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Granting Employees Stock under Federal and State Securities Law

by Peter Moldave

Recently, Google offered to buy back shares of employee-held stock because the shares may have been issued in violation of federal and state securities rules.

Private companies sometimes consider securities law compliance issues only when they are seeking investor funds. However, every issuance or promise to issue securities involves federal or state securities laws. Many times, compliance is either automatic (requiring no filing or other act) or relatively simple, so long as the issuances remain within certain limits. Private companies should ensure that they monitor employee stock and option issuances for compliance with securities laws, under both federal and state law.

Federal Law. Does the issuance have to be registered with the Securities and Exchange Commission? Under federal securities law, compensatory issuances of securities to employees and consultants are permitted without registration under Rule 701 so long as:

  • The issuances are to qualifying individuals – generally, employees and qualifying consultants who are natural persons. Rule 701 does not exempt issuing shares to companies, or to non-employees who help in fund raising. 
  • The amount of securities issued is less than one of several limits, during any 12-month period. Relevant limits for early-stage companies are usually: (1) the aggregate sale price of shares granted cannot exceed $1,000,000; or (2) the number of shares granted cannot exceed 15% of the outstanding common stock (including any preferred stock on an as-converted basis).

The Rule 701 limits cover both the issuance of stock and stock options – and verifying compliance with both is somewhat complicated. This is part of the reason why a formal compliance program is important.

In the event the Rule 701 limits are reached, other exemptions under federal securities law may be

available, but their use is often not optimal for other reasons. Ultimately, if no other exemptions are available, issuances to employees and others may need to be registered with the SEC.

State Law. The laws in each state in which a recipient of stock or stock options resides must be considered (in addition to the laws of the state where the company is located and where it is incorporated, if different). Many states exempt issuances if they are exempt under federal law. Some, notably New York, require pre-issuance filings with state regulators. Others, notably California, have substantive rules on the terms of options and grants to employees and consultants, such as required minimum vesting schedules and pricing terms. In general, before any issuance to residents of a new state, the state’s laws need to be reviewed.

Reporting and Other Requirements. Under both federal and some state laws, stock and option holders have the right to periodically receive basic financial information. In addition, stockholders have certain basic rights (regardless of how they obtained their shares) under state law.

Consequences of Non-Compliance. One result of non-compliance is the right of a holder to rescission. In general, this would involved repayment by the company of any amounts paid for acquisition of the shares. Although in many cases these amounts may be nominal, this is not always the case (examples include grants to senior executives, which could be substantial). The rescission demand could also come at a time (unlike the Google public offering) in which the company’s prospects are much less clear, and cash demands could then be material.

In addition, although not yet an issue for Google at the time of this article, there is always the possibility of state or federal enforcement actions against the company or those individuals responsible for the failure to comply.

Finally, the process involved in securities law compliance also serves as an opportunity to confirm the accuracy and availability of stock records, which are important to maintain for other purposes.

Back to the Technology Law Bulletin Fall 2004