You founded a company; you should be able to grant as much stock as you want to whomever you want, whenever you want, right? Not so fast! To sell company stock or issue options, the securities have to either be registered with the Securities and Exchange Commission (SEC), or be exempt from the registration requirement. Of course, it isn’t practical for startup companies to incur the cost or the burden associated with registration. So instead they usually make grants of equity in accordance with an exemption (like Rule 701!).

One exemption that is commonly utilized by startups when granting options and issuing stock under an employee stock incentive plan is known as Rule 701[1]. Rule 701 under the Securities Act of 1933 covers, “Exemption for offers and sales of securities pursuant to certain compensatory benefit plans and contracts relating to compensation.” Under Rule 701, companies can offer their own securities as part of written compensation agreements to employees, directors, general partners, trustees (if the company is a business trust), officers, or certain consultants (there are qualifications on consultants and advisors to prevent you from claiming your investors as such) without having to comply with federal securities registration requirements.

How do you use Rule 701? There’s no filing to be made or fee to be paid. What you need to do is verify that you are within specific limits for aggregate sales price or amount of securities within a 12-month period every time you make a grant.

There are three checks to apply, and at least one must be satisfied for the grant to qualify for the exemption:

The total value of stock sold or options granted during a 12-month period is less than $1,000,000. For stock purchases, the value is based on the purchase price multiplied by the number of shares granted. In the case of options, the value is based on the exercise price multiplied by the number of options granted.

The total value of stock sold (based on the purchase price) or options (based on the exercise price) granted during a 12-month period is less than 15% of the total assets of the issuer as indicated on the company’s most recent annual balance sheet.

The number of shares sold or options granted during a 12-month period is less than 15% of the outstanding amount of the class of securities being offered and sold (i.e., common stock). The outstanding amount of securities should include those underlying all currently exercisable or convertible options, warrants, or other securities, other than those that were issued under a Rule 701 exemption. For example, if you have five million shares of common stock outstanding (this number includes preferred stock convertible into common stock but does not include other options issued under the company’s incentive plan), you are limited to granting 750,000 shares over a 12-month period.

When your company is very young and your share price is really low, the first check may be all you need (and it’s the most straightforward to calculate). As you grow, these limitations can sneak up on you, so watch out. That’s when you may need to leverage the second or third checks to qualify for the exemption.

Rule 701 also requires issuers to provide the employees, directors, officers, etc. that are receiving equity compensation with a copy of the plan and compensation agreements. If the total value of stock sold or options granted within 12 months exceeds $10,000,000, the issuer must provide additional disclosures to the recipients—including a summary of the plan, risk factors associated with the securities, and financial statements.

As a private company, you may not even have realized that you were subject to any securities laws (but you are). These days, startup companies are raising more capital and waiting longer to IPO, so more and more companies are running into the constraints of Rule 701. If you grant equity without a valid exemption—through ignorance or with intention—and are discovered to be in violation of securities law, the consequences can be serious. You may need to spend money for clean up, you may be fined, your ability to raise capital in the future may be threatened, you may be accountable for returning investment money, and, in rare cases, there may even be civil and criminal charges brought against the company and its officers and directors.

This post serves as a quick primer about the Rule 701 securities exemption—and Fidelity will help you by checking 701 constraints when you grant stock through Fidelity—but there are other exemptions, constraints, and obligations you may need to be aware of when granting stock. For example, are you aware of the applicable state “blue sky” laws you have to comply with? Or did you know that once you have over 2,000 shareholders you may be required to register under the Securities and Exchange Act and meet the same reporting requirements associated with public companies? Talk to your lawyer and have him or her review your grants to ensure you have properly navigated the complexity of securities regulation.

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Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.

[1] 17 CFR § 230.701 (law.cornell.edu)