Restrictions On Transfer in the Facebook Age

Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts

McCarter & English LLP


In some states, agreements respecting the corporation's power to restrict the transfer of its shares, once issued, are not deemed to be effective unless they are set out in the charter (and, like all restrictions, "legended" upon the face of the share certificates themselves); moreover, any agreement purporting to bind shareholders not signatories to the agreement may only be legally effective if set out in the charter. The typical restriction, in the nature of a first-refusal restriction, is a significant element of governance in closely held corporations, important to ensure that stock not fall into the hands of strangers without an opportunity in the company (or the remaining shareholders) to buy back some or all of the shares. In small companies, the shareholders feel the need to relate to each other as partners and a maverick shareholder can be disruptive. Moreover, the wrong transfer can forfeit certain valuable privileges, for example S Corporation status. (An allied restriction is the right of first offer; the potential transferor must first offer. The shares to, say, the company (or her partner(s)), the offeree(s) have a period in which to bid and the trade to a stranger can only occur at a higher price.)

Well-drafted charter provisions are set out a right of first refusal on all proposed transfers, whether voluntary or involuntary, and including insolvency, divorce, incompetence, and death. The list should be specific and comprehensive, since courts may construe any restrictions on alienability narrowly. The provisions usually contemplate a repurchase by the company (if the company so elects) at either a price fixed in advance, at a price varying according to a formula (i.e., book value or an earnings multiple), at a price that matches the price offered by a third party, or at "fair value." There are a number of drafting points to keep in mind; for example, whether the first option applies to pledges (when stock is technically transferred, albeit only as collateral); how "fair value" is established in the case of disputes (by arbitrators picked at the time of the disagreement, by named experts such as the company's accountants); whether the party seeking the transfer, if also a director, may vote in favor or against the company's election to exercise its option; and what sanctions (loss of dividends and voting rights) may be imposed and enforced if the shares are transferred against the restriction. Often there are permitted groups, for example, family members and trusts, related corporations, among which shares can be transferred without triggering the option, assuming the transferee independently accepts the restriction.

First-option restrictions should collapse by their own terms upon the pendency of an initial public offering, since the underwriters and the purchasing public will brook no such encumbrance on the liquidity of the public shares. Restrictions of this nature are to be differentiated from so-called investment-letter restrictions, which evidence the illiquidity of unregistered shares and "buy-sell" restrictions designed to recapture stock when an employee terminates. Charter provisions respecting first-refusal restraints should be compared with similar provisions found in the Shareholders Agreement relating to the rights of other shareholders to a preview of any proposed sales. Sometimes first-option restrictions are exercisable by the corporation, and, if it elects to pass, the restrictions segue to the stockholders.

Finally, it should be noted that the discussion of transfer restrictions in the venture-capital context deals with restrictions to which the stockholders have agreed, at least constructively, when they bought stock in corporations with such restrictions in place. An entirely different set of considerations is involved in attempts by management of besieged public companies to impose ex post facto restrictions on publicly held shares so as to disenfranchise intruders.

With the various changes recently enacted into law, it is becoming apparent to the planners of an early-stage enterprise that control of the number and nature of shareholders is a matter of cardinal importance. The issuer actively should manage that list through the imposition of restrictions on transfer, an imperative in light of the various events that could go wrong if control of the list is lost. Thus, uncontrolled transfers may produce the following:

1 - A loss of S Corporation status once the S Corporation surpasses the number of shareholders test.

2 - Net operating loss carry forwards under §382 of the Code will be reduced if more than 50 percent of the ownership changes hands in a three-year period.

3 - Inadvertent status as an investment company might ensue to issuers that have lost the exemption under §3(c)(1) of the Investment Company Act for issuers with fewer than one hundred shareholders.

4 - Inadvertent status as a public company under §12(g) of the Securities and Exchange Act of 1934 will eventuate if, in addition to total assets exceeding $1 million, the issuer has outstanding a class of equity security held of record by five hundred or more persons, a limit which appears likely to increase to one thousand.

5 - Avoidance of tax on initial corporate organization through §351 can be lost by reason of ownership shifts immediately after such organization.

The need to patrol transfers can only increase as the lawmakers are increasingly prone to contemplate a corporate world divided into two categories: big and small businesses. Note in this connection that the number of shareholders in an issuer can change by reason of transactions that initially may not have been contemplated as "transfers" when the restrictions were being drafted. For example, if a class of redeemable preferred stock is issued, the redemption of those shares may push an issuer over the 50-percent change in ownership threshold and threaten net-operating-loss carry forwards.


Introduction to Venture Capital and Private Equity Finance