• Vesting of Founder’s Stock. Founders may agree that their interest in the stock of the company will “vest” over time (typically 1-3 years), and grant to the company the right to acquire any unvested stock when the Founder’s service with the company ends.

• Termination. The agreement may define the circumstances in which a Founder’s service with the company can be terminated. If termination is for “cause” (i.e. bad acts by the Founder), the company and/or the other Founders may have a right to purchase some or all of the terminated Founder’s stock in the company (including vested stock).

• Restrictions on Transfer of Founder’s Stock. Founders typically agree not to transfer their shares in the company without the consent of the other Founders, except in limited circumstances such as transfers to specified persons (ex. children or spouse) or for estate planning purposes. Founders often grant to the company and/or the other Founders a right of first refusal to purchase any shares proposed to be transferred by a Founder, except as permitted by the agreement.

• Tag-along Rights. Founders may grant each other the right to participate in any sale of a Founder’s shares to a third party. Any potential purchaser of stock from a Founder would then be required to purchase shares held by all Founders, usually pro rata based on the Founders’ relative ownership interest.

• Voting of Founder’s Stock. Founders often agree to vote all of their shares to elect specified individuals (usually including each Founder) to the company’s Board of Directors.

• Non-competition. Founders sometimes agree not to compete with the business of the company or solicit employees or customers for a certain period of time following the end of their service with the company.

While these provisions are common, a Founders Agreements should be customized to fit the needs of the Founders. Your lawyer can help you create an agreement that’s right for you and your company.

The three exemptions from registration encompassed by Regulation D are found in Rules 504, 505 and 506, while the remainder of the rules in Regulation D set forth further limitations applicable to offers and sales of securities pursuant to each of the three exemptions (we plan to delve into some of these limitations at a later date). The most important aspects of each exemption are summarized below, but please note that the summaries do not purport to cover all aspects of Rules 504, 505 and 506, and should not be considered legal advice. Legal counsel should always be consulted in advance of an issuance of securities.

Rule 504: Rule 504 offers a broad exemption from federal registration for offerings of not more than $1 million over a 12-month period. Unlike Rules 505 and 506, Rule 504 does not impose any restrictions on the use of general advertising and solicitation to promote the offering, or the number or sophistication of investors, and the issuer is not required to provide any disclosure materials regarding the offering to potential investors (though it is often advisable to do so). Securities offerings made under Rule 504 remain subject to state securities laws (also referred to as “Blue Sky” laws), which may impose additional restrictions and requirements. Issuers relying on Rule 504 must either register or qualify for an exemption from registration in each state in which securities are offered.

Rule 505: Rule 505 permits an issuer to offer and sell up to $5 million of securities to an unlimited number of accredited investors and up to 35 non-accredited investors. The issuer must furnish detailed information about the company’s business and finances to non-accredited investors, as required by Rule 502(b)(2). Rule 505 also prohibits the use of general advertising or solicitation to promote the offering; either the issuer or an agent of the issuer (officer, director, employee or intermediary such as a placement agent) must have had a “substantive and pre-existing relationship” with any prospective investor. As with Rule 504, Rule 505 offerings are subject to state Blue Sky laws, which may impose additional restrictions and requirements and must be considered on a state-by-state basis.

Rule 506: Rule 506 permits an issuer to offer and sell an unlimited amount of securities to an unlimited number of accredited investors and up to 35 non-accredited investors, but unlike offerings under Rule 505, any non-accredited investor must have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” As with offerings under Rule 505, in a Rule 506 offering the issuer must furnish non-accredited investors with detailed information about the company’s business and finances (required by Rule 502(b)(2)) and the Issuer is prohibited from using general advertising or solicitation to promote the offering. Unlike offerings under Rules 504 and 505, however, offerings that meet the requirements of Rule 506 are exempt from state Blue Sky laws pursuant to the National Securities Markets Improvements Act of 1996, though states may still require issuers to provide notice of the offering to state securities regulators.

Failure to Adequately Protect your IP. To adequately protect your intellectual property, it is not enough to simply file for patent, trademark or copyright protection; it is also necessary to take precautions to ensure your IP is not misappropriated, such as putting in place internal policies and procedures for the handling of confidential information, and requiring your employees, outside service providers and business partners to sign non-disclosure agreements.

