What is Rule 701 and how can it help startup founders?

by Sarath | August 16, 2022 | Rule 701 , SEC , Securities Act

The majority of companies use Rule 701 to distribute employee stock. It’s a federal exception that permits private corporations to give workers up to $10 million in stock without having to make lengthy disclosures. Startups and small businesses who wish to issue stock but can’t afford pricey accountants or attorneys would benefit from Rule 701. In this article, we explain further what is Rule 701 and how it benefits startups.

Rule 701 for startups

Rule 701 permits some startups and private enterprises to offer up to $10 million in securities to workers over the course of a year without having to present them with detailed financial statements and risk disclosures.

What is Rule 701?

Rule 701 exempts some transactions of securities made to reward employees, consultants, and advisers. This exemption is not available to Exchange Act reporting entities. A corporation of any size can sell at least $1 million in securities using this 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).

Why is Rule 701 required in startups?

Rule 701 is exclusively open to private businesses; public businesses are not eligible. Individuals can only be provided benefit plans and compensation contracts if they are written. Former workers, partners, officers, directors, and advisers who were engaged or providing services to the issuing firm at the time the securities were sold may be granted equity compensation.

Situations where Rule 701 is most relevant

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. Only private firms are subject to Rule 701. The effective date of the SEC action was July 23, 2018. Companies relying on Rule 701 that already issued securities in their 12-month period can retroactively apply the new $10M disclosure threshold to all securities issued in that period.

Private IPO – The process of raising money through private placements is known as a private IPO. These placements are exclusively available to authorized investors, such as pension funds, investment banks, and some mutual funds, who fulfill the company’s private IPO conditions.
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Issuance of employee stock options under rule 701

“Rule 701” can only be applied to the issuance of stock to a service provider. This might be an employee, a director, a contractor, a consultant, or a consultant. Regardless of whether you are bullish on the firm, receiving this information, if accessible, can help you decide whether or not to exercise your stock options.

To see if your organization qualifies, multiply the number of new recruits in the previous year by 4,000 (or another cautious estimate of the typical employee’s option grant). If the total amount of equity issued in the previous year were greater than $10 million, your firm would most likely be obliged to provide Rule 701 statements.

The importance of complying with rule 701 for startups

It is critical to follow Rule 701 in order to avoid getting into issues with the SEC. Stock option and equity award recipients are unable to sell their shares without first registering them with the Securities and Exchange Commission. They can take advantage of a valid exception. Civil responsibility, anti-fraud, and any applicable federal securities legislation do not apply to transactions.

It’s also a crucial rule to remember while launching a company and attracting talent. Stock options are commonly given as a way to make a company more appealing to employees. When money is scarce, the lack of a reporting requirement permits the stock to be offered without the added cost of registering the stock and paying a fee.

Rule 701 requirements and regulations

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 to sell at least $1 million in securities regardless of size.

Principle requirements – Principal Requirement means an amount equal to the regularly scheduled principal that is due and payable on the Interest Payment Date following the date of determination, whether by maturity or mandatory sinking fund redemption; provided, however, that with respect to the Subordinate Bonds, Principal Requirement means an amount equal to the regularly scheduled principal that is due and payable on the Interest Payment Date following the date of determination, whether by maturity or mandatory sinking fund redemption.
Restrictions – Rule 701 limits the overall offering price of securities subject to existing offers and the amount sold in the preceding 12 months to no more than $5 million, regardless of the methodology chosen. Our team has kept track of how the regulation has been applied throughout time.
Disclosure requirements – According to the information available at the time of publishing, the Disclosure Obligations give general information regarding the disclosure requirements for securities holdings that Clearstream Banking must comply with.

Understand the 12-month period in rule 701

Rule 701 permits some startups and private enterprises to offer up to $10 million in securities to workers over a year without presenting them with detailed financial statements and risk disclosures. When attempting to clarify how this “12-month window” thing works, a few questions immediately arise. The most prevalent of these queries is whether the 12-month timeframe may be determined on a fixed or rolling basis.

A fixed period is one in which the 12-month timeframe begins and finishes on a set date. This is frequently aligned with a calendar year or a company’s fiscal year. The 12-month window is determined by the 12 months immediately preceding the date of the transaction at issue when using a rolling period. This means that if the Rule 701 disclosure obligation is not triggered, no securities sales can exceed $10 million in any 12-month period.

Required checks to apply under rule 701

Rule 701 is a frequent exception used by startups when giving options and distributing shares as part of an employee stock incentive plan. According to Rule 701 of the Securities Act of 1933, “exemption for offers and sales of stocks pursuant to certain compensatory benefit programs and contracts pertaining to compensation,” therein defined, Companies can offer their own securities to employees, directors, general partners, trustees (if the company is a business trust), officers, and certain consultants (there are qualifications for consultants and advisors that prevent you from claiming your investors as such) without having to comply with federal securities registration requirements under Rule 701.

Cheque 1: $1,000,000 – In the upper right corner, write the current date or the earliest date you want the cheque cashed. It is necessary to provide the month, day, and year. PA On the following line, fill in the payee information, which is the business name or the first and last names of the individual to whom the money is being sent. On the same line, right after the $ sign, type 1,000,000.00 in the box.
Cheque 2: 15% Of The Company’s Total Assets – The total-debt-to-total-assets ratio indicates how much debt has been utilized to fund a company’s assets. The computation takes into account all of the company’s debt, not simply its payable loans and bonds, as well as all assets, including intangibles. For example, if a company’s total debt-to-total-assets ratio is 0.4, creditors finance 40% of its assets, while owners’ (shareholders’) equity funds 60%.
Cheque 3: 15% of the outstanding securities of the class being offered – During a 12-month period, the number of shares sold or options granted is less than 15% of the outstanding amount of the class of securities being offered and sold (i.e., common stock). All presently exercisable or convertible options, warrants, or other securities, excluding those granted under a Rule 701 exception, should be included in the outstanding quantity of securities.

For example, if you have five million shares of common stock outstanding (which includes preferred stock convertible into common stock but excludes other options given under the company incentive plan), you can only grant 750,000 shares in a 12-month period.

Steps to follow for rule 701 compliance

Here are the few steps that you need to follow for 701 compliance. These steps are explained below:

Fill out and deliver the required documents – International trade is based on paperwork that meets the criteria and rules established by the countries of origin and destination. It’s vital to have thorough information about your shipment, business. You will also need to secure suitable authorization for your items if necessary.
Perform a compliance analysis – A Compliance Assessment is a tool for evaluating and documenting the present level of compliance supervision, management, and related risks in a specific compliance area.
The focus of the current year – This was accomplished by encouraging greater growth rates, more equitable income distribution, and a large increase in domestic saving rates. It also emphasized import substitution and the development of exports.
Keep up with the 701(e) compliance – Private companies that offer share-based compensation to their employees frequently rely on Rule 701 of the Securities Act of 1933 (the “Securities Act”), especially if the employees receiving options or restricted stock units (or other forms of compensation that would otherwise trigger the registration requirements of Section 5 of the Securities Act) do not qualify as “accredited investors”.
Risks involved when startups make mistakes – Growth is the most welcome indicator of success in today’s marketplaces, as the engine of innovation propels businesses. There might be some risks involved in this.

How can Eqvista help with rule 701 compliance?

So, if you’re planning to provide your staff stock options, you’ll need to know everything there is to know about Rule 701. This regulation applies to a company’s equity offering. It permits smaller start-up enterprises to be excluded from reporting. As a result, it is preferable to be well-versed with Rule 701 in its entirety. We at Eqvista can help you with 701 compliance. Get started with us today.