Be Mindful of Rule 701 When Issuing Equity Compensation

Posted by Thomas E. Sowers on

Many private companies compensate employees, officers, directors and consultants by issuing them equity (typically stock options or restricted stock).  It is important for these companies to be familiar with and comply with Rule 701 when issuing these securities.

Rule 701 is the federal securities law exemption for securities issued by private companies to employees, officers, directors and consultants as equity compensation.  Under the federal securities laws, any issuance of securities by a company must be registered with the Securities and Exchange Commission (SEC) unless exempt from registration. The registration of securities is a time-consuming and expensive process which many companies are not prepared for and will want to avoid.  Grants of stock options or restricted stock are issuances of securities requiring registration unless exempt.

Rule 701 is a very beneficial tool for private companies to use when granting equity compensation to employees, officers, directors and consultants because there are minimum disclosure requirements to comply with.  Specifically, for aggregate securities offerings of $5 million or less, a company’s disclosure obligation amounts to providing the equity recipient with copies of the applicable benefit plan and the agreement under which the equity compensation was granted.  For aggregate securities offerings exceeding $5 million, in addition to copies of the plan and the grant agreement, the company must also provide the recipient a summary of the material terms of the plan, information about risk factors relating to the securities and GAAP financial statements required under Regulation A (essentially a simplified registration form).

In order to take advantage of Rule 701, a company must comply with the mathematical limitations of the rule.  Specifically, over the course of any 12-month period, the total aggregate amount of restricted stock sold or options granted may not exceed the greater of: (i) $1 million (ii) 15% of the company’s assets (as of the date of its most recent annual balance sheet (if no older than its last fiscal year end), or (iii) 15% of the amount of the class of securities being offered and sold in reliance on the rule (again, measured as of the date of its most recent balance sheet).   If a company is able to use Rule 701, there are no forms to be filed with the SEC and no fees to be paid to the SEC.

In addition to the mathematical limitations, other issues relating to Rule 701 include:

  • The rule may only be relied upon for securities issued under an equity compensation plan
  • It is not available for resales and may only be relied upon by the issuer
  • The rule cannot be used in connection with any capital raising transaction
  • Securities granted under the rule are “restricted” securities, meaning they cannot be resold unless registered with the SEC or resold pursuant to another exemption (such as Rule 144)
  • Any offering under the rule must comply with the securities laws of the state in which each recipient resides
  • Special rules apply to grants being made to consultants and advisors

In summary, private companies issuing equity compensation to employees, officers, directors and consultants need to be sure that they are in compliance with Rule 701. Keeping track of the mathematical limitations of the rule is crucial to be sure the aggregate amount being sold allows the company to take advantage of the rule (see above), as well as to be sure the aggregate amount of the offering does not exceed $5 million and therefore trigger the expanded disclosure obligations.  If a private company issues restricted stock or stock options without complying with Rule 701, the securities must be registered unless an exemption other than Rule 701 exists. The consequences of noncompliance could be severe and could result in personal liability for the company’s directors and officers.