Securities Exemption for Employee Equity Compensation

Even equity compensation given to employees and contractors must be registered under the securities laws unless an exemption to registration can be found. Fortunately, at the federal level the SEC provides such an exemption in the form of Rule 701. Rule 701 permits companies to grant compensatory equity awards, pursuant to a written compensation plan or agreement, to directors, officers, consultants, and advisors. The total amount of securities sold or granted in any 12-month period cannot exceed the greatest of: – $1 million – 15% of the total assets of the company (as determined by the most recent annual balance sheet) – 15% of the outstanding amount of the class of securities offered (as determined by the most recent annual balance sheet) Rule 701 does not require any fees or filings with the SEC, but in order to comply with the rule companies must provide recipients of the compensation with a copy of the plan and agreements that the securities will be governed by. Additionally, if the total amount of securities sold in any 12 month period exceeds $5 million, the company must provide additional disclosures, such as a summary of the plan, risk factors of the securities, and financial statements of a form similar to that required by Regulation A. It is also important to note that Rule 701 has special limitations on who or what can be a “consultant” or “advisor” for the purposes of the rule. Consultants and advisors under Rule 701 must be natural persons (so compensation cannot be offered to the consultant’s or advisor’s corporate entity, if they have one), must provide bona fide services to the company (actual services as opposed to phantom or illusory services recited simply for the purpose of utilizing Rule 701), and those services cannot be in connection with any offer or sale of securities for raising of capital. In other words, investors, brokers, or finders cannot be sold securities under Rule 701 simply by calling them consultants or advisors. It is also worth noting that, unlike securities exemptions under Regulation D, a Rule 701 offering cannot be integrated with another offering, so companies may offer equity compensation plans while simultaneously conducting a capital-raising offering third-party investors. It is also important to note that Rule 701 does not preempt state law, so you must also ensure that your equity compensation offering complies with the applicable state laws. Fortunately, most states also have exemptions for equity compensation — in Massachusetts, a potential exemption exists under MGL c. 110A s. 402(a)(11).

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