Rule 701 – A Complete Guide for Companies

In this guide, we walk you through everything you need to know about Rule 701 and how it can help your company.

For many startups, issuing equity can be costly, with expensive accountants or lawyers. Rule 701 is the solution: it’s a federal exemption allowing private companies, especially startups, to issue a maximum of $10 million in equity to their employees. This exemption also does not require extensive disclosures. In this guide, we walk you through everything you need to know about Rule 701 and how it can help your company.

Rule 701 for companies

If your startup issues stock or stock options, there are securities laws that require you to either register them or have them exempted from registration. Many companies are not aware of the fact that registration has to be done, otherwise, make an exemption for them. This is where Rule 701 plays an important role.

What is Rule 701?

Created by the Securities and Exchange Commission (SEC), Rule 701 is a safe harbor exemption allowing companies to issue stocks or stock options to employees without needing to register the stock under the Securities Act. For most startups, this is one of the legal requirements for equity compensation. This exemption is only applicable to private companies. Certain sales of securities made to reward workers, consultants, and advisers are excluded under Rule 701. Exchange Act reporting firms are not eligible for this exemption.

How does Rule 701 work?

If a firm meets specific standards based on its assets or the number of outstanding securities, it can sell even more. If a corporation sells more than $10 million in securities in a year, it must report financial and other information to anyone who acquired securities during that time. Securities issued under Rule 701 are “restricted securities” meaning they can’t be freely traded unless they’re registered, or their holders qualify for an exemption.

Rule 701 as a safe harbor exemption

Rule 701 is significant because it requires a firm to communicate specific information to prospective purchasers if it expects the total aggregate sales price of stock options issued during any consecutive 12-month period to reach $10 million (i.e., stock option holders who are exercising their options).

How does the 12-month window work with Rule 701?

Now that you have a good understanding of what Rule 701 is, you may be wondering how the 12-month window works. Based on the fixed or rolling period, the 12-month window is calculated. Here is a brief description of fixed and rolling periods:

  • Fixed Period – As the name implies, the 12-month window starts on a particular day and runs exactly 12 months from that day. It basically aligns with the calendar year or the fiscal year. Therefore, the 12-month window will begin and end on the same day every year
  • Rolling Period – With a rolling period, 12 months preceding the date of the transaction in question serve as the definition of the 12-month window. So, in order to avoid the Rule 701 disclosure obligation being triggered, the sales of securities must not be more than $10 million in any one 12-month period.

Limitations of Rule 701

Certain sales of securities made to pay consultants, advisers, and employees are excluded under Rule 701, and there are no fees to pay the SEC, but Rule 701 does contain major criteria and limitations. If you violate them, there can be serious and costly repercussions, including personal culpability for a company’s executives and directors. You should be aware that Rule 701 has rigorous mathematical restrictions that you cannot exceed, as well as unique disclosure obligations that apply whenever the value of the stock awards you give under Rule 701 exceeds $5 million in any 12-month period.

Recent amendments in Rule 701

In order to make Rule 701 more flexible and less complicated, the SEC made amendments to the rule. Here are those amendments:

  • Increasing the limits on how much equity can be issued each 12-month cycle -This plan would give non-reporting corporations more flexibility. The $1,000,000 cap is proposed to be doubled to $2,000,000, and the 15% asset cap is proposed to be increased to 25%.
  • Increasing the number of employees to whom securities may be sold and purchased – In particular, a proposed amendment aims to move forward by including “platform workers” (i.e., employees offering services in the gig economy) in this group.
  • Amending the extra disclosure specifications for exempt transactions over $10 million –  The rules are eased in an effort to make compliance more favorable and less expensive. It is proposed to eliminate the filing requirement for exempt securities transactions that do not exceed $10 million.

How can employees take benefits from the rule?

Rule 701 was designed to make it easier for startups and growing companies in regard to equity distribution. Certain sales of securities issued to pay employees, consultants, and advisors are excluded under Rule 701. However, it is important to note that the Exchange Act reporting companies are not eligible for this exemption. Under this exemption, a company of any size can sell or issue at least $1 million in securities, however, if a company meets specific criteria based on its assets or the number of its outstanding securities, it may be able to sell even more.

While in the case of selling securities with more than $10 million in securities in a 12-month period, the company is obligated to provide certain financial and other disclosure to the individuals who received securities during that period. Additionally, securities issued in accordance with Rule 701 cannot be traded freely until the time they are registered or in case holders qualify for an exemption.

Filing for Rule 701

The Securities Act of 1933 gave rise to Rule 701. It’s a federal exception that exempts firms from having to record stock option awards and performance bonuses. There are no forms to submit to the SEC and no fees to pay. However, giving stock options under Rule 701 is subject to certain restrictions and limits. The rule has numerical boundaries that must not be exceeded. Special disclosure requirements apply if the value of the stock exceeds $5 million, 15% of the issuer’s total assets, or 15% of the outstanding securities in the class in any consecutive 12-month period.

Who uses Rule 701?

