If the company succeeds, we would like to be able to cash in sooner or later. The normal way is to register the stock so that it can be sold on the open market. That, of course, is what we're planning now. Therefore, it's a good idea to know what to expect from a public offering. In order to register some of its stock with the Securities and Exchange Commission for public trading, a company spends $200,000 to $500,000 on lawyers, accountants, printers, etc., plus a few months of the management's time. If the deal falls through (which is quite possible from causes outside anyone's control), much of that money has to be paid anyway and is a dead loss.
The financial effect of the public offering is, to oversimplify, that the underwriters buy a few million dollars' worth of stock from the company and immediately sell it to the public at a profit. The buyers can then sell the stock to each other at ever-increasing prices, we hope. The part of the company that's sold in the offering varies widely, but might typically be 25%. The price is substantially higher than venture capitalists would have paid for the same percentage of ownership; a factor of two is often mentioned.
So now that the company is public, we can all start selling our stock to the public, right? Wrong. The underwriter may allow the existing stockholders to sell some of their stock at the same time that the company sells its stock, but the amount is limited by the public's desire to keep the founders a bit lean and hungry so that they'll make some further profits for the public before going off to lie on the beach. All the old stock that isn't sold then (the majority of the company) is still unregistered and still can't be traded easily.
Over the next few years the founders can dribble their unregistered stock onto the market under Rule 144, provided that the company keeps up with all the SEC's reporting requirements. The essence of this rule is that anyone who has owned his unregistered stock free and clear for two years can sell through a broker in the public market, subject to a limit of 1% of the company (or a formula involving average trading volume) per three months. A person who is not an insider can forget about the 1% rule after owning the stock for three years.
As I understand it, people who own large amounts of stock, as well as officers and directors of the company, fall under Rule 144 restrictions even in trading registered stock.
Three years after the company goes public, it can file a simple little form ($20,000) to register all its stock. In the interim the stockholders could get some more stock registered by persuading the company and the underwriters to make another public offering (another quarter million dollars of expense, shared by the selling stockholders) in which a larger amount of their own stock is sold.
More practically, 90 days after going public, the company can make a simple filing (S-8) which will automatically register any stock that people get later by exercising stock options. Under this system a person who exercises an option for cash right after the effective date of the S-8 filing may be able to sell the stock immediately (though with terrible tax consequences), while someone who exercised earlier has to wait for two years under Rule 144. Nonetheless, this is a very good deal for the employees.
Editor: John Walker