Early Stage Company Equity Incentive Plans: Key Limitations under Securities Laws

At the formation stage of most start-ups, the founders want to adopt an equity incentive plan to augment founder and employee compensation packages and enhance incentives to drive growth of the company. There are many benefits to using equity as a component of employee compensation. It can help align employee motivation with the long-term success of the company and free up cash for the business to spend on other operational needs. The most frequently used equity incentive awards are restricted stock and stock options, almost universally subject to time-based vesting over a period of years. Regardless of the type of equity awarded, traditional equity incentives are still “securities” under the law, which means they need to qualify for exemptions from registration under federal and state securities laws.

Under federal law, Rule 701 of the Securities Act of 1933(17 C.F.R. 230.701) exempts equity incentive awards made by non-reporting companies from registration requirements, subject to a number of specific requirements discussed briefly below. Some states also have exemptions under their own state securities law (“blue sky” laws) for equity incentive awards. Many states have an exemption that essentially tags along with the scope of Rule 701. The key point for the entrepreneur is that Rule 701, and similar state exemptions, are not a license to hand out awards on an unlimited basis, and while there is significant leeway under these exemptions, the company needs to keep in mind several key limitations as it makes awards. These limitations include:

Quantity Limitations – In any rolling 12 month period, the total “sales price” or quantity of awards made cannot exceed the greater of: $1,000,000; 15 percent of the issuer’s total assets (measured based on the issuer’s most recent balance sheet); or 15 percent of the total number of outstanding shares of the class of securities under the award (for instance, 15 percent of the total outstanding common stock for traditional stock options/restricted stock awards).
Written Plan – To qualify for the exemption, incentive awards must be made pursuant to a written plan, which generally must be adopted by the board of directors (and is usually voted on by the stockholders if for no other reason than to permit incentive stock options [ISOs] to be issued). Typically, this written plan will be in the form of a general plan document and individual award notice or agreement.
Eligibility – Employees, officers and directors are eligible as long as they receive awards while they are still employed by the company, or were performing services for the company at the time of the offer. Consultants generally need to be natural human beings, as opposed to a corporation or other business entity, to qualify and must be providing bona fide services.

Disclosure – At a minimum, participants must receive a copy of the plan. However, if the company issues more than $5M in securities in any rolling 12-month period, the disclosure requirements increase significantly.

In addition to the federal requirements involved in claiming the Rule 701 exemption, issuers will also need a state exemption for each state in which securities are being offered or sold. State “blue sky laws” differ from state to state, and a diligent examination of the securities laws of each state where the recipients live is required to make sure that the company does not run afoul of any state requirements.

Fortunately, many states have an exemption analogous to Rule 701 for offers and sales under employee benefit plans, though the availability and criteria for these exemptions vary from state to state. In Pennsylvania, for instance, Section 202(g) of the Pennsylvania Securities Act exempts from state registration securities being issued in connection with a compensatory benefit plan or “being issued in good faith reliance that the transaction qualifies for an exemption under Securities and Exchange Commission Rule 701.” In many other states, however, the applicable state exemption is not so straightforward and may require filings as part of the award process and, in some cases, pre-qualification.

When a company gets to the point where it desires to use equity to attract and retain talented employees, a stock plan and Rule 701 are an excellent means by which to do so. However, it is important to be mindful of the considerations set forth above, and remember that while they can be very useful tools, stock plans are not a license to print unlimited equity for employees of an early stage company.