corporation which predetermine the process for valuing shares for sale. If there is no buy-sell agreement, the shareholders must determine the process most suited to the circumstances guided by the voting rules set forth in the corporate by-laws or in California’s default rules if the corporation doesn’t have written by-laws. Cost is an important consideration. A professional appraisal can be prohibitive sometimes costing tens of thousands of dollars depending on the type of business and the quality of the valuation. Typically, shareholders in private corporations have a sense of the stock’s value based on what they know about the corporation’s profitability. Generally, the market value of the shares (the actual value placed on the shares by prospective investors) is directly linked to the business’ current financial strength and recent profit performance. If a stock sale is important enough, a fair value can be achieved without complicated formulas. Ultimately, coming up with a price that will lure investment is key and its worth considering (depending on how deep the need for a cash infusion is) offering the stock at a discount. Other facts affect the price including whether or not the investor will gain a controlling interest in the company. Current shareholders will be acutely aware of the dilution of their ownership and control. It would be folly to ignore this when determining share price.
Closing the Deal and Issuing Shares: Once the price is set and offer is made it’s important to memorialize the deal in writing usually via a written stock purchase agreement or stock subscription agreement that clearly defines the rights and obligations of the incoming shareholder which include the share price, number of shares and other details of the transaction. A corporate resolution should be agreed upon and memorialized in the corporate minutes, stock certificates issued and the corporate ledger updated. Ideally, these final steps will be conducted with the assistance of an attorney.
Selling shares in your private corporation is equivalent to selling an ownership interest in your business. There is a great potential upside so long as the shareholders understand what they are giving up. In the end, the percentage of ownership, voting rights and the extent of the influence the corporation is willing to offer new investors will depend directly on the amount invested. The by-laws and the stock purchase agreement will define all of the shareholders rights and obligations moving forward.
To learn more about selling shares in your corporation, contact an experienced corporate lawyer in San Diego.