Selling securities is highly regulated in the US (surprise). There's a group of laws that are collectively referred to as the "securities laws". In those laws, there are regulations that list rules that private and public companies must abide by to sell securities.

Options to investors and shares to investors are securities. The SEC, at its discretion, can investigate any issuance of a security and penalize companies for not qualifying for an exemption. To legally issue these securities, you must receive an exemption. Luckily, there are exemptions that already exist for most startup securities.

Exemptions for preferred shares

According to this Seed Financing Overview from Fenwick & West, the two most commonly used federal exemptions for issuing preferred shares to investors are:

  • Section 4(a)(2)

  • Rule 506(b)

Exemptions for issuing employees options

The SEC is busy and doesn't have time to investigate every startup's option issuance practice or Series A rounds. Instead, they investigate big companies that could generate meaningful fees for the agency. If your company scales, not recording the proper exemption can be costly.

If it's so rare, why does it matter? The cost of complying is trivial compared to the fee. In the above link, Credit Karma could have shared some financial statements with the employees and could have avoided the fine altogether.

Disclaimer: We are not lawyers, and this is not legal advice. Although we try to make sure our information is accurate and useful, please consult a lawyer if you want legal advice.

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