If you’re in the process of forming a business, you’re likely realizing that there are many criteria that you need to consider. One of those options is stock. While LLCs cannot issue stock, corporations can do so. In fact, some states require corporations to issue stock to shareholders. However, owners have some flexibility in the type of stock that they wish to release. One kind of stock worth considering is private stock.
Defining Private Stock
Private stock is beneficial for those corporations who are not yet ready to go public. Contrary to popular belief, an overwhelming majority of United States corporations are private. Less than one percent of corporations in the US are public.
Releasing private stock involves trading ownership in the company in return for equity or capital. If you’ve ever watched an episode of “Shark Tank,” you have likely seen investors and business owners negotiate a “loan” for a percentage of the company. Terminology such as, “I’ll give you $20,000 for a 10 percent stake in your company” is likely referring to a private stock exchange.
This is noticeably different than stock that a public-traded company issues. If a corporation is public, they must first go through an initial public offering. During this time, anyone can purchase shares. Purchasers will likely invest in common shares, which gives them the right to vote at corporate meetings. Public corporations do not have much control over who purchases common stock, while private companies do have control over who buys their common stock.
Raising Capital V. Giving Up Ownership
If a new corporation is private, owners will face a dilemma. They will need a way to raise capital to fund their new operations. However, doing so will likely require them to contact investors who will be seeking a share in their company. Owners must weigh how much of the company they are willing to give up. It’s a common catch-22, in that founders must give up ownership to grow the company.
If owners do decide to issue private stock, they should be careful about how much they release. They likely won’t want to give up more than 49 percent of the company’s valuation. Otherwise, outside investors would have a majority stake in the company, allowing them to determine the direction in which the company will go. Giving up a majority stake in the company could prove your dreams to be over before they even started.
There are some alternative options available, such as issuing long-term debt in the form of bonds. In this scenario, investors provide you with initial upfront capital. The corporation agrees to pay the entirety of the loan, plus interest, upon expiration of the bond.
However, this too has its downsides. For one, it may not be an attractive option for investors, especially if they believe in your company. Additionally, it could be harmful to a new business to add significant debt to its balance sheet in the early stages. Although it could provide owners with capital, the long-term debt could reduce their chances of acquiring money from other sources, such as a bank.
Who Invests In Private Stock?
If they are looking to raise capital, many owners first seek out their friends and professional network. If that proves unsuccessful, owners could perhaps target individuals flush with money, such as:
- Angel investors
- Small business attorneys
- Insurance Companies
Even though the issuing is not public, the Securities and Exchange Commission still maintains strict regulations regarding who can purchase private stock. These regulations are not as tight as they are for those going through an initial public offering, but it’s still vital that companies follow them nonetheless. Otherwise, your new corporation could be hit with stiff fees and penalties.
The SEC requires private investors to be “accredited.” This refers to wealthy individuals who make more than $200,000 per year or have a net worth exceeding $1,000,000. Your corporation will not need to file paperwork with the SEC upon completion of the transaction. But, was the SEC ever to investigate your company or if the company were ever to go public, they’d check to ensure that all private investors meet eligibility requirements. This is not a risk worth taking.
What Paperwork Should Owners Provide During A Private Stock Sale?
Upon selling private stock to accredited investors, corporate owners will need to provide and complete relevant paperwork. It’s also critical that the business maintains this paperwork in a safe location. The corporation will also need to create a stock ledger in which they’ll log the transactions. It’s perhaps in a new company’s best interest to store the completed paperwork with the stock ledger.
The corporation will first need to provide its bylaws. Many investors will also request to see similar documents, such as a copy of the Articles of Incorporation and the corporate bylaws. This will demonstrate that the business is operational and compliant. High-quality documents can also lend significant credibility to your company.
Corporations will also likely want to provide a Private Placement Memorandum. This document explicitly explains the terms and conditions the company is offering to prospective investors. The best way to think about this document is as a flyer or brochure. The report will highlight critical aspects the company wishes to share with investors. It could also touch on how much capital the company is looking to raise and the reason for doing so.
Once an investor has agreed to buy into the corporation, owners will need to provide a Subscription Agreement. Essentially, this is the contract that between the company and the investor that completes the sale. The Subscription Agreement must highlight how much capital the investor is providing and the percentage of the company they’re receiving in return.
Lastly, the corporation should require the investor to complete an Accredited Investor Questionnaire Form. This serves as a type of “background check” that allows companies to ensure the investor meets the requirements set forth by the SEC. If an investor is not willing to complete this form, it could raise a red flag to the corporation. The Accredited Investor Questionnaire Form can save companies from significant problems in the long-term.