It is important for the founders of startup companies to understand the securities laws that govern the offer of stock awards to service providers. Failure to comply with the securities laws may result in the requirement to register the shares and in penalties, both civil and criminal, for the company. While the company is private and is not required to file reports under the Securities Act of 1933 (the “1933 Act”), Rule 701 of the 1933 Act provides a safe harbor exemption from registration for stock awards issued as employee compensation. The following conditions must be met to qualify for an exemption under Rule 701:

  • Offers or sales must be made pursuant to a written plan
  • The company must provide each grantee with a copy of the plan
  • The aggregate amount of securities issued in reliance on this section during any consecutive 12-month period must not exceed the greatest of the following:
  • $1 million
  • 15 percent of the total assets of the company, measured at the company’s most recent balance sheet date (if no older than its last fiscal year end); or
  • 15 percent of the outstanding securities of the class being offered and sold in reliance on this section, measured at the company’s most recent balance sheet date (if no older than its last fiscal year end)
  • If the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the company must deliver the following disclosure to optionees in a reasonable period of time before the date of exercise of an option:
  • A summary of the award’s material terms
  • Information about the risks associated with investment
  • The financial statements required under Regulation A, Form 1-A, Part F/S, which must be as of a date no more than 180 days before the sale of the securities

If the above conditions are satisfied, Rule 701 applies. No filings are required to claim this exemption.

Offers and sales exempt under Rule 701 are considered a single, discrete offering. They are not subject to integration with any other offering or sale. If the company intends to make any offers or sales under a private placement or other exemption, the amount of securities sold under a Rule 701 exemption does not affect the aggregate offering price for the other exemption and vice versa. Furthermore, offers and sales under the 701 exemption will not be integrated with offers or sales under other exemptions.

Rule 701 only provides an exemption for transactions in which the securities are offered or sold by the company. The securities acquired pursuant to Rule 701 will be “restricted securities” as that term is defined in Rule 144 of the 1933 Act. Resales of these securities must comply with the registration requirements of the 1933 Act or fit within an exemption. The restricted securities should be stamped or printed with the following legend:

The shares represented by this certificate have not been registered under the Securities Act of 1933, as amended, or applicable state securities laws and may not be sold or otherwise transferred in the absence of such registration or an exemption therefor under said Act and said laws and the rules and regulations thereunder.