By: Jesse Jones
Here is a common scenario for early stage startups: you need help from someone that has expertise your team does not possess (technical, professional services, marketing, etc.) and your budget doesn’t allow for paying the full price for those services.
Many startups will supplement the cash portion of the service provider’s fees with an option grant or some other kind of equity component. We have written about why companies issue stock options, how to determine the exercise price for an option grant, and how to issue stock options in an S corp., but all of those articles assume that the service provider is an individual instead of another business. This post addresses what you can do if the service provider is an entity.
Without getting too far into the weeds, the basic legal issue is that any time a company offers or issues securities (including debt, equity or convertibles, i.e. an “offering”), the United States Securities Act requires either registration or an exemption from registration requirements. When a company sells preferred stock (or convertible notes, or SAFEs) to an investor, the company must register the offering or find an exemption that applies. The same is true when a company issues a stock option.
Suffice it to say that it will almost never be worth it for a non-reporting (i.e. privately held) company to go through the registration process, so the company must find an exemption. The most common exemption for the issuance of compensatory equity comp (usually stock options) is Rule 701 under the Securities Act. We have an article in the queue that takes a deep-dive on Section 701 but this is not that. For the purposes of this article, the point is that Rule 701 only works if the recipient of the option is an individual person. Rule 701 cannot be used to issue equity comp to an entity service provider. So what are you supposed to do?
We are going to briefly cover three alternatives here.
- Negotiate with the service provider to split the fees due under the services contract into cash (if any) paid to the entity and equity comp directly to the owner(s) of the entity. This is often acceptable if the entity is owned by one or two individuals but it can be a problem if there is a larger ownership group. If the service provider is open to this solution, then the company actually can use Rule 701 because the options are being issued to an individual.
- If the options need to be issued to the entity itself, and the entity is an accredited investor, then the company can rely on Rule 506 as an exemption to registration. This is the same rule that is normally used in angel and VC financings. Technically, you could use Rule 506 even if the service provider entity is not accredited – but the disclosure requirements to comply with Rule 506 are almost as onerous as registering, so for practical purposes, you would not want to do that. One added benefit to using Rule 506 for option grants is that it preempts state securities laws (unlike Rule 701) so there are no state filings to make, other than the form D notice filing.
- If the options will be issued to the entity and it is not an accredited investor then the company may have to rely on Section 4(a)(2) of the Securities Act, which exempts “private offerings” of securities, or perhaps a different exemption like Rule 504. This is the least ideal of our three alternatives because, among other things, (a) although investors do not necessarily have to be “accredited”, they do have to be “sophisticated” and that is not specifically defined, (b) while there are no specific information requirements, the company would do well to provide the option recipient with information that an investor would typically ask for (including financial statements), and (c) the company still has to find an applicable exemption from registration requirements under state securities laws (just like under Rule 701).
Alternative 1 is our preferred way of handling situations where the company is compensating a service provider with stock options. The reality is that in many cases, companies proceed with alternative 3 without realizing it, which can potentially put the company in a tough spot later on. Failure to register a securities transaction in which an exemption is not available is a violation of Section 5 of the Securities Act, which can lead to enforcement action by the SEC and/or private lawsuits by recipients of securities that do not comply with the law.
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