Rule 701, a federal exemption under the Securities Act of 1933, is a tool that startup founders should be familiar with.
It provides a legal framework for offering equity compensation, such as stock options, to employees, consultants, and advisors. Understanding Rule 701 can help startups navigate the complexities of equity issuance, align the interests of their team with the success of the company, and ultimately, fuel their growth.
In this article we’ll cover:
- What is Rule 701
- Benefits of Rule 701
- Issuance Limits
- Disclosure Requirements
- Amendments to Rule 701
What is Rule 701?
Rule 701 is a federal exemption that allows private companies to issue securities as part of written compensatory benefit plans. This includes stock options and rewards for performance. The rule is particularly beneficial when not all of your employees or service providers are accredited investors eligible for other securities exemptions like Regulation D. It's important to note that public companies are not eligible for this exemption.
Why Should Startup Founders Care About Rule 701?
Rule 701, a federal exemption under the Securities Act of 1933, offers numerous benefits to private companies, especially startups. These benefits make it an attractive option for businesses seeking to incentivize their employees and service providers without the burden of SEC registration.
Key benefits of Rule 701 include:
- Cost and Time Efficiency: Rule 701 allows companies to issue securities as part of compensatory benefit plans without having to register with the Securities and Exchange Commission (SEC). This can save companies significant time and resources, making it an attractive option for startups with limited resources.
- Talent Attraction and Retention: By offering equity compensation, companies can incentivize employees, consultants, and advisors, aligning their interests with the success of the company. This can be particularly valuable for startups that may not have the cash resources to compete with larger companies in terms of salary.
- Flexibility: Rule 701 provides a level of flexibility, allowing companies to define the 12-month period for the issuance of securities in a way that best suits their operations. This can be particularly beneficial for companies that issue a lot of securities at certain times of the year
How does Rule 701 work?
Rule 701 works by allowing private companies to issue securities as part of compensatory benefit plans to certain individuals without having to register the securities with the SEC. This includes employees, directors, officers, consultants, and advisors who are providing bona fide services to the company.
The rule sets certain limits on the amount of securities that can be issued in a 12-month period. The maximum amount is the greatest of the following three measures:
- An aggregate offering price of $1,000,000
- Fifteen percent (15%) of the issuer's total assets measured at the issuer's most recent balance sheet date (if no older than its last fiscal year end)
- Fifteen percent (15%) of the outstanding amount of the class of securities being offered and sold in reliance on this rule, again measured at the issuer's most recent balance sheet date (if no older than its last fiscal year end)
Defining the 12-month period
The 12-month period can be defined in two ways:
- Rolling 12-month basis
- Fixed basis from a certain date chosen by the company
Most companies align the 12-month period to their fiscal year. However, if your company is issuing a lot of securities at a certain time of year, it may make sense to structure the 12 months so the date of sale for a large batch of securities is split across two periods.
So what happens when a company issues more than $10 million in securities in a 12-month period?
It triggers additional disclosure requirements.
Rule 701 Disclosure Requirements
Rule 701 disclosure requirements come into play when a private company plans to sell or issue more than $10 million in securities within a 12-month period.
These requirements are designed to ensure that recipients of the securities, which include employees and other service providers, are fully informed about the financial and investment risks involved.
The company must provide these disclosures in a reasonable amount of time before the sale or acceptance of an equity award. The key elements of the Rule 701 disclosure requirements include:
- Providing a copy of the compensatory benefit plan or contract.
- Sharing financial statements, including the company's latest balance sheets and statements of income, stockholder equity for the preceding two fiscal years. These statements must be provided only if the company has prepared them, and there is no need for an audit to comply with the disclosure requirements.
- Offering a summary of the material terms of the plan, or a copy of the summary plan description if subject to ERISA.
- Informing about risk factors that are associated with investing in the offered securities
These disclosures are crucial in maintaining transparency and ensuring that all parties involved are aware of the potential risks and rewards.
Amendments to Rule 701
Over the years, Rule 701 has undergone several amendments to adapt to the evolving needs of private companies. One of the most significant changes came in 2018 with the Economic Growth, Regulatory Relief, and Consumer Protection Act.
This legislation mandated the SEC to revise Rule 701(e) to increase the threshold for disclosure from $5 million to $10 million on the aggregate sales price or amount of securities sold during any consecutive 12-month period. This amendment effectively doubled the limit at which companies are required to provide additional disclosures, thereby reducing the regulatory burden on growing companies.
This change has had a significant impact on private companies, particularly startups. It has allowed them to issue a larger amount of securities to employees and other service providers without having to provide extensive disclosures.
This not only saves time and resources but also simplifies the process of offering equity compensation. However, it's important for companies to stay updated on any future amendments to Rule 701 and other relevant regulations to ensure they remain in compliance while maximizing the benefits of their equity compensation plans.
6 Steps to Stay In Compliance With Rule 701
While Rule 701 does not require companies to file with the SEC before issuing securities, there are several steps that companies should follow to ensure they are in compliance with the rule:
- Determine Eligibility: Rule 701 is only available to non-reporting, private companies. The securities must be issued as part of a written compensatory benefit plan to employees, directors, general partners, trustees, officers, or consultants and advisors.
- Calculate the Maximum Offering Amount: The total offering amount under Rule 701 in any consecutive 12-month period cannot exceed the greatest of $1,000,000, 15% of the issuer's total assets, or 15% of the outstanding amount of the class of securities being offered.
- Prepare Necessary Documentation: If the company plans to issue more than $10 million in securities within a 12-month period, it must provide additional disclosures to the recipients. These disclosures include a copy of the compensatory benefit plan or contract, financial statements, and information about the investment's risk factors.
- Issue Securities: Once the company has ensured it is in compliance with Rule 701, it can proceed with issuing the securities as part of its compensatory benefit plan.
- Maintain Records: Companies should keep detailed records of all securities issued under Rule 701, including the recipients and the value of the securities at the time of issuance. This will be important for future reference and for demonstrating compliance with Rule 701.
- Monitor Ongoing Compliance: Companies should regularly review their use of Rule 701 to ensure they remain in compliance, particularly if they are approaching the $10 million threshold that triggers additional disclosure requirements
Remember, while this provides a general guide, it's always recommended to seek legal advice when using Rule 701 to ensure full compliance with all of its requirements and conditions.
In conclusion, Rule 701 is a critical tool for startups and private companies looking to incentivize their team through equity compensation. By understanding the intricacies of this rule, including its issuance limits, disclosure requirements, and recent amendments, companies can strategically leverage equity offerings while maintaining compliance with federal regulations.
However, as with any legal matter, it's always recommended to seek professional advice.
As startups continue to innovate and disrupt various industries, staying informed about regulations like Rule 701 will remain crucial in navigating the path to success. After all, a well-informed founder is a well-equipped founder.