Should We Include Transfer Restrictions in Our Bylaws?

Transfer restrictions are one of the principal tools that startups use to prevent secondary transfers of their capital stock and maintain tight control over their cap tables.

Why include?

As secondary sales of restricted securities become more common, perhaps as a result of blockchain-based digital securities being listed on ATSs (alternative trading systems), market practices may not be best practices and startups may increasingly decide to adopt blanket transfer restrictions in the bylaws. For the time being, this is an important issue to discuss with your counsel as you form your company.

You may consider including blanket transfer restrictions in the bylaws at the time of formation because it is hard to impose them later but easy to remove them by amending the bylaws if needed. Also, Delaware General Corporation Law (DGCL) 202(b) provides that the holders of securities outstanding at the time a restriction is imposed are not bound by the restriction unless they assent to it.

If you do include blanket transfer restrictions in the bylaws, you should include standard carve-outs for estate planning, immediate family and affiliate transfers, and repurchases of shares by the company.

Also, you could include language in your bylaws to permit the board of directors to prospectively waive the transfer restrictions. The board could do so in connection with a fundraising round if requested by the new investors, making the transfer restrictions even less of a potential burden in the future.

Why would a startup want to block a transfer?

There are many legitimate reasons that a startup would want to prohibit transfer of its capital stock, including the following:

• If such transfer would be to a potential competitor or other party unfriendly to the company;
• If such transfer would represent a transfer of less than all of the shares then held by the stockholder and its affiliates or is to be made to multiple transferees;
• If such transfer would increase the risk of the company having to register its stock under federal or state securities laws (e.g., having a class of security held of record by 2,000 or more persons, or 500 or more persons who are not accredited investors); or
• If such transfer would result in the loss of any federal or state securities law exemption or otherwise violate securities laws (e.g., if the transfer is facilitated by general solicitation or by a brokered transaction).

Backstop to the right of first refusal (ROFR)

Startups typically have a contractual ROFR over shares issued to founders, executives, employees, and other service providers. It is less common for these companies to have a ROFR over shares issued to outside investors (even early-stage investors). In situations where the company does have a ROFR, the company still does not control the timing or the price of any secondary transactions subject to the ROFR. Neither can the company prevent the sale from being consummated except by agreeing to purchase the shares itself at the price offered by the third-party buyer (or by assigning its ROFR to another willing buyer). Moreover, the company’s ROFR over shares that are trading at high valuations in the secondary markets may become too expensive to exercise in many cases, thereby preventing the company from effectively using the ROFR to maintain control over its cap table. Including transfer restrictions in the bylaws more effectively prohibits any secondary activity that is not authorized by the company and acts as a backstop to the ROFR.

Apply to common stock only?

As a middle-ground approach, you could draft the bylaws so that the transfer restrictions apply only to common stock (which is typically held by founders and employees), leaving preferred stock (typically held by investors) free from such restrictions. However, it may be preferable to have the transfer restrictions apply to all capital stock (including preferred stock) for the same reason mentioned above: transfer restrictions are easy to waive as needed, but very hard to impose on stockholders down the road. Plus, if the corporation has multiple angel investors holding preferred stock (or securities convertible into preferred stock), future institutional investors may prefer the angels to be bound by transfer restrictions for the same reasons they want the holders of common stock bound by them.

Transfer restrictions are permissible under Delaware law

Section 202 of the DGCL permits corporations to restrict the transfer of their securities, and such restrictions may be contained in the certificate of incorporation, bylaws, or an agreement among stockholders or between stockholders and the corporation. Certain types of transfer restrictions are explicitly permitted by DGCL 202(c), such as a ROFR or a requirement for a stockholder to obtain the consent of the corporation for the transfer, as well as other restrictions that are not manifestly unreasonable. Also, restrictions required to maintain tax status or statutory or regulatory advantages or requirements are conclusively presumed to be reasonable under DGCL 202(d). Bottom line: transfer restrictions in the bylaws are permissible under Delaware law.

Market acceptance

In the wake of the challenges that companies such as Facebook and Twitter faced before their IPOs due to widespread secondary trading in their shares, it is increasingly common for startups to include provisions in their bylaws at the time of formation, or to adopt amendments to their bylaws later, severely restricting the transferability of all their shares (in some cases, permitting only transfers for estate planning purposes or as otherwise approved by the board of directors). These examples of legitimate business purposes for pre-IPO transfer restrictions are likely to support their use among tech startups.

Transfer processing fee

Whether or not you include blanket transfer restrictions in the bylaws, you could include language in the bylaws requiring the stockholder to pay a discretionary transfer processing fee to help the company recoup its costs for processing a transfer (which can be substantial). This fee might also prompt a potential transferee to give the transfer a second thought.