Understanding Stock Incentive Plans and Rule 701

When it comes to employee compensation, companies can offer more than wages and salaries. One of the most popular choices is granting employees equity, giving them a sense of ownership and aligning their interests with the success of the business. For interested companies, one of the best ways to accomplish that goal is through a “Stock Incentive Plan”.

What is a Stock Incentive Plan?

A stock incentive plan is a formalized program that grants employees the option to buy or receive company stock as part of their compensation. This can be a powerful tool for companies, especially startups, to attract and retain top talent. The plan can take various forms, including stock options, restricted stock, and stock appreciation rights. The most common awards are:

  • Stock Options: Employees have the right to purchase shares at a set price, known as the exercise or strike price, after a certain period or upon achieving specific goals. These might be “incentive” stock options, which come with some additional tax benefits (and are subject to some additional requirements), or “nonqualified/non-statutory” stock options.
  • Restricted Stock: Employees purchase shares that are subject to vesting conditions. If the conditions are not met, the employer may repurchase the shares from the employee at the grant price.
  • Stock Appreciation Rights (SARs): Employees receive the financial equivalent of the increase in the value of the company’s stock over a certain period, without actually owning the stock, usually in the form of a cash bonus. RSUs, or “restricted stock units”, are a similar and common concept.

These plans are designed to give employees a stake in the company’s future. If the company does well, the stock value increases, and employees can benefit financially. This creates a win-win situation where both the company and its employees are motivated to work towards shared success.

What is Rule 701?

Rule 701 is a regulation issued by the U.S. Securities and Exchange Commission (“SEC”). Rule 701 provides an exemption from the usual registration requirements for “stock offerings”, including stock incentive plans.

Equity grants, including grants of the types of equity described above, are grants of “securities” as defined by United States law. Issuing securities often comes with obligations to report the form, amount, and recipient information to state and federal authorities, including the SEC.”.

In addition to setting up a program for employees to work towards an economic benefit, Stock Incentive Plans can streamline compliance with these reporting obligations.

Under Rule 701, companies can offer stock to employees, directors, officers, consultants, and advisors as part of a compensation package without having to register the offering with the SEC. However, there are some limitations:

  1. Dollar Limit: The total amount of stock offered during a 12-month period cannot exceed the greater of $1 million, 15% of the company’s total assets, or 15% of the outstanding securities of the class being offered.
  2. Disclosure Requirements: If the total sales or issuances of equity exceed $10 million in a 12-month period, the company must provide detailed disclosures, including risk factors, financial statements, and a description of the material terms of the plan.
  3. Stockholder Approval: The Stock Incentive Plan must be approved by the company’s shareholders, but once approved, may delegate authority to issue the equity set aside for it to the company’s board of directors.
  4. Prohibitions. Public corporations cannot exempt themselves from reporting under Rule 701. They are already governed by the Exchange Act.

Note that the first two conditions above reference dollar values. The dollar value of the equity is based on its “Fair Market Value” measured in accordance with Section 409A of the Internal Revenue Code.

Ultimately, these guidelines ensure that employees are informed about the stock they are receiving and the potential risks involved. Rule 701 aims to protect employees while allowing companies to offer stock incentives without the burden of full registration. In some states, securities filings may be required in connection with issuances under the plan.

Conclusion

A stock incentive plan can be a valuable part of an employee compensation package, offering the potential for financial rewards tied directly to the company’s success. Rule 701 provides a way for private companies to offer these incentives without the need for SEC registration, making it easier to share ownership with employees and attract high-level talent. Understanding these tools can help both companies and employees make informed decisions about compensation and investment in the company’s future.

Brandon J. Huffman

Brandon is the founder of Odin Law and Media. His law practice focuses on transactions and video games, digital media, entertainment and internet related issues. He serves as general counsel to the International Game Developers Association and is an active member of many bar associations and community organizations. He can be reached at brandon at odin law dot com.

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