(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.
Limits
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.