Weil, Gotshal & Manges LLP

Gushing Employee Stock

(February 2006, Private Equity Alert)

By Christopher Aidun and Christine Jarmer

Private equity sponsors are investing in ever larger private companies with greater numbers of employees. Equity incentives issued to accredited investors, directors or executive officers are typically exempt from registration under the federal securities laws. However, when granting equity incentives to a larger pool of employees, consultants or advisors, private equity sponsors and their portfolio companies usually must comply with Rule 701 under the Securities Act of 1933 (the “Securities Act”), which provides an exemption from registration for the issuance of compensatory securities. Private equity sponsors who desire to grant broad-based equity incentives will need to ensure, on an ongoing basis, that their incentive programs avoid the pitfalls of Rule 701. A cease and desist order issued by the Securities and Exchange Commission (“SEC”) against Google and its general counsel last year serves as one recent example of a company tripping up under the technical requirements of Rule 701.

The Google Geyser

Google issued over $80 million worth of stock options to a large number of employees and consultants over a two-year span prior to its initial public offering. Many of the recipients were not accredited investors nor directors or executive officers. In order to comply with Rule 701, Google was required to deliver detailed financial information to stock option recipients, which it chose not to do because it viewed such disclosure as “strategically disadvantageous.” Google instead thought that it could rely on other exemptions from registration, such as the private placement exemption, or that, if it was wrong in its analysis, it could undertake a rescission offer, i.e., an offer to repurchase the options or shares issued under the options from holders. The SEC disagreed and concluded that Google violated the securities laws by not complying with Rule 701. Google commenced a rescission offer and the SEC issued a cease-and-desist order against Google and its general counsel.

What did Google do wrong? How can you avoid the SEC’s wrath when issuing options and other equity incentives to employees?

Rule 701

Stock options, stock appreciation rights, phantom stock and restricted stock are all common equity incentives that are considered securities under federal and most state securities laws. These, like other securities, cannot be issued unless they are first registered under the Securities Act and applicable state law or issued under an exemption from such registration requirements. Equity incentives issued to accredited investors, directors or executive officers are exempt from registration. Equity incentives issued to other employees, advisors or consultants must rely on other possible exemptions, including one that allows for issuances that do not involve a public offering. However, determining whether an offering is sufficiently “non-public” is not an easy undertaking. Several factors must be taken into consideration and each evaluation is dependent upon the particular facts and circumstances. In particular, one factor that makes it difficult for companies to use this exemption when issuing equity to employees is the requirement that purchasers be sufficiently sophisticated. The SEC noted this factor as a reason why Google could not rely on the non-public offering exemption. However, Rule 701 provides a “safe harbor” exemption from registration requirements under the Act provided that certain limitations are adhered to.

Compliance with Rule 701

A number of requirements must be satisfied in order to utilize Rule 701’s registration exemption. These are straightforward and relatively user-friendly.

Private Company

Companies issuing equity incentives in reliance on Rule 701 cannot be public companies, that is, they must not be subject to the reporting requirements of the Securities Exchange Act of 1934.

Written Compensatory Benefit Plan

Securities offered under Rule 701 must be offered under a written compensatory benefit plan or written compensation contract delivered to recipients of the options or other equity incentives. Garden variety stock option plans and employment agreements satisfy this requirement. The primary purpose of the issuance of the equity incentives must be compensatory in nature and not a capital raising transaction (co-investments by management side by side with private equity sponsors are generally not considered to be a capital raising transaction).

Qualified Issuer and Recipients

A benefit plan may be established by the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of its parent (e.g., sister subsidiaries) for the participation of their employees, directors, officers or consultants and advisors. This flexibility is especially relevant for private equity sponsors using a holding company structure to purchase the capital stock of a target company. The holding company may establish a compensation plan and grant options to employees of its subsidiaries.

