How should a company restrict compensation shares?

The concept of restrictions on the resale of corporate shares is uniquely American and does not exist elsewhere in the world. Even in the US the rules are revised from time to time to simplify the capital raising process. As of today, the standard Rule 144 restriction formula in the U.S. is no-resale transactions during the first a year, no more than 1% of the outstanding stock in any rolling 90 day period during the second year, and unlimited resale transactions after the second year.

Those rules have recently been changed (with an effective date of February 15, 2008) to permit (a) unlimited sales of shares in reporting companies after a six-month stand-down period, provided that the issuer is current in its SEC reporting obligations, and (b) unlimited sales of shares in all companies after a one-year holding period. Until the one-year holding period is met, the stock certificates have to be imprinted with a restrictive legend.

In my experience, Rule 144 works well for investors who buy relatively small blocks in private placement transactions, but it can be problematic when people receive large blocks of stock as compensation for services, particularly if they receive stock at a time when there is no active, liquid and sustained market. To avoid the nasty practical problems that can arise when an employee gets stock for work, I typically use a paragraph like the following in agreements that involve stock for services:

We have paid no cash consideration to the Company for the shares that will be issued to us pursuant to the terms of this letter and it is agreed no portion of the proceeds from any resale of our shares will be remitted to the Company or used directly or indirectly for the payment of any expenses of the Company or any of its affiliates. In light of our business relationship with the Company and the limited public market for the Company's shares, we hereby agree that without the Company's express written consent (a) we will not be involved in any activity that promotes or otherwise maintains a market for the Company's shares, (b) as long as we are the beneficial owner of any compensatory shares, we will not engage in "buy-side" trading activities, hedging transactions or other activities that could reasonably be expected to influence the market price of the Company's shares, (c) we will not sell any shares in transactions that are effected at a price lower than the quoted bid price of the Company's shares at the time of sale, (d) if we engage in multiple sales in any ten consecutive trading days, we will not sell any shares in a transaction that is effected at a price lower than the last price received by us for the same securities, (e) we will not sell more than 5% of the shares issued to us in any calendar month or more than 10% in any calendar quarter, and (f) our weighted average sales volume in any rolling 90 day period will not exceed 10% of the reported weighted average trading volume in the Company's shares during such period.

These are tough but reasonable restrictions that are designed to protect a developing market from manipulative trading; bargain priced block sales; heavy-handed selling; sustained selling pressure; and disproportionate selling. The overall goal is to make selling easy when market prices are stable or moving upward, but force the service providers to wait on the sidelines when the market is under pressure.

Impressive Growth in the SPAC Markets

In recent years, a new class of blank check acquisition companies that are generically referred to as special purpose acquisition companies, or "SPACs," have become very popular on Wall Street. The SPAC structure allows a blank check company that prices its offering at $5 or more per share to by-pass Rule 419, conduct a large underwritten IPO, and then go out looking for one or more acquisitions candidates that can effectively put the IPO funds to work. Unlike a Rule 419 shell, the shares of a SPAC can actively trade on the Amex or OTC Bulletin Board while the SPAC is searching for a target.

While SPACs are technically exempt from Rule 419 because of their higher offering price, most SPAC offerings invariably include voluntary escrow arrangements, require shareholder approval of proposed acquisitions and provide for refunds if a shareholder does not approve a proposed acquisition.

Since January 2005, a total of 130 SPACs have registered IPOs and raised unallocated capital pools ranging from $18 million to $900 million.

• In 2005, the average IPO size of 28 new SPACs was $75.8 million.

• In 2006, the average IPO size of 36 new SPACs was $85.5 million.

• In 2007, the average IPO size of 66 new SPACs was $166.9 million.

The average proposed IPO size of the 52 active SPACs that have filed or amended their IPO registration statements during the last three months is $228 million. 

In general, SPACs are designed to serve as acquisition vehicles for businesses that need and can effectively use a large capital infusion. But we have to wonder whether a privately held company that can qualify for acquisition by a SPAC couldn't also qualify for a straight-up IPO and avoid the additional layer of costs, fees and expenses inherent in the SPAC structure.

Welcome to my blog

Small company finance is one of the most difficult processes in the  world; and one of the most fun. Entrepreneurs frequently come to us  with stars in their eyes and dreams of becoming the next Google, Microsoft or Intel. More often than not, we have to shoot their dog and tell them that their business can't be financed in the private placement market.

It's a hard fact of life, but private placement investors invariably want to see an investment proposal that will allow them to earn from four to ten times their investment within a few years. They also want to see a clearly defined exit mechanism that will allow them to take their profits if things go well and cut their losses if things do not work according to plan.

The media makes the IPO process look easy. The reality is that the process is extraordinarily difficult and takes an immense amount of time and effort. The dirty little secret is that many companies that actually make it through the IPO process ultimately fail to reach their business goals.

I plan to use this blog to record my thoughts on the challenges entrepreneurs face in getting private and public financing transactions structured, documented, sold and closed. I also plan to record my observations on the regulatory process and dealing with the SEC. In addition to talking about the great times when a plan comes together without a hitch, I'll also discuss the problems, delays and inevitable failures that are all part of the process. I don't know whether anybody but my wife will ever read what I have to say, but sometimes the mere act of putting thoughts down on paper crystalizes thinking and illuminates the next right step.

A broker friend of mine who works with a lot of small companies is fond of saying there are five essential elements for an entrepreneur that wants to raise money in a private placement and then do a shell merger or IPO. He says the first is PERSISTENCE, pauses for far too long, and then says on second thought the only thing that matters at all is persistence.