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.

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.

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.

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.

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.

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.

Frequently Asked Questions

  • What is a consultant?

A consultant is defined as someone who has significant employment characteristics, such as someone who played an essential role in the operation of the company but were not kept on in a permanent role. These individuals can receive compensatory awards under Rule 701. Individuals acting as franchisees, independent agents, securities promoters and similar roles are ineligible to receive compensatory awards.

  • Where does Rule 701 fit in?

All issuances of securities have to be registered with the SEC unless the offering comes under an exemption from registration. Rule 701 exempts private companies from registering securities issued as equity compensation to directors, employees, consultants, advisors, and officers.

If you need help with Rule 701, you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.