In accordance with the SEC’s requirement that securities issued under Rule 701 be for compensatory purposes only, securities issued to consultants or advisors are subject to additional guidelines. First, the consultants or advisors must be natural persons; second, they must provide bona fide services to the issuer (or to its parents, subsidiaries or sister subsidiaries); and third, the services cannot be in furtherance of a capital raising transaction or to promote the issuer’s securities. The SEC has indicated that persons who provide advice on business development, business strategy or compensation policies, who arrange a bank credit line or who assist an issuer in business combinations (provided that it does not result in taking a company public) may qualify under Rule 701. However, the SEC has classified individuals who undertake the following activities as involved in capital raising activities: (i)CApersons who find investors, (ii)CApersons who arrange or effect mergers that take companies public and (iii)CApersons who arrange a financing that involves securities issuances.


The aggregate sales price (the exercise price on date of grant for options) or amount of securities “sold” in a consecutive 12-month period in reliance on Rule 701 cannot exceed the greatest of (1) $1,000,000, (2) 15% of the issuer’s total assets or (3) 15% of the outstanding number of the class of securities being offered and sold. The 15% calculation of total assets or outstanding securities is measured at the issuer’s most recent balance sheet date (if no older than its last fiscal year end). The 15% of assets and 15% of outstanding class tests may be made on a rolling basis, i.e., at the time of any grant intended to fall within Rule 701, all Rule 701 sales within the prior 12 months are calculated, including the current grant. The $1,000,000 limitation may also be calculated on a rolling 12-month basis.

Sales Over $5,000,000

With respect to incentive plans for most private equity portfolio companies, the limitations discussed above are rarely an issue. However, the pitfall for portfolio companies lies in the requirement that an issuer deliver additional information to recipients of Rule 701 securities if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5,000,000. The additional disclosure items include (i) a copy of the summary plan description required by the Employee Retirement Income Security Act of 1974 if the plan is subject to such act or, if not, a summary of the material terms of the plan, (ii) a risk factor analysis of the investment in the offered securities and (iii) financial statements (or, if the issuer is relying on the assets of its parent to meet the 15% asset test, the financial statements of the parent). These items are required to be delivered to investors a reasonable period of time prior to the date of sale, provided that, in the case of derivative securities such as stock options, they must be delivered a reasonable amount of time prior to the date of exercise or conversion.

Issuers may be reluctant to provide financial information to their employees. Google cited the potential of having its financial information fall into the hands of its competitors as a factor in the company’s decision not to comply with the Rule 701 disclosure requirements after it had reached the $5,000,000 limit. The SEC’s response to such concerns is for issuers to use other means, such as non-disclosure agreements, to protect competitive information or to stay below the $5,000,000 cap.

Offerings made under Rule 701 are not integrated with offers and sales of other exempt transactions. Accordingly, options and incentive awards to foreign employees that are bona fide offshore transactions and option and incentive awards to senior management and other accredited investors under Regulation D of the Act are not included in determining whether Rule 701 securities have been issued within permitted limits. Compliance with the requirements of Rule 701 does not mean that state blue sky laws are inapplicable. Although many states have exemptions tied to Rule 701, issuers should review the various requirements as some states may require notice or filing fees.

Dos and Don’ts

Rule 701 is a logical, user-friendly exemption for structuring employee and consultant equity incentive plans provided the plans are correctly structured and monitored. In particular:
  • Make sure you have a written compensation plan or are working under a compensation contract.
  • Each time you issue incentives, recalculate compliance with Rule 701 limits. Keep a record with other relevant corporate records (this will be particularly relevant if the company ever goes public because not only will underwriter’s counsel review issuances in their due diligence but the SEC may inquire as to pre-IPO exemptions as well).
  • Don’t ignore the disclosure requirements if more than $5,000,000 of securities are issued in any 12-month period. Secure non-disclosure agreements from recipients if you are concerned about maintaining confidentiality.
  • If relying on exemptions other than Rule 701 (such as Regulation D or Regulation S), follow appropriate procedures under the statutes and keep contemporaneous records thereof.
  • Separately verify exemptions under state securities laws where recipients reside.
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