Stock Options

More entrepreneurs are now choosing to sell private stock offerings. And in saying no to IPOs, they're reaping the benefits.
Magazine Contributor
6 min read

This story appears in the May 2002 issue of Entrepreneurs Start-Ups magazine. Subscribe »

When Jeff Behrens thought about expanding his Newton, Massachusetts-based computer systems management firm, he knew he'd need a cash infusion. "We're doing about one and a half million in annual sales, but cash was always tight," says Behrens, president of The Tulluride Group Inc., who discovered that private sale of stock could be a low-cost source for growth capital and expertise.

Public vs. Private

Entrepreneurs are often lured by the appeal of selling stock on the open market: Instant cash realization with no debt to repay. But most are not in a position to go public with the complexities of a public offering-especially in an uncertain market, when a successful IPO is far from guaranteed.

A more practical option is selling private equity stock to a few people who have confidence in your product. There are no investment bankers or financial consultants to worry about, and you can maintain the control associated with a privately held company, all while reaping the advantages of instant cash and no debt. An added bonus is the potential to bring others' expertise to your venture. "In addition to raising expansion capital, selling stock to private individuals allowed me to tie the investors tightly to the company and benefit from their advice and counsel on growing the business," says Behrens, 34.

Why would an investor choose your private stock over a hot IPO? Their direct access to you and your company puts them in a much better position to effectively evaluate the risks and rewards of their investment.

To Sell or Not to Sell

You should ask yourself two questions to determine whether a private equity sale is right for your company. First, is there any market for your stock? Understand that investors will want to know specifically how you intend to use the money and what type of return to expect, as well as a timeline.

of investment industry professionals say the Enron scandal has prompted them to increase their due diligence.
SOURCE: Wall Street Reporter Magazine.

"Selling stock is a great way for a growing company to raise money it needs to succeed," explains J. David Washburn, a Dallas attorney who advises entrepreneurs on practical and legal issues surrounding selling private stock. "But your company must be in a growth position in order to attract private investors."

Washburn says plans to inflate your own salary or pay off old debts with investors' money will not snag any investors. Rather, you must first bring the company to a level where the investor will have confidence in the potential rewards from the investment.

Second, are you willing to give up a little control in exchange for equity? Selling private stock also carries responsibilities for your new shareholders. They will have the right to elect directors of the corporation, inspect books and records, and, depending on the set agreements, vote on major corporate decisions, such as selling assets.

"Raising money sets certain expectations about future company growth and plans," says Behrens. "[Once outside investors are involved,] it is no longer a personal lifestyle business-the owner now has fiduciary responsibilities to the investors."

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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