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Rule 701

What are the financial regulations that a start-up needs to take into account when issuing equity based compensation, whether stock options or RSUs?

It turns out there are quite a few. I will discuss one, which allows private companies to issue securities to their employees without registering the offer with the SEC.

A general rule in US financial regulations is that one cannot issue or sell securities without first registering them with the SEC, unless an exemption applies. We have looked at this before in the context of selling private shares.

The first way to avoid registering securities issued as compensation is by ensuring that the employee who receives the grant is an accredited investor, a director or an executive officer. So that covers your most senior employees. What about everyone else?

The other way to avoid registration is by ensuring that the issuance is ‘non-public’. (remember the section 4 (1 1/2) exemption for selling private shares?). However, determining what a ‘non-public’ offering is can be very difficult. It involves assessing the financial sophistication of the employee and providing information typically found in private placement offerings.

In order to help out, the legislator came up with something called Rule 701 of the Securities Act of 1933.

How to sell up to $1M in stock compensation?

Rule 701 makes is possible for private companies to sell up to $1M in ‘securities’ to their employees as part of a compensation plan (and more than $1M under certain calculations that I am leaving out here). There are some simple requirement such as that the issuance must be made under a ‘written’ plan. This basically means that you must have a contract or other piece of paper which sets out the terms of the plan. So far so good.

How to sell more than $5M in stock compensation, and how not to do it?

If you are a rather large private company and want to issue more than $5M in securities to your employees, things get a little more complicated. In that case, you will need to make certain detailed disclosure to your employees, including financial results. I am not going to go into the details of those disclosure requirements, but let’s say that if you feel that this is too much for your taste, you are not the first. Google chose to ignore those requirements back when it was private, because it ‘viewed the public disclosure of its detailed financial information as strategically disadvantageous’. This became a problem when the company went public and the SEC started looking more closely at the company’s compliance history.

This resulted in a SEC’s cease and desist order in 2005, which also provides a detailed account of Google’s compliance policies and failures.

Google’s path to an IPO, and the $80m in securities issued in the meantime

In it’s first years of existence, Google coud easily rely on Rule 701 as it’s stock option issuance did not reach levels requiring detailed disclosure to recipients. This changed in late 2002, when the company first became aware that it soon would reach such levels as would mandate additional disclosure to employees. The company temporarily stopped issuing stock options because it ‘viewed the public disclosure of its detailed financial information as strategically disadvantageous, and the company was concerned that providing option recipients with the financial disclosures required by Rule 701 could result in the disclosure of this information to the public at large and, significantly, to Google’s competitors‘.

In early 2003 the company wanted to resume issuing stock options. The general counsel, David C. Drummond, came to the conclusion that Google could avoid the additional disclosure that would come from issuing more options by not relying on Rule 701 but instead on more esoteric exemptions(yes the ones mentioned above who are notoriously complicated). If this turned out to be wrong, the company could simply repurchase the issued options under a ‘rescission offer’ as per Mr. Drummond.

Google started issuing stock option again, ultimately resulting in about $80M worth of securities being issued to employees and consultants without registering the offering and without providing financial information required to be disclosed under the federal securities laws. For clarity, when issuing securities you either have to register them(basically go public) or rely on an exemption from doing so(which would be Rule 701 or one of the more esoteric exemptions in this case).

As it turned out, the SEC came to the conclusion that those esoteric exemptions were not available to Google, and that the rescission offer the company made in 2004 did not cure any prior violation of securities law. The company had essentially been issuing about $80m worth of stock illegally.

The lesson seems to be that larger private companies who wish to issue any form of equity based compensation (RSU, options and others) in excess of $5m should meet the disclosure requirements of Rule 701. The majority of your employees are not going to qualify as accredited investors, and attempting to avoid 701 by relying on esoteric private placement exemptions is only going to make your life more difficult and is unlikely to result in a successful exemption.

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