Complex or Confused Equity Structure. A company with a messy or poorly documented equity structure is a headache for potential investors and can be difficult to clean up, which investors often insist on before closing a financing. Companies need to be selective when issuing equity, be sure that all equity issuances are well documented, and be sure that equity incentive compensation granted to employees and others is subject to vesting and other standard conditions that protect the company.

Failure to Comply with Securities Laws. Every issuance of securities – including stock and options – by a private company must qualify for an exemption from federal registration requirements. Failure to comply can result in civil and, in extreme cases, criminal penalties for the company and its officers and directors. Most issuances of equity must also qualify for exemption from state registration in each state where securities are offered. In some cases, companies are required to make detailed disclosure to potential investors in order to qualify for an exemption.

Failure to Comply with Labor Laws. A multitude of federal and state laws govern the relationship between companies and service providers. In addition to laws prohibiting discrimination, federal and state regulations define an employer’s obligation to employees and others. Regulations distinguish between employees and independent contractors, and between so-called “exempt” employees and “non-exempt” employees, and getting these classifications wrong can result in severe pecuniary penalties.

Onerous B2B Contracts. In evaluating agreements with potential business partners, companies need to fully understand their legal obligations as well as their business obligations. Technical legal provisions, such as representations, warranties and indemnification, can have tremendous impact on a company’s potential liability under a contract. Overly onerous obligations can make a company less attractive to a potential investor.

To understand the importance of accredited investors, it is necessary to first understand that a primary goal of the U.S. securities laws is to reduce the possibility that ordinary people will lose their shirts by investing in dodgy companies. This is accomplished in part by requiring that companies provide to potential investors – even to friends and family of a company’s principals – detailed information about the company’s operations and finances, as well as the risks inherent in the company’s business. This information must be provided in a written document (called a private placement memorandum or “PPM”) that can take significant time to prepare and generally requires careful review by the company’s lawyers and accountants. Complying with the disclosure requirements would therefore be cost-prohibitive for companies seeking to raise small amounts from outside investors if not for the fact that the SEC relaxes the disclosure requirements in limited circumstances, including when companies sell only to accredited investors.

A person or entity is “accredited” if he/she/it falls within one of the categories of investors set forth in the definition of “accredited investor” found in Rule 501 of Regulation D, which was adopted pursuant to the Securities Act of 1933. These categories attempt to get at whether an investor has sufficient knowledge and skill to evaluate the risks of a potential investment. For a natural person to be accredited, he or she must be a director, officer or general partner of the issuer or must have, at the time of purchasing securities, either (a) individual net worth, or joint net worth with the person’s spouse, in excess of $1,000,000 or (b) individual income in excess of $200,000 in each of the two most recent years or joint income with the person’s spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year.  [UPDATE: The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law July 21, 2010, provides that individuals may not include the value of their residence in determining  if their net worth exceeds the $1,000,000 threshold for being an accredited investor and requires that the SEC periodically review and update the net worth and income thresholds for accredited investors.]

Because accredited investors are considered better able to fend for themselves, Regulation D permits companies to sell to an unlimited number of accredited investors without requiring that they furnish the information that must be provided to non-accredited investors; provided that the company is available to answer questions from potential investors and provide to them, upon request, the same kind of information that would have to be provided to non-accredited investors, and that the offering also complies with the other applicable restrictions on the scope and manner of the offering. This can save a company thousands of dollars in legal and accounting fees, as well as the time necessary to prepare a PPM. We should point out that the rules of Regulation D allow companies to offer and sell securities to anyone, including friends and family, if applicable restrictions are met; however, if you want the cost savings afforded by streamlined disclosure requirements, then before offering securities to your Aunt Bertha, you’ll want to make sure she’s accredited.

One note of caution: in determining what information to provide to potential investors, it is important to remember that even when offering securities only to accredited investors pursuant to Rule 506, a company is still obligated to comply with the SEC’s anti-fraud rules (we’ll discuss these in a future post), which generally make it illegal to make a misstatement or omission of a material fact in connection with an offering of securities, as well as with any applicable state securities laws. Your legal adviser can help guide you through the intricacies federal and state securities laws.

