Share liquidity in private companies is often viewed with scepticism. However, facilitating transactions internally between shareholders can have amazing effects for both the company and its investors.

Private companies often restrict transfer of shares in order to control who are to become shareholders, and to regulate the power balance between shareholders. Typical restrictions are company approval rights for the sale of shares, and first right of refusal for the other shareholders.

The downside of this is reduced access to capital for the company, as well as lock-in of potential inefficient shareholder structures. For selling shareholders the effect is lower price and longer lead-times for completion of sales.

Alternative configurations

Let us have a look at three typical configurations for share liquidity, the pros and cons and when to apply them:

• Restricted market. With restrictions on all transactions. Both internally between shareholders, and externally to third parties.
• Free internal market. With restrictions on transactions externally, but with a free market internally.
• Free market. No restrictions apply, shares are to be freely traded.

Restricted market

This is the standard configuration for private companies («aksjeselskap») in Norway under the companies act of 1997. In the standard setup there are two types of restrictions on transactions: (1) the need for approval from the company, and (2) first right of refusal for the other shareholders. The company approval usually is not a significant restriction as it can not be unreasonably withheld. Hence, the main restriction is the first right of refusal.

First right of refusal effectively give the other shareholders a call option to buy shares that are up for sale after the terms of such deal is agreed upon. Using simple game theory, existing shareholders would often be better off by either offering a low bid on the shares or simply wait to exercise their call option.

An external buyer will be faced with the dilemma that the option holders probably have better access to information and knowledge about the company. Hence, the external buyer would need to offer a higher price than the intrinsic value, as perceived by the insiders, in order to get the deal completed. If the external buyer offer a price that is on or under the intrinsic value, the existing shareholders might exercise their call option.

Knowing that the other shareholders have little incentive to proactively offer a fair price, and that external buyers are unlikely to give an offer at all, the selling shareholder is often left with no alternative other than giving a hefty discount.

As shown above, restrictions like first right of refusal significantly reduces share liquidity and value for the selling shareholder. Nevertheless, this configuration is widely adopted by e.g family businesses, partner driven organizations and joint ventures. These companies value control with shareholder structure higher than share liquidity and share value. In fact, some companies want restrictions for the very reason of keeping share prices low.

Free internal market

This is a configuration that is adopted by more and more companies as it strikes a balance between the need for control and the need for share liquidity. In this configuration most restrictions are lifted for transactions between existing shareholders. No right of first refusal applies for internal transactions. For external transactions, to non-shareholders, restrictions still apply.

When removing the call option of existing shareholders (the first right of refusal), the other shareholders will offer their maximum price to the seller. The only exception would be in those cases were there are so few shareholders that everyone know the ability and willingness of the other shareholders to bid for the shares.

In addition to getting to a fair price, there are no incentives for the buyers to stall the process. In fact, a buyer could be inclined to ask the seller for a speedy decision in order to prevent other buyers from offering at a higher price.

Restrictions are still in place for transactions to third parties. This way the company can control who is to become a shareholder, and also direct funds from new shareholders to the company itself through new funding rounds if relevant. The potential downside with a free internal market is lack of control over the powerstructure between shareholders, as shareholders can freely trade internally.

Free market

Some companies waive most or all restrictions on share transactions. Then they have no control over who is to own the company. This is the standard configuration for public limited companies («allmennaksjeselskap») in Norway. A free market is good for share liquidity and is often used for private companies that are on a path towards doing an IPO, hence becoming a public company.

For companies not planning to list their stock on a regulated marketplace, free trade of shares is not common due to the loss of control over who owns the company.

Compared with a restricted market

By comparing the configurations we see that moving from a restricted market to a free internal market has the potential downside of the company loosing control with the shareholder powerbase, i.e which shareholders that together form a majority and influence the major decisions in the company («shareholder powerbase» in the table above). With a free internal market the shareholders can freely decide when to sell, at what price and to whom. That is, as long as both the buyer and seller already are shareholders.

The upsides are increased share liquidity and fairer share value for selling shareholders which in turn makes the company more attractive for investors, as well as reduced lock-in of inefficient shareholder structures. The company will have easier access to capital when needed.

Compared with a free market

When comparing with a free market, the free internal market has many of the same benefits of share liquidity, fair value and access to capital. But it also give the company some additional value by being able to control the admission of new shareholders («shareholder admission» in the table above).

Controlling shareholder admission does not only give the company control of who is allowed to own shares, but it also make it easier to enforce shareholder agreements (e.g with drag-along rights that benefit all shareholders), and to make sure that initial investment from new shareholders are reserved for funding of the company if it so chooses.

Q&A on internal markets

What about lock-up and vesting schedules for management and key personell?

Not a problem as this could be treated independent of general restrictions by separate agreement between the company and those with lock-up and vesting schedules.

Adverse effects of setting a price on the company?

When there are transactions the implicit pricing of the company could be affected at later founding rounds, trade sale or sale of other shares. That is in itself true, but it is not necessarily a case for restrictions as those could knock share prices further down, hence worsen the implicit pricing.

One could also argue that the price achieved when selling a minority share of a private company is not directly comparable to the expected price for a trade sale of the company as a whole.

What about shareholder rights like drag-along?

No problem to have a shareholder agreement (SHA) in combination with a free internal market, as the company could make all new shareholders sign the SHA before they are allowed to become shareholders.

How does venture capitalists view internal markets?

Venture capitalists would often impose restrictions on share liquidity as they (1) would like to control share transactions and (2) would want all shareholders focused on a future Exit event. Hence, a company that has a free internal market might have to impose restrictions when accepting VC funding.

Summary

This article has discussed restrictions that impact share liquidity in private companies and three common legal configurations. Companies that currently operate under «Restricted» and «Free market» configurations might find it relevant to discuss moving towards a «Free internal market» configuration.

A free internal market is not for the most closely held companies but often used by startups, growth companies and other private companies that want to strike a balance between control and efficient access to capital.