Securities Exemptions for Employee Stock Options (Rule 701)
by Peter Smith
December 8, 2014
in Finance, formation, IRS, Rule 701, SEC, Securities, Securities Issuance
By Amy Riedel
Once a growing startup begins to take on employees and advisors, one of its first considerations is incentivizing key team members or key advisers with equity. Often, these are awards in the form of options or grants.
A stock option gives the holder the ability to buy stock at an agreed upon price at a later date. Assuming that the value of the stock increases over time, this gives the option holder the ability to purchase the stock at a price lower than the market price at the time of the purchase. Options also usually come with an agreement vesting them over an employee or advisor’s term with the company. From the company’s perspective, this encourages the employees and advisors to stay invested and active in the company, both to receive their full option award, and to make meaningful contributions to the company to increase the stock value.
As a result, stock options and awards are both a great way to incentivize key employees and a valuable compensation tool for startups. But as with all issuances of securities by the company, the securities must either be registered (an expensive and time consuming process), or qualify for an exemption under federal and state securities laws. Luckily, registration exemptions exist at both the federal and state level for these types of stock issuances.
Federal Registration Exemption
Rule 701 provides a federal exemption from registration for compensatory equity issuances. Unlike other exemptions, it is fairly broad and does not have any associated federal filings. However, the company will still need to meet certain requirements to qualify for the exemption.
- First, the award must be pursuant to a compensatory benefit plan or compensation agreement.
- Second, the award must fall within certain mathematical guidelines. In a 12-month period, the aggregate sales price, amount of securities sold, or options granted cannot exceed the greatest of the following:
- 15% of the total assets of the issuer, measured at the issuer’s most recent balance sheet; or
- 15% of the outstanding amount of the class of securities being offered and sold in reliance on this rule, measured at the issuer’s most recent balance sheet date.
- Third, if the aggregate amount of securities sold in a 12 month period exceeds $5,000,000, additional disclosures must be made to investors within a reasonable period of time after the sale.
- Finally, if the award is to an advisor, rule 701 requires that the advisor be a natural person, that the advisor provide bona fide services to the company, and that the services not be in connection to the offer or sale of securities in a capital raising transaction.
Washington State Exemption
In addition to the federal exemption, the options must also qualify for an exemption from securities registration under state law. Under Washington law (RCW 21.20.310(10)), an option is exempt if it is a qualified stock option under one of the following IRS code sections:
- 401 (pensions, profit sharing),
- 423 (employee stock purchase plans), or
- 422 (employee incentive stock options).
However, many times options may be “non-qualified” or an “NQOs,” meaning that they do not fit in one of these categories defined by the IRS. A company may be granting NQOs because they are to advisors who do not qualify under any of the above categories, or because the company and holder prefers the simpler requirements of NQOs. If that is the case, they can still qualify for a Washington exemption by presenting a copy of the plan to the Department of Financial Institutions 30 days before the award.
None of the state or federal requirements prove overly burdensome for the company, or the option holder, but it is important that the requirements, and disclosure deadlines are met BEFORE the award is made. As always, we suggest obtaining the advice of counsel before issuing securities.
The article provided above is for general information purposes only and should not be relied on as specific legal advice. This article does not form an attorney-client relationship. If you have any questions about this article, please feel free to contact Amy W. Riedel at email@example.com
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