Key Takeaways

  • Rule 701 is a federal exemption under the Securities Act of 1933 that allows private companies to issue equity compensation without SEC registration.
  • Exemption Criteria: The exemption applies if equity compensation offerings are below certain thresholds (such as $5 million or 15% of balance sheet assets in a 12-month period).
  • Why it's important: Rule 701 helps startups and small private companies save on the cost and effort of filing with the SEC.
  • Common Mistakes: Offering stock options to ineligible parties, or failing to realize when the $5 million threshold is exceeded.
  • Steps to file: No SEC filing required, but a written compensatory benefit plan must be in place for equity grants.

Rule 701: What is it?

Rule 701 comes from the Securities Act of 1933. It's a federal exemption that frees companies from registering stock option grants and rewards for performance. No forms need to be filed with the SEC, nor do fees have to be paid. But there are conditions and limitations that come with awarding stock options under Rule 701. The Rule has strict mathematical limits that cannot be exceeded. If the value of the equity goes over $5 million, 15 percent of the issuer's total assets, or 15 percent of the outstanding securities in the class in any consecutive 12-month period, special disclosure requirements are triggered.

Rule 701 is only available to private companies; public companies cannot participate. Benefit plans and compensation contracts must be written and can only be offered to individuals. Former employees, partners, officers, directors, and advisors can be offered equity compensation if they were employed or offering services to the issuing company at the time the securities were offered.

Why is Rule 701 Important?

Compliance with Rule 701 is important in order to avoid running into trouble with the SEC. Those who have received stock options and equity awards cannot sell the stock without registering the shares with the Securities and Exchange Commission. They can use an applicable exemption. Transactions are not exempt from civil liability, anti-fraud, and any relevant federal securities law.

It's also an important Rule to understand when starting up a business and attracting talent. Stock options are frequently offered as a means to make the business a more attractive place to work. The lack of reporting requirement allows the stock to be offered without the additional burden of registering the stock and paying a fee when money is tight.

Benefits of Rule 701 for Startups

Rule 701 is especially beneficial for startups, enabling them to offer equity compensation without the burdens of SEC registration or associated fees. By using this exemption, companies can provide stock options to key employees and advisors, which is often crucial for attracting talent. As many startups aim to conserve cash in their early stages, offering equity compensation under Rule 701 becomes a valuable tool to incentivize and retain high-quality talent while keeping overhead low. Furthermore, the flexibility offered by Rule 701 supports long-term growth by allowing companies to offer employee stock options (ESOs) or restricted stock units (RSUs) as part of their compensation packages, without triggering regulatory compliance costs that would otherwise hinder their cash flow.

Private IPOs & A Dry Bubble Make Rule 701 Increasingly Relevant

Startups are staying private for longer and are raising more growth capital than in past periods. Sales sometimes rise quickly in a private company faster than expected. Stock owners then run the risk of running up against the $5 million/15 percent in 12 consecutive months reporting requirement.

Why Private Companies are Turning to Rule 701

As the trend of staying private for longer continues to rise, many companies find themselves in need of capital and skilled employees, but without the ability to go public just yet. Rule 701 helps alleviate some of these challenges by making equity compensation more accessible. As private companies scale up and venture into growth phases, Rule 701 ensures that they can continue to issue stock options and incentivize employees without having to navigate the complexities of a public offering. With fewer IPOs and a dry bubble in the public markets, this exemption has become a key tool for companies to manage the financial hurdles of rapid expansion.

When Rule 701 Applies

The Rule only applies when the actual sales of the company exceed:

  • $5 million
  • 15 percent of balance sheet assets
  • 15 percent of the issued securities of the same class being offered and not counting securities issued under Rule 701

The disclosure requirements are as follows:

  • An aggregate offering equal to or less than $5 million only requires the company to deliver a copy of the compensatory benefit plan or compensation contract to the recipients of the stock

If the aggregate offering is over $1 million, the company must also provide, in a reasonable amount of time, before the sale:

  • Financial statements required by Part F/S of Form 1-A under regulation A including the company's latest balance sheets and statements of income, stockholder equity for the preceding two fiscal years (or less if the issuer's existence is less than two years). These statements must be provided only if the company has prepared them. There is no need for an audit to comply with the disclosure requirements.
  • Summary of the material terms of the plan, or a copy of the summary plan description if subject to ERISA.
  • Information about risk factors that are associated with investing in the offered securities

If any of these conditions occur during 12 consecutive months, a prospectus delivery requirement is triggered.

Understanding the Thresholds for Rule 701

The conditions for applying Rule 701 hinge on specific thresholds. If your company’s total stock option or equity offering exceeds $5 million, or if the total amount of securities issued in a 12-month period exceeds 15% of the company's total assets or outstanding securities, Rule 701’s disclosure requirements are triggered. While this exemption is designed to ease the burden on smaller firms, reaching these thresholds means that additional reporting measures come into play. For example, if a company offers more than $1 million in securities, financial statements and summaries of material terms must be provided, as well as a risk factors document.

