By Amy Leisinger, J.D.
In its last meeting before the transition to a permanent successor Small Business Capital Formation Advisory Committee, the SEC’s Advisory Committee on Small and Emerging Companies explored the need for updates to modernize Securities Act Rule 701, a registration exemption for securities issued by non-reporting companies pursuant to compensatory arrangements. In response to suggestions by industry participants, the committee agreed to recommend that Commission staff take an in-depth look at the requirements of the rule and their impact on private companies, particularly in connection with recent legislation moving Rule 701’s cap from $5 million to $10 million.
Rule 701. Under Rule 701, a company can offer its own securities as part of compensation agreements to employees, executives, or consultants without complying with registration requirements if total stock sales do not exceed certain limitations. For sales over $5 million to specified individuals during a 12-month period, a company must disclose additional information regarding the plan, related risk factors, and certain financial statements. Financial statements must be not more than 180 days old, and stock option disclosures must be delivered within a reasonable period before the date of exercise. If the threshold is exceeded and disclosures are deemed untimely, the Rule 701 exemption is lost for all stock and options granted, not just those exceeding $5 million.
Recommended modifications. During the meeting, Christine McCarthy of Orrick, Herrington & Sutcliffe LLP’s Compensation and Benefits Group noted that many private and startup companies need to compensate with equity in order to incentivize talent and hire for growth and development of the company. However, she explained, private companies at early stages lack the resources to comply with the requirements of Rule 701 and similar rules. Although the SEC staff has provided some clarification on Rule 701, she expressed the importance of further efforts to avoid undue complications to best serve private companies and small startups, as well as employee-investors.
As such, McCarthy recommended a number of modifications to Rule 701 to increase its usefulness. First, she suggested removal of the requirements that consultants be natural persons in order to fall within the exemption. Early-stage companies with minimal resources use a lot of consultants as opposed to hiring full-time at the outset, she stated, and most individual consultants will organize as entities for tax and other legal purposes, she explained. McCarthy also advocated clarifying that a material change to a previously issued Rule 701 security does not result in a new grant or sale for purposes the rule and that restricted stock units are considered “sales” on the date of grant (like options) and should be valued for Rule 701 purposes based on share value on the date of grant. While many of these limitations were put in place to address the threat of Rule 701 use for non-compensatory purposes, they really do not do much to curb abuses, she said. Many companies end up using “accredited investor” exemptions because repricing can lead to Rule 701 issues, and the better solution is to enforce the rule itself, McCarthy opined.
She also suggested a number of changes to Rule 701’s disclosure obligations. Because the $5-million limit could be exceeded at the end of a 12-month period and expanded disclosure could need to be provided for any sales during the period, a company must generally “guess” whether it will go over the threshold and begin providing disclosure before the limit is reached, McCarthy noted. As such, she recommended changing the rule to state that expanded disclosure is only required for sales occurring after the threshold is actually exceeded and to provide a buffer compliance period. Moreover, the rule should be amended to clarify the timing and delivery requirements applicable to disclosures, she said; it is important to specify what constitutes a “reasonable period of time prior to sale” and what level of certainty is required as to the completion of delivery, McCarthy stressed. To reduce the burdens on small and startup companies and simplify the process, the SEC should also consider decoupling the expanded disclosure requirements from Regulation A and other similar disclosure obligations and limiting financial disclosure updates to once a year unless a material event results in material value change, she concluded.
Steve Miller, CFO of online eyeglasses retailer Warby Parker, echoed McCarthy concerns and noted that, at the outset, a startup can face a number of challenges in incentivizing talent to work with a new company. The provision of equity under rules like Rule 701 can be a solution to the dilemma, he said, but people need flexibility in a startup and can inadvertently run afoul of exemptions. It takes time to put a structure in place, and confidentiality can be crucial as a private company begins its journey, Miller explained. Regulators need to avoid imposing onerous requirements on companies least suited to meet them and make efforts to adjust exemptions to ensure that they are truly effective for the benefit of small businesses, he opined.