If you are a non-public company granting stock options or other compensatory equity awards to employees or consultants, you need to be familiar with Rule 701 and worry about complying with it. Rule 701 is the federal securities law exemption for compensatory equity issuances. If you are unfamiliar with the securities law in general, what you need to know is this–you can’t sell stock or issue stock options without either registering the securities with the Securities and Exchange Commission (a very expensive proposition), or availing yourself of an exemption from the registration requirement. You also have to worry about state securities law exemptions with regard to stock options or other compensatory equity award issuances. (In Washington, this exemption is found at RCW 21.20.310(10).)
What Is Rule 701?
Rule 701 is the federal exemption from registration for compensatory equity awards granted pursuant to written compensatory benefits plans or written compensation agreements. Rule 701 is a broad exemption. There are no forms that need to be filed with the SEC, or any fees that need to be paid to the SEC, but Rule 701 does have significant conditions and limitations and if you run afoul of them there can be very significant and onerous consequences, including potentially personal liability for a company’s officers and directors.
You need to be aware that among other limitations Rule 701 has strict mathematical limits that you cannot exceed, and special disclosure requirements that are triggered once the value of the equity awards you grant under Rule 701 exceed $5M during any consecutive 12-month period.
What are Rule 701’s mathematical limits?
Under Rule 701, the aggregate sales price or amount of securities sold or options granted in reliance on the rule during any consecutive 12-month period cannot exceed the greater of the following:
- $1,000,000 (calculated by multiplying the option exercise price times the number of options granted, in the case of options);
- 15% of the total assets of the issuer, measured at the issuer’s most recent annual balance sheet date (if no older than its last fiscal year end); or
- 15% of the outstanding amount of the class of securities being offered and sold in reliance on the rule, measured at the issuer’s most recent annual balance sheet date (if no older than its last fiscal year end).
As a practical matter, what does this mean? Before every set of option grants you need to make sure that you are operating within these mathematical constraints. In addition, if you have granted more than $5M in equity awards during any 12 month period, you will have specific disclosure obligations.
Please see my Stock Option Grant Checklist.
Rule 701 requires issuers to provide to stock option or stock incentive award recipients a copy of the plan and agreements under which the award is granted. In addition, if the aggregate sales price or the amount of securities sold in any consecutive 12-month period exceeds $5M, there are additional, significant disclosures that must be made.
Special Rules for Consultants and Advisors
Rule 701 also has special rules for consultants and advisors.
(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 in connection 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.
Before granting stock options or any form of compensatory equity award, it is critical to review Rule 701 to make sure that you are operating within its constraints.