Understanding Rule 701

If you are involved in the start-up world and have talked to an attorney about issuing stock options, you may have heard the term "Rule 701". But what does it mean? and why should you care? There's enough legal red-tape to think about as is.

A form of regulatory relief, Rule 701 is a securities law exemption that gives private companies the ability to issue equity awards (up to an aggregate sales price of $10M) in a consecutive 12 month period to their employees, contractors, platform workers, and advisors, without having to go through the expensive and time-consuming process of registering them with the Securities and Exchange Commission (SEC).

This exemption has become increasingly popular in recent years, as startups and small businesses rely on deferred compensation as a way to attract and retain talent.

In this article, we will dive deep into the ins and outs of the rule, explaining what it is, how it works, and what you need to know if you are thinking about when relying on it.

Rule 701, explained

What is Rule 701

Named after the section itself, Rule 701 is a safe harbor exemption in the Securities Act of 1933 that allows companies to grant stock options without needing to register the grants with the SEC.

Quick history break...

Adopted in 1988, Rule 701 was first introduced to promote economic growth and allow companies to sell securities to their employees without the need to file a registration statement and satisfy reporting requirements. The underlying intent and rational was that smaller companies should not be burdened by the same disclosure obligations, or incur the large compliance-related expenses, as public companies, simply for issuing compensatory and incentive based awards - especially when they're not trying to raise capital from the public!

Who does Rule 701 apply to

The scope of the federal securities exemptions extends to any securities sold or offered under a plan or agreement between a non-reporting ("private") company and it's employees, officers, directors, partners, trustees, consultants and advisors (let's call them, 'Eligible Persons').

Who can rely on it

To qualify for relief under the federal exemption, companies must be a private company (i.e., not a publicly traded company) - this includes non-US companies, and the securities being sold have to meet the following criteria:

• in connection with a written compensatory employee benefit plans;
• the equity interests sold or offered can only be made to the 'Eligible Persons' we mentioned earlier; and,
• the total amount of equity interests that can be sold during any consecutive 12-month period (fixed or rolling) cannot be more than the threshold.

The threshold being, that the amount of securities sold in a year is either:

• $1 million;
• 15% of the issuing company's total assets, measured at the end of the start-up’s most recently completed fiscal year; or
• or 15% of the outstanding securities of that class
• - whichever is the greatest.

Ps. fyi. no promises here, but, because these rules have been around since 1999, inflation has gone up (just a smidge), and the nature of startups has shifted from being asset-intensive, new limits are currently being discussed - a new cap of $2 million, and 25% of the total assets of the issuer.

12-month period: Fixed or Rolling?

A company can choose whether to use a fixed or rolling period to define its 12-month window, but once a choice is made, it must stick to that choice for all future calculations. This choice is important, because if you're growing headcount (ah, the good ol' days), or bringing on some big cheese executives, and need to sell a large amount of equity in a short period of time, it may make sense to split up that time period into separate windows.

So, naturally, the most common question we see is: should the time period be fixed, or rolling? and what do they mean??

• A fixed period refers to a specific 12-month window that starts on a particular date and ends exactly 12 months later. For example, this window could align with a calendar year, or your company's fiscal year.
• A rolling period means that the 12-month window is based on the 12 months just before the transaction date.

Disclosures and compliance

So when do you have to disclose?

Minimum disclosure requirements

For Companies that want to exceed the $10 million aggregate sales price limitation (which was raised from $5 million as of July 24, 2018) within a consecutive 12 month period, the following disclosure requirements apply and the issuing company must prepare certain disclosures:

• A summary plan description of the stock options agreement under which the securities sold will be issued;
• Information about the risk factors associated with investment in the equity sold pursuant to the written compensatory benefit plan or compensation contract, including a summary of the material terms of the stock options plan;
• Financial statements required by Part F/S of Form 1-A that are not more than 180 days old before the sale, including the company's balance sheets and statements of income, cash flows, and other stockholders' equity;

Foreign private issuers (for example, Cake customers issuing stock options to their US-based team members through our Global Teams product) must provide a reconciliation to U.S. GAAP if their financial statements are not prepared in accordance with U.S. GAAP or IFRS (International financial reporting standards).

Preparing these reporting requirements and financial statements can be expensive and time-consuming, so make sure you work with your accountants to ensure you don't go over the aggregate sales price, and your attorney to determine whether the relevant provisions of the securities act apply to you.

HAZCHEM SIGN: Please note, compliance with the minimum disclosure standards here does not necessarily satisfy the antifraud standards and provisions, federal, and/or state securities laws. We urge you to talk to your attorneys - make sure you stay sweet with the law. And if you don't have one, just let us know and we can connect you with one of Cake's trust startup-focused lawyers.

Integration with other exemptions

Rule 701 may not be used in conjunction with other exemptions from federal securities laws. For example, if a company is also offering securities under Regulation D, it may not also issue securities under Rule 701.

Benefits of Rule 701

There are several benefits to using Rule 701 to issue equity under a written compensatory benefit plan.

1. Cost savings. One of the biggest advantages of Rule 701 is that it allows startups to issue equity without the financial and operational costs of registration. This can save a significant amount of time and money.
2. Attracting and retaining talent. Equity can be a powerful tool for attracting and retaining top talent. By using Rule 701 to issue equity, startups can offer their team ownership stake in the company, which can be a strong incentive to stay with the company and work towards its success.‍
3. Flexibility. Rule 701 provides private companies with a great deal of flexibility in material terms of how they structure their equity plans. Companies can tailor their plans to meet the needs of their specific workforce, rather than having to comply with one-size-fits-all requirements.

Best practices for startups using Rule 701

If you're a startup or small business considering relying on Rule 701, here are some best practices to keep in mind:

• Work with a securities attorney to ensure that you are complying with all of the requirements and limitations of Rule 701.
• Keep accurate records of all equity issued under Rule 701, including the number of securities issued, the date of issuance, and the identity of the recipients.
• Consider implementing a software system to manage your equity plan, which can help streamline the process and reduce the risk of errors or omissions.

Rule 701 is a powerful tool for startups looking to issue equity to their team members through a compensatory benefit plan. By taking advantage of this exemption, companies can save time and money, attract and retain top talent, and enjoy a great deal of flexibility in designing their equity compensation plans. However, it's important to understand the limitations and requirements of Rule 701 in order to use it effectively and avoid a run-in with the SEC.

Quick-fire Q&A

FAQs on Rule 701

Here are a few frequently asked questions about Rule 701:

Can a company use rule 701 to issue equity to investors or outside parties?

A: No, Rule 701 is specifically designed for equity compensation issued to a specific set of persons. If a company wants to issue securities to investors or outside parties, it must comply with other exemptions under securities laws.

Does Rule 701 apply to reporting companies?

A: No, it only applies to non-reporting companies that aren't required to file reports with the SEC under Sections 13 or 15(d) of the Securities Exchange Act of 1934.