Update Rule 701 now to aid equity rich, cash poor employees

The SEC should consider updating Rule 701 — which lets private companies issue equity compensation without registering with the regulatory agency — to facilitate periodic pre-IPO liquidity to rank-and-file employees.  

Why? For one thing, companies are staying private longer. Back in 1980, the median age of a startup at the time of its IPO was six; in 2021, the median wait time to go public was 11 years, according to TIFIN. 

The extra time can give emerging startup founders the freedom to realize their long-term vision, as opposed to appeasing Wall Street analysts' quarterly expectations. After all, it can take years to realize a profit when you're trying to put man on Mars or build artificial intelligence that will advance humanity for generations to come.

But the prolonged run-up time to IPOs has also been a bane for millions of employees who work for those companies, as equity grants given in lieu of cash compensation can constitute a vast portion of a worker's net worth — with no guaranteed ability to realize its value.

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The data tells a devastating tale: Close to half (46%) of options went unexercised when they expired in 2022, according to a 2023 Employee Stock Options Report by Carta, partly because workers have no means of accessing liquidity before their employer goes public and typically forfeit their equity if they leave their job.

Many can't afford to wait for an IPO

 
The merits of offering employees equity as part of their compensation package are obvious: It aligns the interests of the company and its employees and allows the founders to reinvest available cash into the business. The incentivized employees' hard work increases the intrinsic value of the company, which in turn increases the value of the equity its employees hold in it. DoorDash, Pinterest, Uber and many other companies collectively turned tens of thousands of their employees into millionaires when they eventually IPOed. 

But what about the IT worker who needs to pay for her kids' college tuition next year, or the HR manager looking to buy his first home in the next six months or the facilities director paying for long-term medical care for her aging parents? 

These employees can't afford to wait until their employer decides to IPO to realize the value of their equity — and they shouldn't have to. Without the ability to access its value, the promise of equity is an empty gesture.

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Tapping pre-IPO liquidity

To remedy the situation, all interested parties — including financial advisors who share a stake in their clients' financial prosperity — should advocate for an update to the SEC's Rule 701. 

Such an update should facilitate periodic liquidity for rank-and-file employees who were granted equity as part of their compensation. Specifically, it should provide employees with the opportunity to access liquidity of at least 5% of their vested equity annually. 

To allow for market-driven competition and adaptability to different company structures, the SEC should allow for a range of solutions to provide this liquidity, including issuer-sponsored tender offers and secondary market access. The agency should further amend the rule to add to the disclosure requirement regarding the company's liquidity policies. 

These modest but important amendments to Rule 701 would be an all-around win:

• Private-company employees would finally be able to convert their equity into cash, improving their financial positions and fulfilling the promise of the compensation packages that enticed them into joining their employer in the first place.

• Private companies would attract and retain high-quality talent more easily — the very goal that Rule 701 aimed to facilitate when it was first conceptualized almost four decades ago.

• The federal government would benefit from the increased tax revenue generated by more private company employees selling their equity and creating capital gains. 

• Finally, wealth managers could invest the money gained from increased liquidity to secure their clients' long-term prosperity while growing their own advisory practices.

The conclusion is inescapable: Modernization of the SEC Rule 701 is long past due.