What is Rule 701? And if you are a startup or emerging company, why do you need to know about it?
Rule 701 is a federal securities law exemption for issuing equity to employees, contractors and advisors.
You need a securities law exemption or registration statement in place to issue securities, and so finding and complying with an applicable exemption is really important.
When you issue stock options or other forms of equity compensation to your employees, Rule 701 is likely going to be your federal securities law exemption, in large part because there aren’t very many other comparably good exemption choices available.
Here are the highlights of Rule 701:
- Rule 701 is only available to private companies.
- Rule 701 exempts offers and sales of securities under written compensatory benefit plans or written compensation contracts, for the participation of employees, directors, general partners, officers, consultants and advisors.
- Rule 701 only exempts offers to former employees, directors, general partners, officers, consultants and advisors if such persons were employed by or providing services to the issuer at the time the securities were offered.
- You can only issue stock options or other equity compensation to individuals; not entities. So, if you hire a contractor, and he or she wants you to issue the stock options to his or her business entity, you cannot do that under Rule 701. You have to issue the options to this person in their individual capacity.
- The issuance of the equity has to be for compensatory purposes. Rule 701 can’t be used to raise capital. Your capital raising exemption is likely Rule 506.
- You have to give everyone who receives an equity award under Rule 701 a copy of the applicable stock option plan documents.
- Rule 701 has 2 different sets of mathematical limitations. One is an outright cap on how many options or shares you can issue to workers in the aggregate during any 12-month period. Another is not a cap–but triggers a prospectus delivery requirement to workers as well.
- The absolute mathematical limitation allows you to issue the greater of the following three measures during any 12-month period:
- $1M
- 15% of balance sheet assets
- 15% of the issued securities of the same class that you are offering, not counting securities issued under Rule 701.
- If you exceed $5M in equity grants during any rolling 12-month period, you will have a prospectus delivery requirement.
It is important as you move forward in building your company that you plan for Rule 701 compliance. In general what this means is that before each set of option grants you confirm, among other things, that you are operating within the mathematical limitations, and complying with the prospectus delivery requirements if you have triggered them.
State Exemption
You also need a state securities law exemption to issue stock options or equity compensation to employees. In Washington, the statute to refer to is RCW 21.20.310(10). In California, the exemption is 25102(o) and there is a form that is required to be filed and a fee that must be paid.
As always, this information is provided for informational purposes only. Always consult an attorney. This blog post does not constitute legal advice or the establishment of an attorney-client relationship.