Many privately held companies rely on equity compensation awards (typically stock options) to recruit, retain and motivate key employees and other service providers.  The issuance of such equity compensation awards generally needs to comply with, among other things, federal securities laws.  Most commonly, private company issuers of equity compensation awards rely on federal Rule 701 which provides an exemption from the registration requirements of the Securities Act of 1933.

While Rule 701 is usually the preferred securities law exemption for private company equity compensation awards and while it is a relatively flexible rule, Rule 701 does still contain a variety of requirements and failure to comply with such requirements can generate harsh legal consequences to private company issuers.  Without enumerating all of Rule 701’s requirements, a few noteworthy ones are:

  • The grant date value of equity compensation awards sold in reliance on Rule 701 cannot in any consecutive twelve month period exceed the greatest of:  (i) $1,000,000, (ii) 15% of the issuer’s total assets, or (iii) 15% of the outstanding securities of the same class being sold by the issuer in reliance on Rule 701.
  • If relying on either of the 15% tests and if the aggregate grant date value of the equity compensation awards sold during the relevant twelve month period exceeds $5 million, then the issuing company must have delivered to all offerees during such twelve month period a “prospectus” that includes, among other things, risk factors and company financial statement information.  Ominously, this prospectus must have been provided to all affected offerees before the $5 million threshold is actually exceeded.
  • Eligible offerees must be current service providers who are natural persons (i.e., no entity offerees).

Back in 1998, the SEC substantively amended Rule 701.  Such amendments provided a number of clarifications and also relaxed many of its requirements.  In particular, before such 1998 amendments, the foregoing $1 million twelve month limit had previously been only $0.5 million and there had been an absolute $5 million ceiling on the value of issuances during a twelve month period.

Almost twenty years later, there are signs that Rule 701 may be further amended so that it will be easier for private companies to comply with Rule 701 and to enable them to issue a larger value of equity awards under Rule 701.  On September 11, 2017, the Senate passed the “Encouraging Employee Ownership Act” which would compel the SEC within 60 days of enactment to double the $5 million threshold to $10 million.  Moreover, under this Act, the new $10 million threshold would be indexed to, and further adjusted by, the consumer price index.  Earlier in 2017, the House had passed a similar act.

Moreover, on September 21, 2017, the SEC’s Advisory Committee on Small and Emerging Companies (“ACSEC”) (which had been voluntarily formed by the SEC on 2011) issued its final report to the SEC. Such report contained many recommendations on a variety of issues.  With respect to Rule 701, the ACSEC stated that the “time is ripe for changes to modernize Rule 701” and suggested that the SEC take into consideration certain recommendations that private industry had provided to the ACSEC in a presentation earlier in September 2017.  These suggested changes, among others, included the following:

  • Eliminating the annual $1 million/15%/15% ceiling on the magnitude of awards that can be issued under Rule 701.
  • Increasing the $5 million prospectus threshold to at least $10 million.
  • Providing that the prospectus disclosure only be required for recipients of issuances in excess of the $5 (or $10) million threshold (not to all offerees).
  • Allowing non-natural persons to be offerees under Rule 701.
  • Other suggested technical changes that would generally make compliance with Rule 701 easier and lessen the negative impact of noncompliance.

It has been a long time since Rule 701 has been substantively modified.  While it is unclear if the Encouraging Employee Ownership Act will be enacted or whether/when the SEC will take action on the above recommendations, it does appear that in the foreseeable future there may be changes to Rule 701 that would be favorably received by private companies which rely on equity compensation programs.  Companies may wish to stay abreast of developments in this area. In the meantime, companies should continue to maintain compliance with the existing Rule 701 requirements which are all still in effect as is.

For further information, please contact Gregory Schick by email or at (415) 774-2988.


This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.