Only private firms are subject to Rule 701. To qualify for the exemption, the corporation must only offer stock to workers, directors, consultants, and advisers under a documented compensatory benefit plan (such as a stock option plan).

What conditions do private companies need to fulfill for Rule 701?

The business must be private (i.e., exempt from Section 13 or 15(d) of the Exchange Act’s reporting obligations). However, a business that submits Exchange Act reports voluntarily or as required by a contract may do so under Rule 701. Workers (including employees of majority-owned subsidiaries), directors, general partners, and trustees, where the issuer is a business trust, officers, consultants, and advisers are among the people to whom offers and sales of shares may be made in accordance with the Rule 701 exemption.

Disclosure requirements for Rule 701

In order to file Rule 701, there is certain information that needs to be disclosed. Some of them include an overview of the employee benefit plan’s important terms, financial statements, and most recent balance sheet. Below are some of the disclosure requirements for Rule 701:

  • General requirements – The construction contract’s general conditions are an essential component. They are products and resources that are required to complete a project but will not be included in the completed result that is handed over to the owner.
  • Specific requirements – Program criteria imply that the partner must meet both initial and continuing program requirements. Only if the firm has previously completed audited financial statements are required to be published; a financial audit is not necessary for the company to explicitly comply with these disclosure requirements. The disclosure requirements are generally not very onerous, and there are no SEC reporting obligations. A number of restrictions and exclusions are nonetheless imposed by the Rule, which the corporation must scrupulously follow with.
  • Enforcement requirements – The program’s purpose is to give the theoretical foundation, applied skills, and specialized knowledge needed to excel in the law enforcement recruitment process and boost a graduate’s prospects of success in a variety of investigative and law enforcement positions.
  • Competing interests – When the writers’ interpretation of facts or presentation of information is impacted by their personal or financial relationships with other persons or organizations, they have a competing interest.
  • Rule 701 amendments – The proposed Rule 701 modifications raise the size of eligible offers, simplify the financial statement disclosure requirements for offerings worth more than USD 10 million, and widen the list of eligible award winners to include former employees and consultant legal entities.

Important steps to follow while filing for Rule 701

The Securities and Exchange Commission (SEC) adopted Rule 701 to allow corporations to offer stock options without having to go through the effort and expense of registering the shares under the Securities Act. Here are some considerations before you file Ruly 701 for your company:

  • According to Rule 701, both consultant and employee services should be valued to determine the exempt amount.
  • The antifraud requirements of the securities legislation may or may not be satisfied by compliance with the minimal disclosure requirements under Rule 701. The mandatory disclosure will be determined by the facts and circumstances.
  • Finally, Rule 701 gives private firms some of the advantages that Form S-8 affords public companies.

FAQs on Rule 701

Many startups find it difficult to understand and prepare for Rule 701. It might be confusing to figure out the right forms, or the right calculations to do. We have compiled, as well as answered, the most common questions asked about Rule 701:

How to calculate Rule 701?

The number of Rule 701 shares you own must be less than 15% of the total number of shares in circulation (15 percent of outstanding shares amount, excluding shares issued under Rule 701). Your Rule 701 shares are worth less than 15% of your company’s total assets.

What is exempt from the disclosure requirements of the Securities Act?

Exempt securities are financial assets backed by the government and often have government or tax-exempt status, as defined under Section 4 of the Securities Act of 1933. To further understand this form of security, consider the following examples: Securities issued by the government. Securities are issued by foreign governments.

What is Rule 701 and do I need to worry about it?

Certain sales of securities made to reward workers, consultants, and advisers are excluded under Rule 701. Exchange Act reporting firms are not eligible for this exemption. This exemption allows any corporation, regardless of size, to sell at least $1 million in securities. The total of all cash and other compensation received by the issuer for the sale of such shares is used to compute the aggregate sales price of stock sold in reliance on Rule 701. The “sales price” for stock options is the total exercise price to be paid for the options.

How to use the Rule 701 report?

Rule 701, promulgated pursuant to Section 3(b) of the Securities Act of 1933, as amended (the “Securities Act”)1, exempts certain offers and sales of securities made pursuant to the terms of compensatory benefit plans or written contracts relating to compensation by an issuer that is not subject to the reporting requirements of Section 13 or Section 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)1 from the Securities Act’s registration requirements.

How can Eqvista help with filing for Rule 701?

Now that you know more about Rule 701, you may avoid getting into trouble with the SEC by adhering to the rule’s limitations and restrictions. Remember to file the essential documentation if your company’s threshold hits $5 million ($10 million from July 2018). Furthermore, it is critical to keep meticulous records of all the shares you are distributing to the corporation. You should use a cap table software program like Eqvista for this. Check out the Eqvista program if you’re looking for a dependable tool to help you keep track of all your shares and manage them effectively. Contact us today to learn more about how Eqvista can help you manage your company’s equity!

Interested in issuing & managing shares?

If you want to start issuing and managing shares, Try out our Eqvista App, it is free and all online!