Retaining Key Employees in a Privately-Held Company through Equity Compensation – Part 6: Securities Law and Corporate Governance Implications

This post is the sixth in a series exploring techniques to attract and retain key employee, directors, and other service providers of privately held companies through equity-based compensation arrangements and alternative arrangements that provide cash payments tied to the value of the company’s stock or ownership interests.

In previous posts, Casey Riggs discussed various arrangements available to companies that wish to compensate employees and their service providers with equity, including stock options, restricted stock awards, phantom stock plans, stock appreciation rights, and profits interests in LLCs. When issuing equity compensation, companies should be mindful of the securities law and corporate governance implications of such awards. This post will explore those implications.

Securities Law Implications

Equity compensation arrangements are subject to both federal and state securities laws. This means that a company cannot utilize equity compensation without either registering the securities that are issued to service providers or finding an exemption from registration. Many startups frequently overlook this, resulting in problems for them down the road. The seminal case, SEC v. Ralston Purina Co. involved a company that sold its stock to its own employees. The court found that this was an unlawful issuance of unregistered securities (without an exemption), notwithstanding the fact that the securities in question were only offered to the company’s own employees.

Fortunately, since then, the SEC has created an exemption from federal securities registration through a regulation known as Rule 701, which allows companies to compensate service providers with the company’s own securities (or that of an affiliate) without registering with the SEC. The rule is relatively straightforward to use, compared to some of the other federal securities exemptions. For instance, no filing is required with the SEC to take advantage of it (in contrast to Regulation D, which requires the filing of Form D). In addition, offers and sales under Rule 701 will not be “integrated” with other securities offerings, which means, for instance, that a company can simultaneously compensate employees with stock under Rule 701 while also conducting a Reg. D offering. The class of potential recipients is quite broad, including directors, employees, officers, their families, and even outside consultants or advisers (as long as those consultants or advisers are not assisting the company in its capital raising). Securities sold under Rule 701 are “restricted securities,” which means that they are issued with significant restrictions on resale. Finally, while the terms of the offering must be disclosed, there are no other specific disclosure requirements (as long as the total value of securities issued under Rule 701 in any 12-month period is under $5 Million).[1]

There are some downsides to Rule 701. It is subject to a numerical value cap over any 12-month period of time, which is always at least $1 Million, but can be higher in the case of companies with significant assets.[2] In addition, unlike Rule 506 of Regulation D, there is no preemption of state registration requirements, which means that the issuer will need to find a state exemption for each state in which recipients reside. States are actually quite varied in their approach to offerings of securities to service providers. Some states have an exemption which is identical or similar to Rule 701, but require that the issuer make a notice filing with the state securities division, while other states do not require a filing. Still other states have exemptions that are quite different from Rule 701, resulting in the company being required to comply with both the federal and state securities regulations.

Corporate Governance Implications

One issue that founders of startups do not always think about when granting stock to employees is that once these employees have stock in the company, they will be entitled to all of the privileges of stockholders, including voting rights and records inspection rights. In addition, management will have a fiduciary duty to these stockholder-employees, which they did not have prior to granting the equity compensation.

It is possible to mitigate some of these effects. For instance, when dealing with the issue of voting rights, if the equity compensation is in the form of restricted stock, the company could issue that stock as non-voting stock. If the company is a Delaware LLC, the issue of fiduciary duty can be mostly eliminated by including a provision within the company’s governing documents which has the equity compensation recipients waive management’s fiduciary duties to them.[3] Ultimately, however, if a company wants to avoid these issues altogether, it should not use actual equity in its incentive compensation plan, but rather should use stock appreciation rights or a phantom stock plan.

Equity compensation arrangements can be a great way of aligning the interests of a company with its employees and other service providers. However, properly utilizing them is also quite complex and will introduce new legal and accounting issues for the company. Therefore the decision to issue equity to any service provider should not be taken lightly.


[1] While there are no specific disclosure requirements, issuers remain subject to the anti-fraud provisions of securities laws, which means that any statements made to recipients can’t be untruthful or misleading.

[2] The aggregate sales price of securities sold under Rule 701 in any consecutive 12-month period cannot exceed the greatest of: (a) $1 Million, (b) 15% of the total assets of the issuer, or (c) 15% of the outstanding amount of the class of securities being offered under Rule 701.

[3] This would not be effective for a Delaware corporation or an entity organized in most other states.


This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Alexander J. Davie

Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

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