Be Careful Who You Issue Stock Options To Under Rule 701

Intro to Rule 701

Any time a company grants stock options or compensatory equity awards of any kind, the company must comply with the registration requirements of federal and applicable state securities laws or find an applicable exemption from the registration requirements.

If you are a startup, the securities law exemption you will probably rely on the most in issuing options or other types of compensatory equity awards is Rule 701. 

Rule 701 is a federal securities law exemption that allows you to grant your employees or independent contractors compensatory equity issuances under the Equity Incentive Plan you (hopefully) adopted when you formed your company. 

For example, if you want to grant your employees or independent contractors stock options, you would typically rely on Rule 701 as your exemption. 

Happy almost Fourth of July!

What to Watch Out For

However, Rule 701 has several qualifications, conditions, and limitations you need to familiarize yourself with.  One of the issues we frequently run into is startups attempting to grant compensatory equity under Rule 701 to non-individuals, e.g., somebody’s consulting LLC.  

Rule 701 says you can grant options or compensatory equity incentives to employees and consultants, and advisors as long as they are natural persons. Here is its plain language: 

(1) Special requirements for consultants and advisors. This section is available to consultants and advisors only if:

(i) They are natural persons;

(ii) They provide bona fide services to the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of the issuer’s parent; and

(iii) The services are not connected with the offer or sale of securities in a capital-raising transaction and do not directly or indirectly promote or maintain a market for the issuer’s securities.

The SEC’s Advisory Committee on Small and Emerging Companies has recommended that this rule be changed, but it is still the rule of writing this blog post.

Practical Guidance

Thus, if someone wants their compensatory equity titled in the name of their consulting LLC or other business entity, you have to tell them no. You cannot do that under Rule 701. You need to find a different securities law exemption. For example, if your award recipient was an accredited investor, you could grant them under Rule 506(b), but you would then need to make sure you are fully complying with all the requirements of that particular securities law exemption.

You also probably can’t grant the compensatory equity award to any non-individuals under your Equity Incentive Plan because your Plan probably limited eligible award recipients to individuals eligible to receive awards under Rule 701. Thus, you have to grant them under some other exemption other than outside Rule 701 and outside your Equity Incentive Plan.

Always have a separate ledger in your cap table for options or other compensatory equity award issuances outside Rule 701 and your Equity Incentive Plan. 

Don’t forget to make sure you’re following Rule 701’s mathematical limitations, either. If you have any questions on the above, always feel free to reach out.

By: James Graves

Disclaimer: this post is for informational and educational purposes only. It is not intended to provide any legal advice.