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Law Offices of Ronald W. Rutz
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May 30, 2000: Selling Stock in a Newly Forming Corporation

Q: My neighbor stopped and wanted to sell stock in a corporation he is going to form. Can anyone go out and just do that?

A: But of course! Many of the familiar corporate names around Fort Collins started out in just this way. So even today, as a general rule, anyone has the right to form a business entity and seek investors. But before you exchange one piece of paper (your check) for another piece of paper (stock certificate), consider several factors.

First, be sure that all of the required registration and reporting requirements have been done, or that this particular offering falls under one or more of the exemptions for both the federal and the state securities laws and regulations. You do not want to be in the middle of a legal fight with the government when all you wanted to do was get in on the ground floor and ride a rocket to the financial moon.

Next, remember that if you should want to sell your stock later, there is no ready made "used resale stock market" with sellers and buyers such as the New York Stock Exchange. But even if you locate potential purchasers, no one may want to buy because this is a closely-held company, or maybe pay what you are asking. And if the stock is "lettered," you might not be able to sell part or all or your stock even if you have a buyer at your price.

However, you can create your own private stock market through a buy-sell agreement that sets out the terms by which you can unload those shares to other shareholders or to the company, thereby creating an escape hatch.

The shares that you are receiving may not have voting rights attached. But even if they do, unless cumulative voting is provided (e.g., in voting for directors, a shareholder can multiply the number of directors by the number of shares owned and cast the total for one director as opposed to being outvoted for each director by those in the majority), a minority shareholder has no power and is at the mercy of those that control at least 50.1% of the voting shares.

Thus, with no effective control and no market to resell shares, your investment value might be skyrocketing on paper, but you may have to be content just looking at your piece of paper. And do not expect dividends (profits) to flow your way. Those in control can do all kinds of interesting things to access the profits for themselves without sharing with you.

Finally, if a financial suitor comes with pockets full of money to buy the Company, do not necessarily expect to ride the buy-out coat tails of the majority owner. Yes, there are laws and cases that may or may not give you effective rights, and if the stock is registered, then maybe the same price and terms would be offered, but certainly not the golden parachutes being offered to those in control. You could very well end up being a corporate passenger with new drivers and heading in a different direction.

Consider, however, if you are committed to parting with your money without an effective buy-sell in place, instead of an equity investment through stock ownership, a secured loan with a right to convert to stock at a later time might be more appropriate. Or you might want to have veto power over certain actions or the right to assume control if certain things happen. There are many, many other ways to protect your investment but the bottom line is that you need to realize that the shares in your neighbor's corporation will not give you the same legal ride as shares in one of the Dow Jones companies.

And by the way, unless you are committed to spending the time and money necessary to stay on top of everything going on with the new business, do not be a director yourself because then you can be liable for business problems if a "reasonable" director should have known. (It is sometimes hard to explain to your spouse why you no longer have corporate limited liability protection for your assets.) You might also stay away from being any officer, even those with a "vice" in front of the designation, since you could end up personally liable for unpaid withholding or even salaries, although your particular officer designation did not have responsibility over such areas and you may not have even known there was a problem.

So investor beware, protect thy self, and remember being an officer or director of a corporation may give you something with which to impress people at cocktail parties but it comes with a price.

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