Should we include a transfer restriction in our bylaws?
Takeaway: For most startups, it is better for the company and arguably worse for the founders to include a transfer restriction in the bylaws. Transfer restrictions on preferred stock (i.e., investor’s shares) will eventually get removed.
Venture-backed startups may consider including transfer restrictions in their bylaws as a way to prevent secondary transfers of their stock and maintain control over their cap tables. Transfer restrictions limit the transferability of shares by requiring the approval of the company’s board of directors and can be used to protect the interests of the company, its investors, and its stockholders. Typically, transfer restrictions are limited to the Common Stock held by founders and employees and do not restrict the Preferred Stock held by investors. Here's a detailed guide to the pros and cons of including a transfer restriction in a venture-backed startup's bylaws.
Pros
From the company’s perspective, transfer restrictions offer a few benefits, including:
Protecting the Company's Interests: Transfer restrictions can help protect the company's interests by preventing the transfer of shares to parties who may not be aligned with the company's goals and objectives. For example, they help avoid shares being held by competitors who may then be entitled to information rights you don’t want them to have. Transfer restrictions can help ensure that the company's strategic decisions are made in the best interests of the business and its stakeholders.
Maintaining Control: Transfer restrictions can help maintain control of the company's shares and avoid having undesirable stockholders on your cap table. This can be important for startups that are in the early stages of growth and want to maintain control over the direction of the business and the people that own pieces of it.
Cons
From the founders’ perspective, the cons to having a transfer restriction are:
Limiting Liquidity: Transfer restrictions can limit the liquidity of shares and make it more difficult for stockholders (typically founders and employees) to sell their shares. This can be a disadvantage for stockholders who want to sell all or a portion of their shares in order to realize their investment.
Restricting Stockholder Freedom: Transfer restrictions can be seen as a restriction on stockholder freedom. Stockholders may feel that they are not able to fully control their investments or make decisions about their shares. There are typically carveouts to the transfer restriction for transfers such as for estate planning purposes.
Conclusion
Including a transfer restriction in a venture-backed startup's bylaws are usually better for the company and arguably worse for its founders and employees. Transfer restrictions can help protect the company's interests and maintain control. However, they can also limit liquidity and restrict stockholder freedom. Transfer restrictions are often already contained in the company’s Equity Incentive Plan or Founder Restricted Stock Purchase Agreements, which could obviate the need to include one in the company’s bylaws. Ultimately, the decision to include a transfer restriction in a venture-backed startup's bylaws will depend on the specific needs and circumstances of the business and its stakeholders.