Rule 701

Under Rule 701, private companies can issue up to a certain amount of equity to employees in a 12-month period. Learn more about the Rule 701 exemption and its disclosure requirements.

What is Rule 701?

Rule 701 is a federal regulatory exemption under the Securities Act of 1933 that allows private companies to issue equity compensation, like stock options and other securities, to employees, consultants, service providers, and advisors without registering the securities with the SEC.

Under Rule 701, the issuance of securities must be part of a compensatory benefits plan, like an equity incentive plan, and comply with certain conditions. The maximum amount of securities that can be issued in a 12-month period using the Rule 701 exemption is the greatest of:

• An aggregate offering price of $1,000,000
• Fifteen percent (15%) of the outstanding shares of that class
• Fifteen percent (15%) of the value of your company’s total assets

If you issue more than $10 million in securities in a 12-month period, you may have to comply with additional disclosure requirements.

Rule 701 provides a path for startups and private companies to attract and retain talent with competitive equity incentives when employees and service providers are not accredited investors eligible for other securities exemptions like Regulation D. Public companies are not eligible for the Rule 701 exemption.

Rule 701 disclosure requirements

Rule 701 disclosure requirements are most likely only applicable to later-stage companies. If your company wants to sell or issue more than $10 million in securities within a 12-month period, you must provide additional financial and investment risk disclosures to recipients (prospective purchasers). This includes employees and other service providers who will be receiving equity in your company. They must be given the chance to review the disclosures before the purchase decision (or acceptance of an equity award) is made.

The 12-month period

Once your company chooses to use one method to calculate the 12-month window in which securities are issued, it’s required to stick with it to issue securities going forward. The 12-month period can be defined in two ways:

1. A rolling 12-month basis
2. A fixed basis from a certain date chosen by the company

Most companies align the 12-month period to their fiscal year. However, if your company is issuing a lot of securities at a certain time of year (perhaps related to bonus structures or cohort hiring), it may make sense to structure the 12 months so the date of sale for a large batch of securities is split across two periods.

Your legal counsel can give you advice about the best way to structure your grants and time period calculations. If your company is close to the $10 million threshold, it’s important to plan equity issuance carefully to comply with any additional disclosure requirements.

Benefits and limitations of Rule 701

The Rule 701 exemption provides companies with several benefits, including:

• The ability to provide equity compensation—including stock options, restricted stock awards (RSA), restricted stock units (RSU) and other equity awards—to their employees and service providers who may not qualify for other securities exemptions
• The flexibility to design compensation plans

The exemption has some limitations and risk factors, including:

• Restrictions on the amount of securities that can be issued
• Compliance requirements with state securities laws
• Securities issued under Rule 701 are “restricted” meaning they cannot be traded without SEC registration, which usually does not occur until a company becomes publicly traded on a national exchange through an initial public offering (IPO), direct listing or de-SPAC transaction

Rule 701 amendments

The Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 mandated that the SEC revise Rule 701(e) to increase the threshold from $5 million to $10 million on the aggregate sales price (amount of securities sold) during a consecutive 12-month period. Since then, private companies have been able to issue up to $10 million of securities to employees without extensive disclosures, saving valuable time and money.