When Employees Sell Private Company Stock

As the IPO market tanked in recent years, SharesPost and SecondMarket, both of which operate online marketplaces for trading private company stock, grew in popularity. SharesPost estimates it has handled about $229 million in transactions since it launched its service in June 2009; SecondMarket puts its transaction total at $225 million since the launch last April. This March, SharesPost unveiled an index that tracks the valuations of hot venture-backed companies including Facebook, Twitter, and Zynga. These marketplaces seem inevitable—and exciting—because employees can cash in some chips and private investors can get shares in a deal before a company goes public.

Employers, of course, have their concerns. What are the risks of having employees post shares for sale? What if a rival buys the shares? Could employees lose their incentive as they cash out?

First, some background: When an employee sells shares in a privately held company, the process is called secondary market trading—and it has been around for decades. But the process has long been fairly cumbersome. An employee needs to hire an attorney to put together the paperwork, which can easily cost $5,000 or more. Next, he or she needs to find accredited buyers for the shares. This often means trying to persuade friends or colleagues who meet the accreditation criteria to pay for the shares as well as to sign the legal documents. Because of all this, secondary market trading has usually been inactive and the valuations relatively low.

Online marketplaces changed this by streamlining the process. The fee models are in flux, but trading typically involves a brokerage firm, which will charge anywhere from 3% to 5% of the transaction amount. Despite the improvements, it can still take a month or more to sell shares. Bear in mind that these marketplaces are geared toward larger private companies, often those with market values of more than $100 million. The main reason is that these are the kinds of companies that are easier for investors to evaluate because there are usually revenue streams, which can be used as a measuring stick for a valuation.

Here's my advice on what entrepreneurs should consider if they foresee their employees using these marketplaces.

Restrict how much an employee can sell. Limit the amount to 10% of the holdings or $500,000, whichever is less. In other words, try to find a way to balance an employee's need for liquidity while still making sure he or she has skin in the game.

Set a policy and communicate it. Given the headlines, a company can't ignore these marketplaces. So it is a good idea to set up a meeting or conference—say, for an hour—to explain your policy and answer questions. This will certainly help with expectations and avoid confusion.

Keep incentives in mind. Employees will certainly want to unload shares and make a tidy profit. But try to temper things. If a company goes public, the upside can be even greater. Besides, stock options are meant to keep employees motivated to stay with the company for the long haul. Again, this could also be a good topic for an employee meeting or conference.

Involve corporate counsel. This is critical because securities laws can get complicated. For more on choosing a lawyer, see my previous column.

Understand that rivals may buy shares. Do you want a competitor to get access to critical corporate information? Consider what happened with Craigslist after a former employee sold a hefty stake to eBay (EBAY).

If you look back at the history of the financial services, it is clear that technology has been transformative. And now, the power of technology is changing the old ways of handling private stock. While it may seem scary, it should not be. If anything, online marketplaces likely will help improve the process, lower costs, provide more control, and in the end, result in less distractions for the company leadership.