Be Careful About Issuing Stock To Employees: Avoiding a hidden "gotcha" in business

There's a hidden “gotcha” out there for many business owners. Many business owners and leaders don't realize that any offering of stock in your company may technically be a securities offering.

This even includes issuing stock to your employees in exchange for work. “Sweat equity” is actually a securities offering.

And while this seems like technical mumbo-jumbo to many business owners this can come back to haunt you if one of those employees is upset later and decides to sue you or turn you in. It can also come back to haunt you when your next round of investors look through your historical paperwork when deciding to make their investment (investors like to invest in clean companies without buried legal issues).

Sometimes, by doing a securities offering incorrectly, you are buying yourself a potential lawsuit, lots of expense and potential criminal liability.

But with a little awareness and planning this can all be made better.

Let's start with the basics: anytime you offer stock in your company, it's almost always a securities offering. From there a Securities offering must be one of two things: (1) registered or (2) exempt from registration.

For most small companies there's not much thinking to be done here. Registration is expensive and cumbersome. This means you want almost every securities offering to be exempt from registration.

So let's think about employee stock offerings and how to make them exempt.

NOTE: This article will provide a general overview of federal exemptions. You also need to look at state law. Don’t rely on this article. It’s an overview, not legal advice. Consult your counsel.

It Seems So Innocent

Issuing stock to employees seems like it's a very innocent and simple transaction. Many business owners have argued to me they should be allowed to do it.

They’ll tell me it's a win for the employee because not only do they get paid but they get some ownership of the company.

Sadly I don’t write the laws and the law is not set up that way. The law was setup to protect innocent investors from buying stock from pushy stock sellers.

And an employee coming to work every day, from the eyes of a securities regulator, is a very innocent person. Here's somebody who cannot potentially negotiate for themselves and might rather have cash payment rather than stock ownership in a company.

Just because your intentions are good and you wish the best for your employees doesn't mean that you're going to avoid getting through the regulatory process related to a securities offering.

What really matters is what's happening in the transaction, not your good intentions or your well wishes for your employees.

Employees Get Protection Too

And many business owners and leaders mistakenly believe that just because an employee is getting cash payment plus stock the employee is already protected under the eyes of the law.

Many view the stock as being a bonus or icing on the cake. Something extra the employee is taking away.

But the securities regulators typically don't think this way. They see that the employee is giving up their time and effort in exchange for stock. This means under the law it's a purchase.

Since the employee is buying the stock with their time and effort they too are a purchaser and get all applicable protections under securities law. This means are entitled to disclosures, understanding the investment and all the other things that go into a securities offering.

No Special Status Under Securities Law

And to make it clear there's no special status under the securities laws for offerings to employees. As we mentioned in the opening, securities offerings have to be either registered or exempt. There's no different classification of securities for employees.

There are, indeed, special exemptions available for offerings of stock to employees. But it doesn't make it any less of a securities offering. It just means that there might be an exemption that's more readily available.

There Are Special Exemptions

Looking at the SEC and the federal regulatory environment, there is a Rule 701 exemption for offerings of stock to employees.

This is where most companies will find their ability to get stock to employees on reasonable terms. If you want to issue stock to employees a Rule 701 exemption may be exactly where you want to go. Rule 701 makes it very simple to offer stock to employees if you fall within the dollar amounts and terms of Rule 701 (it’s your job to check compliance).

We must remember that Rule 701 is a federal exemption. You will also need to understand which state laws are implicated based on where you are doing business and where your employees are located. The good news is that many state law systems have parallel exemptions that work well with Rule 701.

It Pays To Do It Right

Some might be saying “why bother with all this? I'll probably never get in trouble.”

It's much like speeding on a highway. While a securities law violation is potentially much bigger deal, many people say “everybody else is doing it, why can't I?” And the truth is if you get caught you are just as liable even if other people are breaking the law. It's not okay and it's not a defense to point to other people breaking the law.

Additionally, doing a Securities Law offering incorrectly can haunt you when you bring in your next round of investors. Typically sophisticated investors joining your company later in its life want to know that all prior securities offerings done prior to their involvement were done correctly.

So it pays to do this right. The good news is the law is set up for you to be able to do this correctly. You just have to take the time and energy to comply.

And now, after reading this article, you are more aware of what's going on out there and what to avoid.

What To Do Now

With this awareness you can plan your next securities offering better. This means you know what to think about before you even get started.

Remember that basically every offering of stock in your company is going to be a securities offering. Start a conversation early with your attorney to make sure that you will be in compliance early in the process.

The laws are sometimes a challenge to comply with, but with proper planning it can be done as part of your business process. Just add it to your planning and you'll be happy down the road when you bring in those investors and everything goes smoothly.

This Article is from The Our Shawn McBride - The Planning Done Right Guy(TM).

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DISCLAIMER: This article talks about legal issues. I am a lawyer licensed in multiple US jurisdictions, but I am not your lawyer unless we have signed an engagement agreement. Please view this material as educational and general in nature (as it is). Consult counsel you have retained for advice on your specific facts and circumstances and applicable laws. Do not rely on the statements in this article as legal advice.

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