United States

Share-based awards: Private company compliance with SEC Rule 701

FINANCIAL REPORTING INSIGHTS  | 

SEC Rule 701 provides an exemption from the registration requirements of the Securities Act of 1933 for securities issued by a private company under a written compensatory benefit plan (e.g., ESOP or 401(k)), or written compensation contract, to employees, directors, officers, consultants, advisers and their family members. To qualify for the exemption under this Rule, the aggregate sales price or amount of securities sold and options granted during any consecutive 12-month period must not exceed the greatest of:

  • $1 million (measured in accordance with the provisions of Rule 701);
  • 15% of the total assets of the issuer, measured at the issuer’s most recent balance sheet date (if no older than its last fiscal year end); or
  • 15% of the outstanding amount of the class of securities being offered and sold under Rule 701, measured at the issuer’s most recent balance sheet date (if no older than its last fiscal year end).

Under Rule 701, if the aggregate sales price or amount of securities sold or issued during any consecutive 12-month period exceeds $5 million, the issuer must furnish financial statements as required by Part F/S of Form 1-A (Regulation A Offering Statement) under Regulation A. The issuer must deliver the financial statements and other required disclosures (i.e., a summary of the compensation plan and information about investment risks) to investors within a reasonable period of time before the date of sale (or grant), or in the case of stock options, before the date of the stock option exercise or conversion.

If the provision of financial statements is required, the financial statements must be prepared in accordance with generally accepted accounting principles for the two most recently completed fiscal years, unless the issuer has been in existence for a shorter period. Regardless of the offering amount, private companies may elect to follow the financial statement requirements for either Tier 1 or Tier 2 of Regulation A, which are briefly summarized as follows:

  • Tier 1 – Financial statements do not have to be prepared in accordance with Regulation S-X, and the financial statements may be unaudited unless audited financial statements are available. Unaudited financial statements must be labeled as such.
  • Tier 2 – Financial statements must be audited and must comply with the financial statement requirements for smaller reporting companies under Article 8 of Regulation S-X.

The financial statements must be as of a date no more than 180 days before the sale of securities in reliance on the exemption; therefore, unaudited condensed interim financial statements also may be required to make sure the date of the most recent financial statements is never more than 180 days before the sale or issuance of securities in reliance on the exemption. In addition, financial statements of acquired entities and related pro forma information may be required for significant business combinations or operating real estate acquisitions.

If a private company fails to provide the requisite disclosures and financial statements under Rule 701, it loses the registration exemption for the entire offering made during the 12-month period in which it exceeded the $5 million threshold. Therefore, it is important that private companies track the volume and expected timing of their share-based awards carefully so as to know whether the threshold will be triggered and financial statements will be required to be provided.