Importance of Rule 701 in Stock Options

The Securities and Exchange Commission (SEC) established Rule 701 to allow companies to issue stock options without the time & expense of registering the stock under the Securities Act. If a startup company is issuing stock or stock options, securities laws require those assets to be either registered or exempt from registration. Most private venture-backed companies raise funds based on an exemption from registration. Many people need to be made aware that the same rule shall apply to stock options granted to employees by the company. The offering must be registered or exempted with Rule 701. Rule 701 applies only to private companies. To qualify for the exemption, the company must issue securities only to employees, directors, consultants, and advisors under a written compensatory plan for benefit. 

This article will cover an understanding of Rule 701, stock options, the Importance of rule 701, rule 701 safe harbor exemption, rule 701 for employees, requirements for rule 701 & more.

Rule 701 and stock options 

Certain regulations & reporting requirements govern the issuance of equity to the general public. The Securities Act of 1933 is a key piece of legislation for securities regulation. Section 5 of the Securities Act asserts that a business may not sell or offer securities to the public unless the securities are first Securities and Exchange Commission (SEC) registered. The logic here is that registration allows investors to obtain critical information about the company’s finances while allowing the SEC to review the company’s disclosures.

What Rule 701 is and how it affects stock options

Rule 701 applies only to the issuance of stock options to a service provider. An employee, a director, a contractor, a consultant, or a consultant may be involved. Regardless of whether you are bullish on the company, having access to this piece of information can help you decide whether or not to exercise your stock options.

To find out if your company qualifies, multiply the number of new hires in the previous year by 4,000 (or another conservative estimate of the average employee’s option grant). If your company issued more than $10 million in equity the previous year, you would certainly be required to provide Rule 701 statements.

How Rule 701 came about and why it’s important

The Securities and Exchange Commission (SEC) established Rule 701 to allow corporations to grant stock options without having to go through the time & expense of registering the shares under the Securities Act. Rule 701 applies only to private companies. The SEC action became effective on July 23, 2018. Companies that rely on Rule 701 and have already issued securities during their 12-month period can retroactively apply the new $10 million disclosure threshold to all securities issued during that period.

It is critical to adhere to Rule 701 to avoid problems with the SEC. Stock option and equity award holders can only sell their shares if they first register them with the SEC. They may be able to take advantage of a valid exception. Transactions are exempt from civil liability, anti-fraud, and any applicable federal securities legislation.

It’s also an important rule to remember when starting a business and attracting talent. Stock options are frequently granted to make a company more appealing to employees. When funds are limited, the lack of a reporting requirement allows the stock to be offered without incurring the additional cost of registering the stock and paying a fee.

How can you become eligible for Rule 701 stock options

To qualify for the Rule 701 exemption, a non-reporting company of any size must have total securities sales of less than a certain amount over a 12-month period. (By “non-reporting company”, we mean a company not required by the SEC to file reports.) In practice, this means that all of the following must be true:

• The total sales price under Rule 701 is supposed to be less than $10 million.
• The total sales price that is sold as per Rule 701 is less than 15% of the issuer’s total assets on the date of the issuer’s most recent balance sheet; or
• The number of securities sold by the issuer under Rule 701 is supposed to be less than 15% of the total quantity of common shares outstanding on the date of the issuer’s latest balance sheet.

The benefits of Rule 701 for employees and employers

Suppose your company distributes more than $10 million in equity to employees in a 12-month period. In that case, they must provide the Rule 701 disclosures to any option holder seeking to exercise their options. As a stock options holder, you need to obtain this information if it is available, as it will help you decide whether or not to exercise your stock options. 

To see if your company qualifies, multiply the number of new hires in the previous year by the current fair market value multiplied by 4,000 (or another conservative estimate of the average employee’s option grant). This should provide a conservative estimate of the total amount of equity issued in the previous year; if that number exceeds $10 million, your company is likely required to issue rule 701 disclosures.

Recent updates to the rule and what they mean for businesses and employees

Though not yet published as a final rule, the SEC has considered other amendments to Rule 701 to make it more flexible and helpful to modern startups. These proposals’ highlights include:

• Increasing the number of workers who can buy and sell securities. A proposed amendment, in particular, seeks to include “platform workers” (i.e. individuals working in the gig economy) in this group going forward.
• Revisions to the additional disclosure requirements for exempt transactions valued at more than $10 million. A number of related proposals aim to ease the requirements and make compliance less expensive and more beneficial. For example, suppose a new hire receives restricted stock units (RSUs). In that case, the disclosure is considered timely if it is delivered within the first 14 fundamentally working days from the date of employment. This requirement aims to limit potential sensitive information leaks by not providing disclosures to new hires prior to the start of their employment.
• Raising the maximum sum of security that can be issued in a 12-month period. This proposal, as mentioned earlier, would increase flexibility for non-reporting companies. It proposes doubling the $1,000,000 dollar cap to $2,000,000 and increasing the asset cap between 15% – 25%.

This means securities regulation is dynamic. To its credit, the SEC regularly attempts to respond to the changing landscape of equity awards by amending its regulations.

Example of how Rule 701 has been used in practice

These are some probable use cases of Rule 701, which shall help in understanding its practice better:

• Private IPO – A private IPO is a process of raising funds through private placements. These placements are only available to authorized investors who meet the company’s private IPO conditions, such as pension funds, investment banks, and some mutual funds.
• A dry bubble – By learning more about the biology of the fungus that produces it, growers may be able to control dry bubbles. For some producers, the illness is merely a recurring nightmare. Because of the difficulties in obtaining new pesticide registrations or renewing existing ones, it appears that the battle against this illness will last for many years.

Get experts help to comply with Rule 701! 

You must be well informed about Rule 701 if you want to provide stock options to your employees. Are you unsure whether Rule 701 exempts the stock remuneration your company may grant? Eqvista experts can assist and make it simple to determine if your business qualifies for the Rule 701 exemption. Just get in touch with us and connect with us to learn more.

You may discover further details about utilizing Eqvista to verify Rule 701 compliance on this page. Schedule a conversation with us now if you have more questions regarding Rule 701 compliance and how Eqvista makes it simple.