‘Some of Silicon Valley’s most highly valued private technology companies, including Airbnb and Uber, are expressing concern and taking action over a new breed of brokers trying to solicit shares from employees and early investors..’(FT 15.08.16) Stephen Diosi , Partner at Mishcon de Reya, offers his thoughts on the controversy and advice for London’s leading entrepreneurs.

Awarding stock to employees, whether through a formal share plan or otherwise, can be a very powerful tool to reward and incentivise behaviour, playing a key part in the growth and success of a business. Of course, the incentive is only tangible if there is an opportunity to crystallise the value of the shares at some point in the future – normally at the time of an initial public offering (IPO) or trade sale. Equally, early investors will also want a plan so they can realise all or part of their investment.

However, as private companies are currently in the position of being able to raise additional capital from investors more easily without having to IPO, employee shareholders and early investors are being locked in for longer than they had initially expected or wanted. As a result we have seen other solutions being developed through which privately held shares can be traded, primarily through a private secondary market over which the company has little control. Whilst this clearly enables shareholders to realise some of the rewards early, this can have negative effects as far as the company is concerned: an uncertain shareholder base, volatile trading, an unstable share price and in some cases an unwieldy number of shareholders. Employee shareholders also cease to be aligned with the founding shareholders and together this creates a challenge for the company when it does ultimately decide to IPO.

Although in practice the issue has tended to be one faced more by US companies, it is an experience that UK companies should be aware of, learn from and protect themselves accordingly. So what can businesses do?

Firstly a decision should be taken as to whether any trading in the company’s shares should be allowed. Often the answer to this question for private companies is no, in which case sufficient protection should be built into the constitutional documents. For example:

  • the articles of association will normally include a transfer restriction that prevents a shareholder from selling his or her shares without the consent of the majority shareholder. Should a shareholder attempt to transfer any shares, the directors can refuse to register the transfer;
  • in the context of an employee share plan, a further step could be taken by making it a term of the plan that, should the employee shareholder attempt to transfer any shares, he would automatically forfeit all rights to those shares. They would then become worthless.

Should the company be willing to permit trading it would be wise to do this through a controlled process. This could be done for example by:

  • establishing a trading window each year managed by the company and during which shareholders are able sell their shares to the current investors or to other approved third parties. Trades would be carried out at current market value for which purpose a valuation would be needed;
  • to facilitate trades by employees, the company could establish an employee benefit trust (EBT). The EBT would be able to buy shares from either current or departing employees. Those shares would then be warehoused in the EBT until such time as the company wanted to award shares to other employees, sourcing them from the EBT. Consideration would need to be given as to how the EBT is funded to buy the shares. Often it is done by way of a company loan;
  • should the company be prepared to allow shareholders to offer their shares more freely, the company could look to join a peer to peer trading arrangement. This would allow the company to create a private trading platform through which shares can be traded within parameters set by the company, giving it control over who buys, who sells and when.

The key messages are (i) ensure that the legal framework in which shares may or may not be traded is clear and within the company’s control and (ii) that regular dialogue with employees and investors will help to set and manage expectations around when shareholder value can be crystallised.

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