Equity Compensation & Securities Laws: Complete Compliance Guide

In this comprehensive guide, we'll cover everything you need to know about securities regulations when granting equity compensation, how to take advantage of various exemptions, and examples to make each point more actionable.

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Introduction to Equity Compensation and Securities Regulation

Equity compensation allows employers to reward employees, officers, directors, and even contractors with an ownership stake in the company. It can be in the form of stock options, restricted stock, or deferred stock units, among other vehicles. Equity compensation is typically arranged under an equity incentive plan, which serves the dual goals of retaining qualified individuals without significant upfront cash expense and aligning the interests of employees with those of the company.

However, granting equity compensation involves issuing securities, which makes it subject to securities laws. The consequences of failing to comply with these regulations can be severe—think substantial fines, penalties, and the risk of invalidating the securities transaction itself. Just look at what happened to Google in its early days when it had to revoke over 28 million unregistered shares issued to employees and was forced to pay penalties before its initial public offering (IPO).

The requirements for issuing equity differ depending on whether the company is public or private. Public companies register employee shares using Form S-8, while private companies must rely on exemptions from registration requirements—which can be complex and vary by jurisdiction. Private companies often rely on three common exemptions: Rule 701, Rule 506(b) of Regulation D, and Section 4(a)(2) of the Securities Act of 1933.

Federal and State Securities Law (Blue Sky Laws)

In the United States, securities regulation involves both federal and state laws, commonly known as Blue Sky Laws. This means that companies need to comply with both federal securities regulations and individual state laws when issuing equity.

Federal Securities Law and Preemption

In 1996, the National Securities Markets Improvement Act (NSMIA) was enacted, allowing federal securities law to preempt state securities laws in some situations, specifically for securities classified as "covered securities." Securities issued under exemptions like Rule 506(b) are considered "covered securities," meaning they are exempt from most state requirements. However, securities issued under Rule 701 are not covered, which means companies must comply with both federal and state regulations, making the issuance more complex.

Rule 701 Exemption for Equity Compensation

Rule 701 is one of the most common federal exemptions used by private companies to issue equity compensation. Promulgated under the Securities Act of 1933, Rule 701 is specifically designed to facilitate the issuance of securities for compensatory purposes without requiring an extensive registration process.

Eligibility and Conditions for Rule 701

Rule 701 allows companies to grant equity to employees, officers, directors, consultants, and advisors. These individuals must be natural persons (not other business entities). The securities can be in various forms, such as direct stock grants, stock options, or stock appreciation rights. However, certain conditions must be met:

1. Written Contract: The compensation plan must be in writing, and the company must provide a copy to all recipients.

   Example: A tech startup offering stock options to a software developer must draft a clear written agreement, including vesting schedules and other conditions, and provide it to the developer for review and acceptance.

2. Compensatory Purpose: The securities must be issued for compensation purposes and not as a way to raise capital.

   Example: A private company cannot issue stock options to outside investors under Rule 701 if its intention is to raise capital. Instead, the equity must be used solely to compensate service providers.

3. Cap on Securities Issued: Rule 701 imposes a cap on the amount of securities that can be issued within a 12-month period. Specifically, the cap is the greatest of:

   • 15% of the company's total assets, or

   • 15% of the company's outstanding securities of the same class, or

   • $1 million.

   Example: A company with total assets worth $5 million can issue up to $750,000 worth of equity (⅓ 15%) under Rule 701 in a 12-month period without breaching the cap.

Equity Compensation Strategies for Startups

Filing and Disclosure Requirements for Rule 701

Rule 701 is designed to ease the regulatory burden on companies, meaning no SEC filing is required, unlike Rule 506(b), which requires a Form D filing. However, companies must be aware of certain disclosure requirements:

• If the total value of securities issued exceeds $5 million in any 12-month period, the company must provide additional disclosures to recipients, including the company's financial statements and a summary of risk factors.

  Example: If a growing startup issues $6 million worth of restricted stock, it must share its financial statements, prepared in accordance with GAAP, with each equity recipient before the grant is made.

Rule 701 and State Securities Law

One of the major downsides of Rule 701 is that it does not preempt state securities laws, meaning companies must comply with state Blue Sky Laws in addition to federal rules.

Example: If a California-based company grants restricted stock under Rule 701 to an employee residing in Texas, it must ensure compliance with both California and Texas securities regulations, which may involve paying state filing fees or meeting state-specific disclosure requirements.

