Pitfalls issuing securities to employeesThis is the fourth part of our Securities Law 101 series.  Because capital raising is such a critical function for middle market companies, we designed this series to introduce their management teams to some of the fundamental concepts in securities law.  We hope that this series will prevent some of the most common mistakes management teams make.  We will periodically publish posts examining different aspects of securities law.

For startup companies, cash is almost always tight.  Despite the cash crunch, startups need to be able to attract qualified employees to get their business off the ground.  So, a question I get all the time from founders of startups is: Can’t I just give my employees some shares?  The answer, of course, is “yes, as long as there is an exemption from registration.”

So, what is this “exemption from registration”?

Well, as a reminder every time you issue securities the securities must be registered with the SEC and each state’s securities commission unless there is an exemption from registration.  When you are issuing securities to employees, the exemption that you would most likely rely on is “Rule 701.”  To be able to rely on Rule 701, you need to meet the following conditions:

  • The issuer can’t be a 1934 Act reporting company or registered under the Investment Company Act of 1940;
  • The purpose of the offering cannot be to raise capital.  It can only be used to reward employees;
  • The securities must be offered under a written compensatory plan;
  • The maximum that you can offer to employees over any 12-month period is the greater of (i) $1 million, (ii) 15% of the issuer’s assets, or (iii) 15% of the outstanding securities of the class being sold; and
  • You must deliver to all investors a copy of the written compensatory plan.

Also, if you issue more than $5 million in securities under Rule 701, then you will need to provide additional disclosure such as a copy of the material provisions of the plan, a summary plan description (if plan is subject to ERISA), certain financial statements, and information related to the risks associated with the investment.  Joe Wallin’s blog gives a great overview of Rule 701 as well.

Can’t I just call the stock a gift to avoid Rule 701?

Probably not.  While giving shares away for no consideration isn’t subject to the federal securities laws, it is highly unlikely that the SEC would consider an employer giving shares of stock to an employee as not involving consideration.  Employers give shares of stock to employees in exchange for continued service.  Remember the “free stock” given away in the dotcom bubble of the 1990s?

Ok.  So, if I comply with Rule 701 am I free and clear of all securities law issues?

Unfortunately, no.  First, even if you comply with Rule 701 you still need to find an exemption from registration for each state where you offer the securities.  Most states have some sort of offering exemption for employee benefit plans, but you need to read the rules carefully.  Second, just complying with Rule 701 doesn’t mean you won’t get sued.  The anti-fraud provisions of the securities laws are fairly broad such as Rule 10b-5.  If somehow you made “any untrue statement of a material fact” or you omitted “to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading” you may have a problem.  Plaintiffs need to prove that you acted with “scienter” (i.e., intentional or reckless conduct) to win, but having to defend securities litigation is expensive.

Also, even though we usually just blog about securities law issues, you can’t forget the tax issues that may come up.  For example, an employee remembering to make a so-called Section 83b election can lead to a significantly reduced tax liability for the employee if the shares increase substantially in value.

What kind of issues arise when employees are shareholders?

Once you issue shares of stock to an employee, the employee is entitled to all the rights as a shareholder, including the right to elect directors and the right to examine the books and records of your company.  While you may prefer to keep your company’s financial statements confidential, once you have shareholders that is not a possibility.  I would also recommend entering into a shareholders’ agreement with all of the shareholders to restrict the rights to transfer the shares to third parties as well as to give the right of the company to repurchase shares of stock in the event of a shareholder’s death, divorce, or termination of employment.  Founders should also make sure a shareholders’ agreement provides drag along rights, which is a provision that allows the majority shareholders to force the minority shareholders to sell their shares in an exit transaction.

How can I avoid some of these issues?

If you want to avoid some of the issues with having your employees as shareholders, you may wish to consider giving securities that do not provide the same ownership rights such as stock appreciation rights or phantom stock.  These securities provide the potential “up side” to your employees without giving them ownership rights.  Providing compensation this way limits your exposure to shareholder lawsuits, but helps align the founder’s and employee’s interests.  You still need to address securities and tax issues though.

What’s the bottom line to all this?

The bottom line is that you can issue securities to your employees, but before you do that you need to make sure you have thought through the issue.  The last thing you want to happen is having a stock grant to employees make it more difficult for the company to raise additional capital or to successfully find an exit strategy for its founders.