Options and Blue Sky Securities Laws

Since we first began representing startups with their securities issuances and other mergers & acquisitions needs in 2011, there has been a marked increase in our startup clients knowing that they must be cognizant of securities laws’ requirements – most clients come to us with the expectation that navigating both federal and blue sky securities regimes will be a major component of any capital raise the company effectuates.  What still comes as a surprise to most of our startup clients, however, is the fact that option grants to employees are themselves securities issuances, and must therefor also comply with the state and federal securities laws.

At the federal level, rule 701 covers most options issuances, and is not difficult to comply with as long as the issuer takes the requirements into consideration before making its first options grants, and then revisits the rule when new grants are made.  However, most issuers (and some practitioners), even if wary that they need to respect federal securities issuances, seem to forget that they must also comply with the blue sky laws for the states in which their grantees reside.

A few further twists:  first, the securities requirements attach whether the options are incentive stock options (ISO’s) or non-qualified stock options (NQSO’s).  Second, because many issuances are done under 506(b) of Regulation D of the Securities Act, the National Securities Markets Improvement Act of 1996 (NSMIA) usually exempts the offering from state registration and review.  However, because options issuances are often done under Rule 701 of the Securities Act and not 506, option issuances are not preempted by the NSMIA, and the blue sky requirements for such offerings are therefor different than those for 506.

Accredited Investors

Whenever a company offers or sells its securities, it must register with the US Securities and Exchange Commission (the “SEC”) or do its offering under the an exemption from the SEC’s registration requirements.  For many angel rounds, the exemption used is Ruglation D of the Securities Act of 1933 (the “Act”).  An important consideration when ascertaining whether an issuance is properly exempted under Reg D is an inquity into whether the investors are “accredited” under the Act.  The federal securities laws define the term accredited investor in Rule 501 of Regulation D as:

1. a bank, insurance company, registered investment company, business development company, or small business investment company;

2. an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;

3. a charitable organization, corporation, or partnership with assets exceeding $5 million;

4. a director, executive officer, or general partner of the company selling the securities;

5. a business in which all the equity owners are accredited investors;

6. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;

7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or

8. a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

For more information about the SEC’s registration requirements and common exemptions, read the SEC’s brochure, Q&A: Small Business & the SEC.