How Does Stock Work in a Private Company?

Understanding Private Company Stock

Stock in a private company signifies ownership in a business whose shares are not traded on public exchanges. This means individuals cannot buy or sell these shares through a stock market. Instead, private companies are owned by a smaller group of investors, founders, or employees. This structure offers flexibility and privacy, but also fewer avenues for buying or selling shares.

Private companies issue stock to raise capital and incentivize founders and employees. Offering equity secures funding for growth without incurring debt and aligns team interests with company success. Unlike public companies, private entities are not subject to extensive regulatory and reporting requirements from the Securities and Exchange Commission (SEC).

Private companies have less public disclosure of financial and operational details. While subject to anti-fraud provisions and some SEC regulations, scrutiny is lower than for public firms. Most private companies do not meet the threshold requiring SEC financial reports (assets of $10 million or more and over 500 shareholders). This reduced burden allows greater freedom in business decisions.

Types of Stock and Equity Grants

Private companies commonly issue Common Stock and Preferred Stock. Common stock represents basic ownership with voting rights, allowing shareholders to influence major company decisions like electing board members. In liquidation, common stockholders are last to receive assets after creditors and preferred stockholders.

Preferred stock carries preferential rights over common stock, especially for dividends and liquidation proceeds. Holders receive dividends and liquidation payouts before common stockholders. Preferred stock often lacks voting rights but can include conversion rights to common stock. Investors, like venture capitalists, frequently use this stock for its protective features and potential upside.

To incentivize employees and founders, private companies use various equity grants. Stock options give the recipient the right to purchase shares at a predetermined strike price within a set timeframe. Restricted Stock Units (RSUs) promise shares once vesting conditions, like continued employment, are met. Direct stock grants involve immediate issuance of shares to individuals, often founders or early employees, which may be subject to vesting or transfer restrictions.

Acquiring and Valuing Private Company Stock

Individuals obtain private company stock through various mechanisms. Founders receive initial equity upon company formation. Employees acquire shares by exercising vested stock options at the strike price. RSUs convert into shares once vesting conditions are met. Investors, like angel investors or venture capital firms, acquire shares through direct purchase agreements, often during funding rounds.

Valuing private company stock is challenging due to the absence of a public market price, unlike continuously traded public company shares. Private companies often obtain a “409A valuation,” an independent appraisal of their common stock’s fair market value (FMV). This valuation is crucial for compliance with U.S. Internal Revenue Code Section 409A, ensuring equity compensation is issued at or above FMV to avoid tax penalties.

A 409A valuation provides a “safe harbor” with the IRS if performed by a qualified, independent third-party appraiser. Other valuation methods include discounted cash flow analysis, which projects and discounts future cash flows, and comparable company analysis, which evaluates the company against similar businesses. These methods involve more subjectivity than public market valuations. The illiquidity of private company stock means its valuation is less fluid and changes less frequently, often tied to funding events or business milestones.

Shareholder Rights and Transferability

Owning private company stock grants shareholders several rights, which vary based on governing documents and stock class. Voting rights allow participation in corporate decisions like board elections, mergers, or charter amendments. Information rights ensure shareholders receive financial and operational details, providing transparency.

Pre-emptive rights, sometimes in shareholder agreements, give existing shareholders the first opportunity to purchase new shares. This maintains their proportionate ownership and prevents dilution. Dividend rights, if applicable, outline how and when shareholders receive a portion of company profits, though many private companies reinvest profits instead of distributing dividends.

Private company stock has limited transferability. Unlike publicly traded shares, private stock lacks a liquid market. Contractual restrictions reinforce this illiquidity, maintaining control and alignment among shareholders and the company. Common restrictions include Rights of First Refusal (ROFR), requiring a selling shareholder to first offer shares to the company or other existing shareholders before selling to an outside party.

Co-Sale Rights (Tag-Along Rights) protect minority shareholders by allowing them to sell shares alongside a larger shareholder. Drag-Along Rights enable a majority to force minority shareholders to join a company sale, ensuring a smooth acquisition. If a private company goes public via an Initial Public Offering (IPO), early investors and employees are subject to lock-up periods, restricting share sales for a specified time (e.g., 90 to 180 days). These restrictions highlight the long-term, less liquid nature of private company stock ownership.