How Can Private Companies Issue Stock?

Private companies can issue stock, a fundamental mechanism for establishing ownership and raising capital. Navigating stock issuance involves understanding legal frameworks and strategic considerations. Issuing stock provides flexibility in attracting investment and incentivizing key personnel.

Understanding Stock in Private Companies

Stock in a private company represents an ownership stake, granting shareholders certain rights, including a claim on company assets and earnings. The most common form is common stock, which typically carries voting rights and represents residual ownership after all other claims are satisfied.

Preferred stock is another type, often providing priority in receiving dividends or proceeds during liquidation events, though it usually comes with limited or no voting rights. These shares can be structured with various preferences. Equity-linked instruments like stock options or restricted stock units (RSUs) also provide a future right to acquire shares. Initially, stock in a private company is commonly held by its founders, early employees, and initial investors, such as angel investors.

Regulatory Requirements for Private Stock Issuance

Issuing stock is subject to federal and state securities regulations designed to protect investors. The Securities Act of 1933 mandates that all securities offerings must be registered with the Securities and Exchange Commission (SEC) unless a specific exemption applies. Most private companies rely on these exemptions to avoid the burdensome and costly public registration process.

Regulation D

Regulation D provides common exemptions for private placements.
Rule 504 allows companies to raise up to $10 million in a 12-month period, often permitting general solicitation and advertising, particularly if the offering is registered under state “Blue Sky” laws or sold only to accredited investors.
Rule 506(b) permits offerings of unlimited size without general solicitation, allowing sales to an unlimited number of accredited investors and up to 35 non-accredited investors, provided specific disclosure documents are received.
Rule 506(c) also permits offerings of unlimited size and allows general solicitation, but all purchasers must be accredited investors, and their accredited status must be verified.
Companies utilizing Regulation D exemptions must file a Form D notice with the SEC after the first sale of securities.

Regulation A

Regulation A, sometimes referred to as a “mini-IPO,” permits larger private offerings that can include non-accredited investors.
Tier 1 allows companies to raise up to $20 million within a 12-month period, requiring review by state securities regulators but not audited financial statements.
Tier 2 permits offerings of up to $75 million within a 12-month period, necessitating audited financial statements and ongoing reporting requirements with the SEC, but generally preempting state-level registration.
Companies must also comply with state “Blue Sky” laws, which often require notice filings or registration unless a state-specific exemption applies.

Issuing Stock for Investment

When a private company seeks to raise capital from outside investors, the process involves several distinct stages and documentation requirements. The initial step typically involves valuing the company, which can be done through methods such as discounted cash flow analysis or by comparing the company to similar businesses. This valuation helps determine the price at which new shares will be issued to investors.

Following valuation, the company and potential investors negotiate a term sheet, which outlines the principal terms of the investment. This document covers aspects such as the valuation, the amount of investment, the type of security being issued, investor rights, board representation, and protective provisions that safeguard the investor’s interest. Investors then conduct due diligence, a comprehensive review of the company’s legal, financial, and operational aspects to verify its representations and assess risks.

Upon successful due diligence, definitive legal documents are prepared and executed. These often include a Stock Purchase Agreement, detailing the terms of the share sale; an Investor Rights Agreement, specifying rights related to information access and future funding rounds; and a Voting Agreement, outlining how certain shares will be voted. Amendments to the company’s Certificate of Incorporation may also be necessary to authorize new classes or a greater number of shares. The process concludes with a closing, where funds are transferred, and the new shares are officially issued to investors.

Issuing Stock for Compensation and Ownership

Beyond external fundraising, private companies frequently issue stock to establish internal ownership and incentivize employees. At the company’s inception, founders typically receive an initial issuance of shares, often subject to a vesting schedule to ensure their continued commitment to the business. A common vesting arrangement involves a four-year period with a one-year “cliff,” meaning no shares vest until the first anniversary of employment.

Stock Options

Employee equity compensation is commonly structured through stock options, which grant the holder the right to purchase company shares at a predetermined price, known as the exercise or strike price. Incentive Stock Options (ISOs) offer potential tax advantages, where the difference between the exercise price and the fair market value at exercise is not immediately taxable as ordinary income. For ISOs to qualify for long-term capital gains treatment upon sale, specific holding periods apply. Non-qualified Stock Options (NSOs) result in ordinary income taxation at the time of exercise on the difference between the exercise price and the fair market value of the shares.

Restricted Stock Units and Awards

Restricted Stock Units (RSUs) represent a promise to deliver shares upon the fulfillment of specific vesting conditions, such as continued employment over a set period. Upon vesting, the fair market value of the shares delivered is taxed as ordinary income to the recipient. Restricted Stock Awards involve an immediate grant of actual shares, but these shares are subject to forfeiture until vesting conditions are met. Recipients can elect to be taxed at the time of grant, potentially converting future appreciation into capital gains. These mechanisms are important for aligning employee interests with the company’s long-term success.