Category: Securities Law

Issuing Equity to Employees – Rule 701 and the Changing Landscape

For most companies, but especially for early-stage tech companies, granting equity to employees can be a win-win. For the company, granting equity helps preserve cash and aligns the interests of the employees and the company by giving the employees a financial interest in the company’s success. For the employees, owning equity allows them to share in a company’s upside, potentially making them wealthy. The best known form of granting equity interests is offering stock options, but there are many other alternatives – restricted stock and stock appreciation rights to name a few.

Whatever form equity granted to employees takes, the grant is a security that must be registered under federal law and qualified under applicable state law, absent applicable exemptions. For privately held companies, the exemption that is most often useful in this situation is SEC Rule 701. One important caveat is that Rule 701 applies only in compensatory situations and not for capital raising. It is available to U.S. domestic and foreign private issuers, but may not be used by brokers, affiliates, and other persons seeking to resell securities.

Without listing all of the nuances of Rule 701, there are a few key requirements that should be mentioned:

  • Rule 701 requires an issuer to provide a copy of the relevant compensatory plan to all eligible recipients in a reasonable time before issuing the securities. In addition, if the aggregate sales price of securities sold in reliance on Rule 701 exceeds $10 million in a 12-month period, the issuer must also provide additional detailed disclosures to all eligible recipients, which can be quite burdensome.
  • Rule 701 permits issuances to employees, officers, and directors, provided that the securities are granted or issued pursuant to a written compensatory benefit plan, which can include an employment agreement. Although it also permits grants to consultants, there are a number of additional restrictions in that case.
  • The aggregate sales price or amount of securities sold under Rule 701 must not exceed the greatest of the following: (i) $1 million; (ii) 15% of the total assets of the issuer, measured as of the date of the issuer’s most recent balance sheet; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, measured as of the date of the issuer’s most recent balance sheet.
  • Securities issued pursuant to Rule 701 are “restricted securities” as defined under Securities Act Rule 144, and the person receiving them must only transfer them in compliance with such Rule or another exemption from registration.
  • Employers seeking to issue compensatory equity must also comply with state laws regulating the offer and sale of securities. Some but not all states have exemptions similar to Rule 701, so the laws of the state or states where the employees are located must be reviewed to ensure full compliance.
  • Issuances of equity under Rule 701 are always subject to the antifraud provisions of the securities law even though a formal registration is not required. This means that to reduce the likelihood of future claims in the event that the securities end up with little or no value, it is vital for the company to work with legal counsel to prepare comprehensive disclosure about the company and its management, operations, competitive landscape, and other relevant aspects.

Companies should also be aware that the SEC has officially requested public comments regarding possible changes to Rule 701. The main impetus behind the possible changes is that Rule 701 allows grants of equity to employees, but is very restrictive when it comes to granting equity to independent contractors. With the changing nature of work and the expansion of the gig economy, there is a good argument that Rule 701 unfairly discriminates against contractors. The SEC is accordingly considering whether to amend the definition of employee to include individuals who provide freelance services and that currently may not be issued securities under Rule 701. Stay tuned!

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