More Startups Adopt Transfer Restrictions, Insider Trading Policies To Tame The Rise Of Secondary Trading

As many as 20% of venture funded startups receiving expansion or later stage funding now place restrictions on the secondary trading, according to lawyers and experts in the field. Expect this number to increase.

The secondary market has become a valuable source of liquidity for founders, top management and venture investors feeling the pain of longer marches to liquidity. But only if a sense of decorum governs the rush for cash and gives young companies a sense of control.

To achieve this control, startups are turning to new measures to restrict secondary trading, particularly the use of transfer restrictions added to bylaws and the imposition of insider trading policies. A couple of the highest profile companies, Twitter, for instance, have begun issuing restricted stock.

Secondary markets themselves seem to be paying attention. Trading platforms, such as Xpert Financial, have in place tools to better let startups manage trading activity.

Sayre Stevick, a partner at the law firm Fenwick & West, says the transfer restrictions he sees require boards to approve all share transfers. Often the restrictions apply to common shares held by employees, but sometimes to the preferred stock held by VCs. Term sheets are now being written to demand transfer clauses and to demand startups convince a percentage of early shareholders to retroactively abide by them, he says.

They are part of “a growing wave,” says Stevick.

Also employed are insider-trading policies. The reasoning is that everyone at a startup has some sort of insider information and therefore must be cautious about when or whether to sell stock. Potentially windows can be set up within policies for permissible trades.

The challenge these policies raise is employee retention. If an engineer has a pile of vested shares, it might make sense to take a new job and unload the stock.

So far, insider-trading policies are rare and more typically adopted when market activity increases.

Behind the new efforts is the belief that employees will be motivated to work hard when they continue to hold options and vested shares.

Trading platforms, such as Xpert Financial, are eager to be part of the new trend. Since Xpert kicked off operations earlier this year, the company has allowed startups to set both a minimum and maximum limit on the number of shares investors can buy. Startups also can set a minimum price and approve investors before they get a chance to bid. More tools are on the way.

The secondary markets can seem a little like the “wild, wild west,” says David Pearl, vice president of business operations.