What Happens If You Fail to Comply with Rule 701?

Failure to comply with Rule 701 can lead to severe consequences, including enforcement actions by the SEC and significant fines. If a company fails to meet Rule 701's requirements, it can turn to other exemptions, such as Rule 506(b), to potentially cure any non-compliance issues.

Rule 506(b) Exemption for Equity Compensation

Rule 506(b) is another commonly used exemption under Regulation D for issuing equity, which is popular for both compensatory and capital-raising purposes.

Advantages of Rule 506(b)

• No Cap on Issuance: Unlike Rule 701, Rule 506(b) does not cap the number of securities that can be issued.

• Covered Securities: Securities issued under Rule 506(b) are "covered securities," meaning they are exempt from state Blue Sky Laws, making compliance simpler.

  Example: A large private company issuing $10 million worth of equity to executives would benefit from using Rule 506(b), as it would not need to navigate complex state securities regulations.

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Limitations of Rule 506(b)

Rule 506(b) has some significant limitations:

• Accredited Investors Only: To avoid disclosure requirements, the company must only issue equity to accredited investors. If equity is issued to non-accredited investors, it triggers comprehensive disclosures that can cost more than $50,000 in legal and accounting fees.

  Example: A wealthy executive earning over $300,000 per year qualifies as an accredited investor, allowing the company to issue equity without triggering extensive disclosures.

• Bad Actor Disqualification: Companies or "covered persons" involved in "disqualifying events," such as certain criminal convictions or SEC cease-and-desist orders, are not eligible to rely on Rule 506(b).

Filing Requirements

Rule 506(b) requires companies to file Form D electronically with the SEC after issuing securities. This filing serves as a notice of the exempt issuance.

Section 4(a)(2) Exemption

Section 4(a)(2) of the Securities Act allows companies to avoid registration by issuing equity in a private placement. Unlike Rules 701 and 506(b), Section 4(a)(2) lacks specific eligibility requirements, but its application is often unclear due to the vague statutory language.

Practical Limitations of Section 4(a)(2)

• Lack of Clarity: Courts and SEC guidance have not provided clear rules on what constitutes a "private placement." Factors such as the number of investors, their financial sophistication, and the level of information available are all relevant, but there are no definitive standards.

• Dual Regulation: Securities issued under Section 4(a)(2) are not covered securities, meaning companies must comply with both state and federal laws.

  Example: If a small business wants to issue equity to three sophisticated angel investors in a private placement, it might rely on Section 4(a)(2), but it should be prepared to face potential uncertainties and state-level regulatory requirements.

Comparing Rule 701, Rule 506(b), and Section 4(a)(2)

Interplay Between Exemptions and Section 12(g) of the Securities Exchange Act

Section 12(g) of the Securities Exchange Act imposes a registration requirement if a company has over $10 million in assets and its securities are held by either 2,000 shareholders or 500 non-accredited investors. However, securities issued under Rule 701, Rule 506(b), and Section 4(a)(2) are exempt from this count, provided they are not transferred.

Example: A company that grants equity compensation to 600 employees under Rule 701 does not need to include those shares in its shareholder count for Section 12(g) purposes, helping it avoid triggering registration.

Resale Restrictions and Rule 144

Recipients of equity compensation may eventually want to sell their shares. However, shares received under exemptions are considered restricted securities, meaning they cannot be freely sold unless certain conditions are met. The Rule 144 safe harbor provides a way for individuals to sell restricted shares without being considered underwriters engaged in a distribution.

Conditions for Resale Under Rule 144

For affiliates (individuals with control over the company, such as directors or large shareholders), the following conditions must be met:

1. Holding Period: The shares must be held for at least one year.

2. Volume Limitations: The number of shares sold in any three-month period must not exceed 1% of the company’s outstanding shares.

3. Public Information Requirement: The company must be compliant with disclosure requirements under Rule 144.

Example: A director holding restricted stock for over one year who wishes to sell part of their shares can do so through a broker transaction, provided it meets Rule 144 conditions.

Conclusion

While equity compensation is a powerful tool for rewarding employees, it comes with the challenges of complying with complex securities laws. The choice of which exemption to use—Rule 701, Rule 506(b), or Section 4(a)(2)—depends on factors such as the company's size, the number of recipients, and their investor status. Each exemption has unique advantages and disadvantages, and understanding the interplay between federal and state regulations is crucial to minimizing risk and ensuring compliance.

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