Why would a company prevent their employees from selling their pre-IPO equity?

Question

I have heard and read that some non-publicly traded companies prevent their employees from selling their pre-IPO equity. Why would they have such a policy?

For example, from How to Sell Private Company Stock (mirror):

A sale of private stock must be approved by the company that issued the shares. Some companies may not want their shares to be widely distributed. In addition, some employees of startups may feel pressured to hold onto their company stock as proof of loyalty. If there is a good reason for the sale—such as a downpayment on a house—a company could be persuaded to approve a sale.

I understand the proof of loyalty argument, but I don't understand the reason why

Some companies may not want their shares to be widely distributed

Is that to prevent some entity from obtaining a large fraction of shares of the company, and thereby get some control of it?

Answer 1

One reason for a Private company to restrict the number of shareholders is that is there are additional SEC reporting compliance requirements once you exceed the threshold of 2,000 shareholders / 500 non-accredited investors:

Exchange Act Regulation

Even if your company does not have an effective registration statement for a public offering, it could still be required to file a registration statement and become a reporting company under Section 12 of the Exchange Act if:

• it has more than $10 million in total assets and a class of equity securities, like common stock, that is held of record by either (1) 2,000 or more persons or (2) 500 or more persons who are not accredited investors

• it lists the securities on a U.S. exchange

...

The information about the company required in an Exchange Act registration statement is similar to what is required in a registration statement for a public offering.

From: https://www.sec.gov/smallbusiness/goingpublic/exchangeactreporting

The number of investors was raised to 2,000 from 500 as part of Congressional acts in 2016. Prior to 2016 the number was 500 shareholders.

If employees who had founder shares were able to sell some of those shares then the investor limit may be triggered requiring SEC reporting before any prospective public offering. Private companies (pre-IPO) don't have the reporting requirements of Public companies and choosing when to go public should be a strategic one.

From my understanding those individuals with desirable shares could (if allowed?) use them as private loan collateral or use other structured finance to access the value prior to the IPO.

Answer 2

Typical IPOs tend to have a lock-up period which prevents insiders (founders, employees, venture capitalists) from selling their shares for some amount of time after the IPO. The waiting period tends can be up to 6 months although SPACs tend to have much longer lock-ups.

The purpose of an IPO lock-up period is to prevent insiders with large positions from from flooding the market with shares and depressing share price.

For the most part, the only way around a lock-up period is if it's a mid to large cap company and options become available shortly after the IPO (for example, Snowflake). However, the options tend to be very expensive due to high implied volatility.

Although it didn't involve an IPO, in 1998 Mark Cuban and his partner sold Broadcast.com to Yahoo for $5.7 billion. Cuban's portion was 14.6 million shares, then trading around $95. He put on a 3 year no cost option collar by selling an OTM call and buying the $85 put. In less than 3 years Yahoo was down to $13 and when the lock-up was over, he got $85 per share. Not too shabby.

Answer 3

Some companies may not want their shares to be widely distributed

Consider a small, family owned corporation. One of the part owners needs cash now (for example, due to a divorce settlement). Without a clause in the corporate bylaws stating that existing owners have Right Of First Refusal, that cash-needing part-owner could sell to an outsider, which dilutes family ownership.

Answer 4

Gonna just give you an example right now. SNOW(Snowflake) just IPOd, the share price is currently around 378. It IPOd at 120, and the early employees are surely a lot under the IPO price. Currently only 24M shares are on the market, the float. Out of 240M shares.

If there was no limiting of employees being able to sell, everyone would cash out, float the market and the price would drop, by a lot.

So there are limits on how much can be sold. On monday you can check SNOW again and see the effects of 14M stocks being allowed to be sold. Price is probably gonna drop a bit, but since its controled and expected it probably wont drop by all that much, probably a few percent.

Then afaik a couple weeks later, if the price is stable, another 37M will be released.

Now imagine they just allowed all these 51M shares to go, Thats over twice the current float, it would crash the price, induce panic selling,...

So there are controls.

Answer 5

Interesting answer from David S. Rose on https://qr.ae/pNebBa:

For a host of reasons, most of them quite practical from the company’s perspective:

1. The more shareholders there are, the more complicated it is to maintain the company’s records, get shareholder consents, etc.
2. The company itself is raising, or planning to raise, money, and if anyone is going to buy the company’s stock they want that money to go to the company rather than an employee.
3. The company is, by definition, a private company and wants to have control over who its shareholders are, avoiding potentially hostile and problematic people or board battles.
4. Since shareholders are entitled to information about the company, the company wants to keep that information private rather than have it fall into the hands of other people, including competitors.
5. An employee who really needs cash may well be willing to sell his or her shares at a low price, thus setting an unwanted valuation on the rest of the company.
6. Employees selling shares (especially highly placed ones) sends bad signaling to outsiders, because they assume that if the insider really thought the company had a bright future, they wouldn’t be selling.
7. Employees selling shares (especially highly placed ones) sends bad signaling to other employees because it smells like rats leaving a sinking ship, and can trigger a run of other sales or even resignations.
8. The idea behind compensating employees with equity is that it serves as an incentive because better/harder work directly benefits the employee. Once they sell their shares, that incentive is gone.

Answer 6

Others have presented lots of practical reasons that non-public companies don't let their employees sell shares. Those are right.

The important reason is this: It was never part of the deal!

The deal with typical venture-funded hopefully-IPO-bound companies is this:

1. Employees get shares or options cheap: cash-cheap, investing mostly their time and talent.

2. Investors pay real money for their shares.

3. Employees aren't allowed to cash out before investors.

Because investors hold the balance of power.

If either the employees or the investors have a way to take the money and run, a startup company is seriously weakened. Starting businesses is REALLY hard and takes a lot of patience. The private-company share selling rules have a strong bias toward keeping the team together.

Sometimes companies make exceptions.

Answer 7

Take a look at creatures like the infamous Sir Philip Greenbacks, who has grabbed a personal fortune approaching £1 billion while not only running some of Britain's best-known brands into the ground but also bankrupting their pension funds.

What if you consider "putting" shares into a company as being a founder investor with a clear belief in the company's hopes and "buying" shares as being a later speculator with no interest but profit?

Since the shareholders control the companies, would you rather see the shares owned by supporters of the company vision, or trough-snouters like Sir Piggybanks?