capital markets reform

Private companies in the gig economy like Uber and Airbnb would love to issue compensatory equity to their platform participants, just like they’re able to do with their employees. The problem is that the exemption from registration for compensatory issuances only covers issuances to employees and consultants of the issuer.  Last July, however, the Securities and Exchange Commission published a concept release seeking comment on whether the exemption should be extended to equity issued to participants in the gig economy.  This past Friday, Airbnb delivered a comment letter to the Commission advocating for an expansion of the exemption to cover sharing economy participants. This blog post will seek to explain some of the key issues involved here.

Background: Rule 701

Rule 701 of the Securities Act of 1933 provides a safe harbor exemption from registration for equity securities issued as compensation by non-reporting companies to employees, consultants, advisors or de facto employees providing services to the issuer. The purpose of the exemption is to facilitate securities-based compensation; it’s not available for capital-raising issuances or any other issuances for any purpose other than equity compensation.

The aggregate sales price or amount of securities that may be sold during any rolling 12-month period must not exceed the greatest of (i) 15% of the issuer’s total assets, (ii) 15% of the outstanding amount of the class of securities being offered and sold under Rule 701, or (iii) $1 million.

The issuer must give all participants a copy of the benefit plan or contract setting forth the incentive equity.  Beyond that, if the aggregate sales price or amount of securities sold under Rule 701 during any rolling 12-month period exceeds $10 million, the issuer must also provide additional mandated disclosure, including risk factors and specified financial statements.

Finally, under the amendments to Section 12(g) of the Securities Exchange Act of 1934 introduced by the JOBS Act (which increased the shareholder thresholds at which issuers must register a class of securities under the Exchange Act to 2,000 or 500 non-accredited investors), persons holding only securities received under an employee compensation plan in a transaction exempt from registration (including under Rule 701) are not considered to be holders of record for calculating record holders under Section 12(g).

Concept Release on Compensatory Securities Offerings and Sale

The Securities and Exchange Commission published its Concept Release on Compensatory Securities Offerings and Sales on July 18, 2018. In the introductory sections of the concept release, the Commission described the characteristics of the gig economy where service providers use a company’s Internet platform for a fee to provide peer-to-peer services such as ride-sharing, food delivery, household repairs, dog-sitting, tech support and lodging. These are not traditional employment relationships, and so the participants aren’t deemed to be “employees” — or consultants, advisors or de facto employees – and thus are ineligible to receive securities in compensatory arrangements under Rule 701. But the same compensatory and incentive motivations to include equity in employee compensation may exist with respect to gig economy participants, i.e., alignment of interests, recruitment, retention and enhanced compensation relative to what a company may be able to pay in cash or other benefits.

Accordingly, in light of the significant evolution in the composition of the workforce since Rule 701’s last meaningful amendment 20 years ago, the concept release sought comment on possible ways to modernize the exemption and expand it to cover securities issued to participants in the gig economy.  In seeking comment from the public to determine what attributes of gig economy relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption, the Commission posed several specific questions, including the following:

  • What activities should an individual need to engage in to be eligible?
  • Should the test identify Rule 701 eligible participants as individuals who use the issuer’s platform to secure work providing lawful services to end users?
  • Should there be a sufficient nexus between the individual and the issuer to justify application of the exemption for compensatory transactions?
  • Should it matter whether individuals provide services to the issuer, or instead to the issuer’s customers or end users?
  • Does it matter whether that business activity provides a service typically provided by an employee or is more of an entrepreneurial nature?
  • Whether a potential eligibility test should consider the individual’s level of dependence on the issuer, or, conversely, the issuer’s degree of dependence on the individuals?
  • Should it matter what percentage of the individual’s earned income is derived from using the issuer’s platform?

Recognizing that extending eligibility to individuals participating in the gig economy could significantly increase the volume of Rule 701 issuances, the Commission posed these additional questions:

  • Would revising the rule have an effect on a company’s decision to become a reporting company?
  • Would such revisions encourage companies to stay private longer?
  • To what extent do companies utilizing “gig economy” workers issue securities as compensation to those individuals?
  • What effect would the use of Rule 701 for “gig economy” companies have on competition among those companies and newer companies and more established companies vying for the same talent?
  • Should a gig economy participant receive the same disclosure as an employee?

The Airbnb Comment Letter

In a letter dated September 21, 2018, Airbnb responded to the concept release and offered a convincing rationale for reforming Rule 701 as well as several interesting specific proposals.

As to rationale, Arbnb’s comment letter argues that expanding the category of persons eligible to receive securities under the Rule is consistent with the goals of the JOBS Act to facilitate entrepreneurship and growth startups. Doing so would further democratize share ownership and enable many ordinary individuals who have been effectively excluded from early stage investing to benefit from the potential growth of startups. It would align the interests of sharing economy companies with the service providers who use their platforms to the benefit of both. (Note that Airbnb is careful to use the term “sharing economy” rather than “gig economy”; for a good, concise explanation of the distinction, see here.) Extending the exemption to issuances to sharing economy participants would also incentivize individuals to leverage their assets to participate in the sharing economy and supplement their income. Finally, it would help younger and smaller companies compete with older and larger competitors yielding better outcomes for end users.

Because of the magnitude of Airbnb’s and other sharing economy companies’ participants, Airbnb asserts that the extension of Rule 701 to sharing economy participants would only be useful to those companies if they were allowed to exclude the recipients from the number of record holders under Section 12(g), as is the case with recipients under the current Rule; otherwise, such issuers would easily exceed either or both the 2,000 holder or 500 non-accredited investor holder threshold forcing those companies to register with the Commission and be saddled prematurely with its regulatory and reporting regime.

But shouldn’t sharing economy participants receive adequate disclosure when receiving securities? Airbnb asserts that most Rule 701 recipients are not making an investment decision when they receive their shares (which is why there’s no mandated disclosure obligation under the current Rule unless a dollar threshold is exceeded). Moreover, sharing economy participants would be expected to know much more about the issuer than typical investors, thus minimizing the need for disclosure. Finally, the primary motivation for issuing equity to participants would not be to raise capital but rather to align interests.

Airbnb advocates for the creation of a new subcategory of eligible recipients under Rule 701, which would be more restrictive than for recipients under the current Rule. The focus of any amendment to Rule 701 to create what Airbnb calls the Sharing Economy Award Exemption should be on the nature of eligible companies, nature of securities awarded to participants and transferability of the securities.

Eligible companies would need to satisfy the following criteria to ensure they are bona fide sharing economy companies and not just seeking to sell securities:

  • Provide a platform to allow third parties to provide goods and/or services to end users;
  • Derive a significant portion of its revenue from fees paid by platform participants;
  • Control the platform by either having the right to exclude a listing or participant for violating terms, or by determining amount of user fees and terms and conditions for receiving payment for goods and services sold on the platform.

Airbnb believes the securities permissible under the Sharing Economy Award Exemption should be more limited than currently allowed. Recipients should not be permitted to choose between securities or cash, so that they aren’t making an investment decision. Not more than 50% of the value received by the recipient from the issuer for goods and services sold on the platform over a 24 month period should be in the form of equity. And any equity award should not be made contingent on making a capital contribution, to ensure the absence of a capital raising motive.

Finally, Airbnb believes the restrictions on transferability of securities issued in the Sharing Economy Award Exemption should be more restrictive than under current Rule 701, even suggesting that it would be appropriate to provide that such securities be non-transferable prior to an IPO or a change in control. If such serious transfer restrictions are imposed and no cash is contributed in connection with the issuance, Airbnb believes any disclosure obligation should be minimal.