Stock Options

Getting Started

Behrens advises other entrepreneurs to consult professionals early in the planning stage to get a good grasp of the issues from the outset. "I spent two hours with my attorney before I even approached an outside investor," he says. "I was better prepared to meet with investors at that point. And when it came down to drafting the term sheet and preparing the deal documents, my attorney already knew the basics of the transaction."

Unwary entrepreneurs can land in hot water if they don't fully understand the legal implications of offering an unregistered security. Experts caution that not operating within the confines of securities law can result in civil, administrative and even criminal liability. Passing out a business plan, using a mass mailing for soliciting investors and even discussing private stock over the phone can constitute an "offering." All the more reason to get your lawyer involved early in the process.

Even the sale of one share of private stock becomes a securities offering "immediately," according to attorney Washburn. "Selling one share to your next-door neighbor is a securities offering. Period. No debate." Washburn points out, however, that stock can be exempt from the long and expensive process of registration with state and federal authorities. "Since the adoption of the National Securities Market Improvement Act [in 1996], a number of useful exemptions exist for entrepreneurs wishing to sell stock," says Washburn, "as long as the sale of stock is structured correctly."

Washburn explains that most private companies use an offering known as a "private placement" to raise money. This type of offering does not need to be registered with the Securities and Exchange Commission or, if structured correctly, any state securities board. Rather, it involves having a stock sale agreement drawn up by a qualified attorney that complies with the specifics of state and federal law.

"The overwhelming majority of entrepreneurs use the private placement exemption known as the '4(2) exemption,' " says Washburn. Generally, this exemption is available to companies selling stock to individuals who have substantial financial means and are able to evaluate the risks and merits of that investment by looking at an investor's net worth or current gross income. These individuals must be provided with, or otherwise have access to, all information about the entrepreneur and full disclosures.

Tyranny of the Minority

While the money from a stock sale comes without obligation to a banker, entrepreneurs who sell stock to outside investors have changed the entire dimension of their company's structure. Though your company is still private, you now have certain obligations to your shareholders.

Experts say that agreeing to reasonable goals and objectives at the beginning of the relationship can save you headaches associated with minority shareholders' rights and even lawsuits in the future. "Be sure you have a shareholders agreement delineating the rights between parties," advises Washburn. The agreement should include how and when a shareholder will be paid dividends, who controls the board of directors, and under what circumstances shareholders must be consulted on major decisions.

Can You Relate?

Beyond the legal obligations, Behrens advises other entrepreneurs to become investor relations experts. "You have to be willing to invest time in building a relationship with your investors if you want them to be an asset for your company," he says.

Washburn agrees. "Make sure you keep the investor as happy as possible by providing him information about the company on a routine basis," he advises. "Have a tour of the new facility if one is constructed with the offering proceeds, send new product information, maybe even call to solicit his advice from time to time."

Most experts believe that shareholders who are more involved in the business are much less likely to feel boxed-out and are far less likely to be suspicious that something is being hidden from them. Says Washburn, "Lack of information breeds disgruntled shareholders and that, in turn, leads to lawsuits."


Sean P. Melvin is an author, attorney and assistant professor of business at Elizabethtown College in Elizabethtown, Pennsylvania.

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This article was originally published in the May 2002 print edition of Entrepreneur with the headline: Stock Options.

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