Employee stock purchase plans (ESPPs) have traditionally been a vehicle for public companies, and are often rolled out upon an initial public offering to rally human capital. For private companies, securities law constraints and the illiquidity of the stock were often considered challenges that outweighed the benefits of an ESPP. Changes in securities law since 2012, together with the growing infrastructure for private liquidity programs, have given additional latitude for private companies to offer ESPPs.
Changes in Securities Law
The Jumpstart Our Business Startups Act (JOBS Act), signed into law on April 5, 2012, increased the threshold for mandatory registration under Section 12(g) of the Securities Exchange Act of 1934 (Exchange Act) from 500 to 2,000 shareholders, and an exclusion is provided for holders of securities issued under employee compensation plans that are exempt from registration under the Securities Act of 1933 (Securities Act). This exclusion applies to both current and former employees if securities were offered as part of their participation in the plan as employees. However, the exclusion no longer applies once securities are transferred to another holder. The Securities and Exchange Commission (SEC) released its final rules implementing the JOBS Act on May 3, 2016. These changes in the Exchange Act have reduced the risk of mandatory registration, an important consideration for private companies in offering broad-based ESPPs.
The Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), signed into law on May 24, 2018, provided additional flexibility for private companies in offering stock-based compensation. Previously, SEC Rule 701 under the Securities Act required that if the sales value of non-registered securities issued pursuant to compensatory benefits plans exceeds $5 million in any consecutive 12-month period, the issuer must provide additional disclosure to the offerees that includes (1) the material terms of the plan; (2) risk factors associated with an investment in the securities; and (3) U.S. GAAP financial statements. The EGRRCPA increases the threshold for heightened disclosure from $5 million to $10 million, and therefore reduces the risk for private companies of having to prepare public company-style disclosure and having sensitive financial information be widely disseminated to participants in a broad-based ESPP. It is important to note that disclosure under the Securities Act, even if not required, could be helpful in responding to antifraud claims by employees participating in the ESPP. The SEC issued final rules to amend Rule 701 on July 18, 2018.
A private company ESPP often comes with increased pressure from employees for ways to sell their holdings. Over the last decade, changes in federal law and availability of capital have resulted in more companies delaying their decision to go public and have led to a thriving market for private company equity sales. The rapidly growing nature of the private market has led to an increasing array of alternatives for holders of private company securities to sell those securities.
Liquidity programs are becoming a common alternative to address the demand from employees for ways to sell their company stock. These programs can take the form of a share buyback by the company or a tender offer by investors or jointly by investors and the company. Liquidity programs provide the company with much control over the determination of the purchase price, the eligible employees, the limitations on shares they may sell individually or in the aggregate, and the frequency of the program (e.g., ad hoc or annual). A technology solution is often used to streamline the eligible employee workflow (facilitating the election to sell and execution of documents) while enforcing eligibility and sellable shares limit pre-set by the company.
We’ve highlighted above the market and regulatory development. If you are considering an ESPP in a private company context, other important considerations include, without limitation, compliance with state and federal securities law (in addition to the topics discussed above), implementing stock transfer restrictions and company repurchase rights upon termination, and valuation of the stock, in addition to the ESPP design issues that public companies typically evaluate.