When Rule 701 Does Not Apply

The rule does not apply in the event sales do not reach $5 million or 15% of balance sheet assets or issued securities in the same class in 12 consecutive months.

Exclusions Under Rule 701

Rule 701 does not apply if a company’s offerings exceed the specified thresholds of $5 million, 15% of total assets, or 15% of outstanding securities within a 12-month period. In these cases, the company will be required to file for regular registration with the SEC. Furthermore, the exemption is only available for compensatory grants such as stock options and RSUs, not for offerings aimed at raising capital. If a company seeks to raise funds or sell securities outside the scope of employee or director compensation, Rule 701 cannot be used.

Common Mistakes

A common mistake is offering compensation to those who are ineligible under Rule 701. Consultants and advisors who maintain the market for the securities of the company are not allowed to receive stock as compensation.

Startup companies that experience fast growth often fail to realize they've reached the threshold that requires a Rule 701 disclosure requirement. Once the threshold has been reached, companies must make the required disclosure going forward.

Avoiding Rule 701 Pitfalls

Common errors with Rule 701 often arise from misjudging eligibility or exceeding the exemption limits. Companies may inadvertently offer compensation to consultants or advisors who do not meet the qualifications under Rule 701. Additionally, rapid growth can lead to miscalculations, where companies cross the $5 million threshold without realizing it, triggering new disclosure requirements. Failing to stay on top of these requirements can result in penalties or legal complications. It’s crucial for businesses to have legal counsel involved in drafting compensatory benefit plans to ensure compliance.

Steps to File Under Rule 701

As Rule 701 is an exemption to filing, there is no need to fill out paperwork for the SEC. But there needs to be a written agreement to show that an individual has been issued stock from the corporation as an incentive or reward. When the stock owner wants to sell their shares, the stock has to be registered with the SEC under normal registration rules.

Requirements and restrictions related to the Rule 701 offering:

  • Only the issuer is allowed to use the Rule 701 exemption. It is not available for resales.
  • The company must be private and not subject to reporting requirements of Section 13 or 15(d) of the Exchange Act. A company that files Exchange Act reports is eligible to use Rule 701.
  • Eligible persons of the company include directors, general partners, trustees, the issuer is a business trust, advisors, consultants, and officers. Startups should check with their lawyer to avoid issuing Rule 701 equity to those who are ineligible.
  • Securities offered under the rule are restricted and cannot be resold unless they are registered with the SEC or are resold pursuant to another exemption.
  • Offers and sales under Rule 701 must comply with any state "blue sky" laws
  • Rule 701 equity may only be offered and sold according to a written compensatory benefit plan. A compensatory benefit plan as defined by the rule as "any purchase, savings, option, bonus, stock appreciation, profit sharing, thrift, incentive, deferred compensation, pension, or similar plan."
  • The rule does not apply to transactions entered into for the purpose of raising capital.
  • Equity offered and sold to consultants and/or advisors have special rules. The Rule is only available to them if they are natural persons and provide actual services to the company that are not connected to the offering or sale of securities in a transaction to raise capital. Nor can they be intended to promote or maintain a market in the issuer's securities.

Practical Steps for Implementing Rule 701

To make the most of Rule 701, startups should create a written compensatory benefit plan that outlines how equity compensation is offered and distributed. While no SEC filing is necessary, companies must be prepared to provide all required disclosures if the thresholds are exceeded. It’s also recommended to track all stock options granted, including the total value and the number of recipients, to avoid unintentionally breaching Rule 701’s limits. Furthermore, companies must ensure that all equity awards are documented and compliant with state regulations, including "blue sky" laws, which can vary depending on the jurisdiction.

Frequently Asked Questions

  1. What is the Rule 701 exemption?
    Rule 701 is an SEC exemption that allows private companies to issue stock options and other equity compensation without registering with the SEC, provided certain conditions are met.
  2. Who qualifies to receive equity under Rule 701?
    Employees, directors, advisors, and consultants who provide services to the company are eligible for equity compensation under Rule 701, but consultants must meet specific criteria regarding their role and services.
  3. What happens if my company exceeds Rule 701’s thresholds?
    If your company exceeds the thresholds for Rule 701 ($5 million or 15% of total assets or securities), you will need to comply with additional SEC disclosure requirements.
  4. Can Rule 701 be used to raise capital?
    No, Rule 701 is strictly for compensatory equity offerings. It cannot be used for securities offerings aimed at raising capital.
  5. How can I avoid compliance issues with Rule 701?
    Regularly monitor your company’s equity compensation offerings, ensure that only eligible individuals are granted options, and work with legal professionals to comply with the disclosure requirements if thresholds are exceeded.

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