Securities & Compliance for Equity Grants

The Howey Test Applied to Equity Compensation

Under SEC v. Howey, an "investment contract" (security) exists when there is:

• Investment of money (or services with monetary value)
• In a common enterprise
• With expectation of profits
• Derived from efforts of others (the company/founders)

Equity grants in exchange for services check every box. The fact that no cash changes hands does not matter - services have value.

Why This Matters

Issuing unregistered securities without an exemption is a federal crime punishable by:

• Rescission rights for recipients (they can demand cash back)
• Fines up to $5 million for individuals
• Criminal penalties up to 20 years imprisonment
• Personal liability for officers and directors
• Injunctions preventing future securities offerings

Rule 701 Deep Dive (Most Common for Startups)

Rule 701 is the go-to exemption for compensatory equity grants. Key points:

• Must be pursuant to a written compensatory plan (equity incentive plan)
• Recipients must be employees, directors, general partners, trustees, officers, or consultants/advisors providing bona fide services
• Consultants may not provide capital-raising or securities promotion services
• If grants exceed $10M in 12 months, enhanced disclosure required (financials, risk factors, plan summary)
• No SEC filing required (unlike Reg D)
• Securities are "restricted" and cannot be freely resold

Accredited Investor Qualification

For Reg D offerings, accredited investors include:

• Net worth over $1M (excluding primary residence)
• Income over $200K individual ($300K joint) for past 2 years with expectation to continue
• Directors, executive officers, or general partners of the issuer
• Knowledgeable employees of private funds
• Certain professional certifications (Series 7, 65, 82)
• Entities with $5M+ in assets or all equity owners accredited

Required Restrictive Legends

All certificates or book entries for restricted securities must include legends:

• Securities Act legend stating shares not registered under 1933 Act
• Cannot be sold without registration or exemption
• Company right of first refusal legend
• Reference to stockholders agreement transfer restrictions
• State-specific legends if required (e.g., California)

Sample Securities Act Legend

THE SHARES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR THE SECURITIES LAWS OF ANY STATE, AND MAY NOT BE SOLD, TRANSFERRED, PLEDGED, HYPOTHECATED OR OTHERWISE DISPOSED OF EXCEPT PURSUANT TO (i) AN EFFECTIVE REGISTRATION STATEMENT UNDER SUCH ACT AND APPLICABLE STATE LAWS, OR (ii) AN APPLICABLE EXEMPTION FROM REGISTRATION THEREUNDER.

Lock-Up and Holding Periods

• Rule 144 holding period: 6 months for reporting companies, 1 year for non-reporting
• Contractual lock-ups may extend beyond statutory periods
• IPO lock-ups typically 180 days post-offering
• Volume limitations apply even after holding period for affiliates

Prohibited Consultant Services Under Rule 701

Consultants cannot receive Rule 701 grants for:

• Raising capital or finding investors
• Promoting or maintaining market for company securities
• Finder or broker activities
• General "business development" that includes fundraising

If consultant performs these services, you need Reg D or another exemption.

What Requires Board Approval

• Adoption of equity incentive plan
• Individual grants over threshold amount (per plan terms)
• 409A valuation updates and fair market value determinations
• Option repricing or exchange programs
• Amendments to equity plan terms
• Early exercise provisions
• Acceleration of vesting

Delegation to Committee or Officers

Board can delegate grant authority within limits:

• Compensation Committee for executive grants
• CEO for non-executive employee grants up to threshold
• Must stay within plan parameters and aggregate limits
• Quarterly or annual ratification recommended
• Maintain written records of delegated authority

Documentation Best Practices

• Board resolutions approving each grant (or ratifying delegated grants)
• Grant date documentation (409A timing requirements)
• Fair market value determination at grant
• Signed award agreements from recipients
• 83(b) election receipts if applicable
• Updated cap table after each issuance

State Compliance Overview

Each state has its own securities laws. Key considerations:

• Rule 701 grants generally preempted from state registration (NSMIA)
• Reg D 506 offerings also preempted from state registration
• But states can require notice filings and fees
• State anti-fraud provisions still apply
• California, New York, Texas have active enforcement

States Requiring Notice Filings for Reg D

Most states require Form D notice filing within 15 days of first sale to resident:

• California: Form D filing + fee ($25-$300 depending on amount)
• New York: Form D + Form 99 + fee
• Texas: Form D notice + fee
• Florida: Form D notice within 15 days
• Check each state where recipients reside

California-Specific Requirements

California has special rules for equity compensation:

• Section 25102(o) exemption for employee plans
• Requires plan be in writing and approved by board
• Recipients must be employees, directors, or consultants
• No filing required but must qualify for exemption
• Additional legends may be required on certificates