Growth companies often play it too fast and loose with share issuances. The difficulty of raising money in the early stages often leads entrepreneurs to tap "friends and family" for early-stage capital. Successful early-stage companies will often layer on tiers of preferred stock as the business grows and matures. Growth companies and their private equity sponsors should be wary of the pitfalls that may follow. Although these share issuances may comply with federal and state securities laws, the sheer number of shareholders (often impacted by employee option exercises and share transfers) may later complicate an exit.

As time passes on a growth company's path to an exit event, stock issuances add up. Friends and family investors may grow impatient for liquidity and may transfer shares. Employees may exercise options, and if there are no constraints imposed by the option plan and/or shareholder agreements, employees may sell shares. Shareholders who were accredited investors when they purchased their shares may no longer meet accredited investor requirements. In today's market, the path to liquidity for venture capital-backed companies is fairly long (seven to 10 years on average). Over that period of time, venture capital-backed companies can often find that their shareholder base has grown substantially and that many of their shareholders are nonaccredited.

In a potential sale of a venture capital-backed company to a strategic acquirer, the buyer may favor using its capital stock as acquisition currency. (In today's economic climate in particular, with tight credit and share prices having rebounded, strategic buyers may be more inclined to favor stock versus cash.) A buyer (whether privately held or publicly traded) will wish to consummate the acquisition quickly and cheaply, which, in a stock-for-stock merger, means that the buyer will likely propose issuing its shares pursuant to a private placement exemption rather than in a Securities and Exchange Commission registration.

This is the point where a venture capital-backed company's management (or lack of management) of its shareholder base can become critically important. The shares to be issued by the acquirer in a stock-for-stock acquisition will only qualify for a private placement exemption if the number and nature of the target's stockholders make the private placement available -- which for most transactions will require (under Rule 506) that there be no more than 35 nonaccredited target shareholders. In the event that the target company has not closely monitored its shareholder base, and if, at the time of the transaction, more than 35 of the target company's shareholders are nonaccredited investors, the acquirer's desired acquisition structure may be frustrated. This is the so-called widely held private target problem. A public company acquirer might elect to move forward with the transaction nonetheless by registering the shares to be issued in the transaction, although the added time and cost may be an annoyance to both parties. A private company buyer, however, will not likely proceed with an acquisition that requires it to register shares -- because the registration process for a company that is not yet public is typically too burdensome and time consuming, and few private companies would choose to "go public" in that manner. If the privately held buyer does not have sufficient liquidity to allow it to pay cash and is not able to identify a suitable alternative transaction structure, the transaction may be dead on arrival. In a deal climate where any exit may be hard to come by, obviously, any such potential impediment to a transaction should be avoided.

There are ways to structure around the widely held private target problem. The acquirer and target may agree that only target shareholders who are accredited will receive stock in the acquisition and all others will receive cash. Corporate laws generally do not favor treating shareholders differently within the same class of stock, and the California corporations code expressly prohibits it, so that solution may not be feasible. Alternatively, the transaction could be structured so that target common stock is cashed out in the transaction and only preferred stock of the target (typically held by institutional investors) will receive acquirer stock. That approach may solve the securities law problem, but it may not be satisfactory in light of the acquirer's liquidity constraints, and it might not be consistent with the acquirer's desire to avoid cashing out the target management team.

Another structural option for the acquirer in a stock-for-stock merger may be the "fairness hearing" process under Section 3(a)(10) of the Securities Act. Section 3(a)(10) exempts transactions in which securities are issued in a transaction where the terms and conditions have been approved in a fairness hearing by any court, federal official or agency expressly authorized by law to grant such approval. The fairness hearing is available in a few states (including in California, where the use of the Section 3(a)(10) fairness hearing exemption has become fairly common). Unlike shares issued in a Regulation D private placement, shares issued in reliance upon a Section 3(a)(10) exemption are generally freely tradable upon closing, and the process is less expensive and time consuming than an SEC registration. Nonetheless, fairness hearings take much longer than a private placement (generally 40 to 60 days), are more costly and require acquirers to prepare and file a formal disclosure document describing the transaction. Also, the fairness hearing is open to everyone to whom securities are proposed to be issued, which increases the risk that a disgruntled shareholder may impede the sale process.

There is no magic solution that will enable all growth companies to avoid the widely held private target problem. Even with the best planning and advice, certain things are outside of a company's control, and financing needs and other considerations often override these issues. Nonetheless, there are a few pointers that growth companies and their private equity sponsors should keep in mind as they develop their capital-raising and equity incentive strategies.

Issue securities only to accredited investors. Growth companies should try to avoid issuing securities to any unaccredited investors. This is patently obvious, but the number of times in practice that this is ignored (out of ignorance or otherwise) by growth companies is staggering.

Restrict the transferability of equity in shareholder agreements. Growth companies should closely manage their shareholder agreement provisions that restrict the transfer of shares (for example, by providing that investors cannot transfer shares except in compliance with applicable securities laws). Growth companies can significantly impede the expansion of their shareholder bases by including mandatory notice requirements in such provisions, and by closely monitoring all transfers to ensure they are made in compliance with securities laws. These stock transfer provisions are sometimes ignored by private companies (particularly those without a general counsel). As typically drafted, these provisions give a private company some leeway in determining whether a proposed transfer is being made pursuant to a valid exemption and may provide a company with a legitimate basis to discourage transfers to unsophisticated (or nonaccredited) investors.

Adopt a well-crafted option plan and manage it closely. To limit the risk that option exercises by departing employees will swell the ranks of unaccredited investors, growth companies should include in their equity plan documents a right to cash out options or shares held by employees within a specified period of time following the termination of employment.

The exercise of options in advance of a sale can also dramatically increase a company's nonaccredited shareholder base. Equity incentive plans should include a mechanism that allows the board of directors, at its election, to provide for the conversion of options into options to purchase acquirer stock or to cash out options upon a change of control.

Impose a company right of first refusal on all shares held by employees. As a part of the implementation of any equity incentive plan, growth companies should include in the equity incentive plan or a shareholder agreement a provision granting the company a right of first refusal to purchase any shares proposed to be transferred by employees.

Bradford P. Weirick is co-chairman of Gibson, Dunn & Crutcher LLP's emerging technologies practice group, focusing his practice on mergers and acquisitions, private equity investment transactions, and public and private securities offerings. Joelle Khoury is a corporate associate with Gibson Dunn.