There are several forms of equity incentives, and it is important to understand the tax and accounting implications of each in addition to the impact each can have on the equity ownership of your company. This post gives a high level overview of the most popular forms of equity incentives among technology companies – stock options and restricted stock – but while we note some basic tax considerations below, this entry does not purport to explain the tax or accounting implications of granting options or restricted stock. It is very important that you consult with your professional advisors before putting in place an equity incentive plan for your company or making equity incentive grants. Also, this entry only concerns private companies and does not attempt to deal with various issues that publicly traded companies must address in connection with making equity incentive grants.

Equity Incentive Plans and Grant Agreements

Equity incentive grants are usually made subject to various conditions that are spelled out in an equity incentive plan (often just called an “option plan”) or in the grant itself. The plan usually gives the company’s Board of Directors, or a committee of the Board, the power to make grants and determine the conditions of each grant, including when the recipient’s rights in the grant are no longer subject to forfeiture (called “vesting”) should the recipient’s service with the company end. The grant may provide for vesting upon occurrence of certain events, but most technology companies issue options and restricted stock that vest over time. A common vesting schedule would provide for a percentage of the options or restricted stock to vest after one year, with the remainder vesting monthly or quarterly over the following two to three years.

Options

A stock option gives the recipient (or “optionee”) the right to acquire a set number of shares of the company’s stock (referred to as shares “underlying” the option or “option shares”) subject to certain conditions. The optionee pays nothing up-front for the option, but the option does not confer on the optionee any benefits of stock ownership – such as voting rights or the right to receive dividends – until the underlying shares are purchased (also known as “exercising” the option) by payment of a predetermined exercise (or “strike”) price for each share. There are two types of options distinguished by their treatment under the Internal Revenue Code (IRC) – nonqualified stock options (NQOs) and incentive stock options (ISOs).

Nonqualified stock options may be granted to employees, directors, consultants and other service providers, but when the option is exercised the difference between the strike price and the then-current fair market value of the underlying shares (called the “spread”) is taxed to the optionee as ordinary income, subject to withholding, and the company receives a corresponding compensation deduction. Any further gain realized when the stock is sold is taxed at the applicable short or long-term capital gains rate, depending on the length of the holding period following exercise. Incentive stock options may only be issued to employees, but unlike NQOs the optionee does not recognize any taxable income when the option is exercised (though the spread is taken into account in calculating the employee’s alternative minimum tax, if applicable) and instead only reports income when she sells the underlying shares, at which time the entire taxable income (the difference between the sale price and the strike price) is treated as long-term capital gain instead of ordinary income. In order to realize the tax benefits of an ISO, the optionee must not sell the underlying shares for at least two years after the option is granted and at least one year after the option is exercised. If the holding period requirements or other conditions in the IRC are not met, then the option converts to a NQO and the optionee is taxed accordingly.

Restricted Stock

Unlike options, which give the recipient the right to acquire shares of a company, restricted stock is actual stock that comes with all of the benefits of stock ownership. Restricted stock is subject to conditions imposed by the company at the time of grant, including the company’s right to repurchase the stock should the recipient’s service with the company end before the restricted stock vests. Restricted stock is usually issued in exchange for cash and/or services at a price per share equal to or less than the stock’s fair market value, and the recipient is required to pay any cash portion of the purchase price at the time the grant is made. The default tax treatment for restricted stock requires the recipient to recognize ordinary income as the restricted stock vests (over time or upon the occurrence of specified events) on the difference between the original purchase price for the shares and their fair market value at the time of vesting. If the stock is subsequently sold, the recipient must recognize a taxable capital gain or loss on the difference between the sale price and the fair market value of the stock at the time of vesting. The recipient may, however, make an election under Section 83(b) of the IRC to pay tax on the value of the entire grant in the year the award is made in exchange for the right to claim capital gain treatment on any future gain. An 83(b) election, which must be made within 30 days of the award, requires the recipient to treat as ordinary income the difference between the original purchase price of the restricted stock and the fair market value of the stock on the date of grant. If the stock is subsequently sold, the recipient would have a taxable capital gain or loss on the difference between the sale price and the original purchase price.