Rule 701 is an essential federal exemption under the Securities Act of 1933 that startup founders need to understand. This rule establishes the legal guidelines for providing equity-based compensation, such as stock (ESOPS), to employees, consultants, and advisors.
By familiarizing themselves with Rule 701, startups can effectively manage the process of issuing equity, ensure their team's goals are aligned with the company's success, and support their overall growth.
What does Rule 701 entail?
Rule 701 is a federal provision that permits private enterprises to distribute securities under written compensation plans, which encompass stock options and performance incentives.
This rule proves advantageous, especially when only some employees or service providers qualify as accredited investors under alternative securities exemptions such as Regulation D. It is crucial to understand that this exemption does not apply to public companies.
Why is Rule 701 Important for Startup Founders?
Rule 701, established under the Securities Act of 1933, presents significant advantages for private startups, making it an essential consideration for companies aiming to motivate their workforce and service providers without undergoing SEC registration complexities.
The primary advantages of Rule 701 include:
Resource Savings: By enabling companies to offer securities under compensatory benefit plans without SEC registration, Rule 701 offers a pathway to conserve considerable amounts of time and financial resources. This feature is particularly beneficial for startups operating with constrained budgets.
Enhanced Recruitment and Loyalty: Equity compensation allows startups to attract/retain talent by providing a stake in the company's success, creating a shared goal of prosperity. This approach is especially critical for startups that may need more financial leeway to offer competitive salaries compared to established firms.
Operational Versatility: Rule 701 offers operational flexibility, allowing startups to determine their own 12-month periods for securities issuance that align with their specific business cycles or peak issuance needs. This offers strategic benefits, particularly when scaling operations.
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Understanding Rule 701's Mechanism
Rule 701 enables private entities to distribute securities as a component of compensatory benefit plans to select groups like employees, directors, officers, consultants, and advisors without necessitating SEC registration for these securities. These individuals must be engaged in legitimate services for the company.
The rule delineates specific caps on the volume of securities that can be allocated within a year. The ceiling is determined by whichever is highest among these three criteria:
- A total offering price of up to $1,000,000.
- Fifteen percent of the issuer's total assets, based on the most current balance sheet date, provided it's within the last fiscal year.
- Fifteen percent of the outstanding amount of the securities class being issued under Rule 701 was also evaluated at the latest balance sheet date within the past fiscal year.
Setting the 12-Month Framework
There are two methodologies to establish this period:
- A rolling 12-month interval.
- A fixed span starting on a date selected by the company.
Typically, firms align this period with their fiscal year. Nevertheless, if a company frequently issues securities at specific times, it may be strategic to organize the 12-month window such that a significant issuance is divided over two separate periods.
Exceeding $10 million in securities issuance within 12 months triggers further disclosure obligations for the company.
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Disclosure Obligations Under Rule 701
When a private company intends to offer or sell securities exceeding $10 million within a 12-month timeframe, Rule 701's disclosure obligations are activated.
These obligations are structured to guarantee that all recipients of the securities, including employees and other contributors, are adequately informed about the financial and investment risks they are undertaking.
To comply, the company must deliver these disclosures sufficiently in advance of the sale or the grant of an equity award.
Essential components of Rule 701's disclosure requirements encompass:
- Distribution of the compensatory benefit plan or agreement documentation.
- Financial statements should include the most recent balance sheet, income, and stockholder equity statements for the last two fiscal years. These must be supplied only if the company has prepared them, and audits are optional to fulfill disclosure requirements.
- A summary of the plan's key terms or the summary plan description if it falls under the Employee Retirement Income Security Act (ERISA) is presented.
- Disclosure of risk factors associated with the securities being offered.
These disclosures play a pivotal role in ensuring transparency and helping all involved parties understand the associated risks and benefits.
Revisions to Rule 701
Rule 701 has undergone various modifications over time to align with private enterprises' changing requirements. A pivotal update occurred in 2018 with the enactment of the Economic Growth, Regulatory Relief, and Consumer Protection Act.
Under this act, the SEC was directed to amend Rule 701(e), elevating the threshold for required disclosures regarding the aggregate sales price or amount of securities sold within any 12-month sequence from $5 million to $10 million. This adjustment effectively increased the threshold, easing the disclosure mandates for expanding firms.
This enhancement has particularly benefited private entities, especially startups, enabling them to allot more securities to their workforce and other contributors without detailed disclosures.
The amendment aids in conserving time and resources and streamlines the equity compensation offering process. Nonetheless, it remains crucial for firms to keep abreast of any subsequent changes to Rule 701 and related regulations to ensure ongoing compliance and to optimize the advantages of their equity compensation schemes.
Ensuring Compliance with Rule 701: A Six-Step Guide
While Rule 701 exempts companies from registering securities with the SEC before issuance, there are critical steps to adhere to for compliance:
Verify Eligibility: Only non-public, private companies can leverage Rule 701. The securities should be allocated as part of an official compensatory benefit plan targeting specific groups such as employees, directors, partners, officers, consultants, and advisors.
Determine the Limit: Under Rule 701, over any 12-month span, the issuance should not surpass the largest of $1,000,000, 15% of the company's total assets, or 15% of any class of securities being issued.
Assemble Required Documents: Issuing over $10 million in securities within 12 months necessitates furnishing additional disclosures to recipients, encompassing the benefit plan or contract, pertinent financial statements, and risk information.
Proceed with Issuance: Post compliance verification, the company may distribute the securities under its compensatory plans.
Document and Track Issuance: It is crucial to maintain accurate records of all Rule 701 securities issuances, noting the recipients and securities' value at issuance time, to substantiate compliance and future evaluations.
Continually Assess Compliance: Regular scrutiny of Rule 701 utilizations is essential, especially to avoid unintended $10 million disclosure threshold breaches.
Final Thoughts
Rule 701 stands as an essential provision for startups and private enterprises aiming to motivate their workforce via equity compensation.
Grasping the nuances of Rule 701, such as its offering caps, necessary disclosures, and the latest modifications, allows businesses to utilize equity incentives judiciously while adhering to federal laws.
Nevertheless, navigating legal frameworks necessitates professional guidance.
For startups poised at the forefront of industry innovation, being knowledgeable about rules like Rule 701 is pivotal in charting a successful trajectory. In essence, an enlightened founder is one who is thoroughly prepared.
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