What is Rule 701?
Takeaway: Rule 701 is an important SEC regulation that allows private companies, including startups, to issue equity compensation to employees, consultants, and advisors without needing to register those shares in an expensive and impractical public offering.
Equity compensation is a vital tool that startups use to attract and retain top talent. Often, they can't match the high salaries offered by more established companies, so they offer a piece of the future upside through stock options or other forms of equity. This is where Rule 701 comes into play.
What is Rule 701?
Rule 701 is an exemption under the U.S. federal securities laws that allows private companies to issue equity-based compensation to employees, directors, consultants, and advisors without having to register the securities with the U.S. Securities and Exchange Commission (SEC). The rule was specifically designed to help private, often smaller, companies to attract and retain employees and other service providers.
How Does Rule 701 Work?
Rule 701 allows a company to offer its own securities as part of written compensation agreements to employees, directors, general partners, trustees, consultants, and advisors. However, it's important to note that the exemption only applies to offers and sales to such persons. It does not cover resales of securities by those folks to other parties.
The total value of securities sold during any consecutive 12-month period must not exceed the greatest of the following three measures:
$1 million.
15% of the total assets of the company, as of the company's most recent balance sheet.
15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701.
If the company sells more than $10 million of securities within a 12-month period, it is required to provide additional disclosure to employees including risk factors and financial statements.
Benefits of Rule 701
Rule 701 offers several key advantages for startups. It allows startups to issue equity incentives to their staff without going through the complex and expensive process of registering the securities with the SEC. This flexibility makes it easier for startups to attract and retain talent, especially in the early stages when cash resources may be limited.
Key Considerations
While Rule 701 is a useful tool, it is crucial for startups to ensure they are in compliance with the rule's requirements. The exemption is strictly for compensatory purposes, not for capital-raising. Also, the rule does not preempt state securities laws, so companies must ensure that they are in compliance with relevant state laws as well.
Furthermore, companies must remember the disclosure requirements if they sell more than $10 million of securities within a 12-month period. Failure to comply with these requirements can lead to penalties and even the loss of the exemption.
Conclusion
Rule 701 is a valuable instrument for startups that wish to use equity to attract and retain their workforce. As always, it's recommended to consult with legal counsel to ensure that any equity compensation plan is in compliance with Rule 701 and other applicable securities laws.