Where does Rule 701 fit in?
As you know, all issuances of securities by a company have to be registered with the SEC unless a particular offering falls under an exemption from registration. You are familiar by now with Rule 506 that provides an exemption from registration for securities issued in a private placement. Well, Rule 701 provides an exemption from registration (also on a federal level) for securities that private companies may issue as equity compensation to its employees, directors, officers, consultants and advisors.
Principal requirements and restrictions relating to a Rule 701 offering.
1. Only the issuer (i.e. the company) may use the Rule 701 exemption. This rule is not available for resales.
2. The company has to be a private company (i.e., not be subject to reporting requirements under Section 13 or 15(d) of the Exchange Act). But a company that files Exchange Act reports on a voluntary basis or in accordance with a contractual obligation, is eligible to use Rule 701.
3. The persons to whom offers and sales of securities may be made pursuant to the Rule 701 exemption include employees (including employees of majority-owned subsidiaries), directors, general partners, trustees, where the issuer is a business trust, officers, consultants and advisors. There are many SEC no-action letters regarding who are the eligible recipients of Rule 701 equity (there is some uncertainty about who are the eligible advisors and consultants), so startups should check with their attorney to ensure that they do not issue Rule 701 equity to ineligible persons.
4. Securities offered under Rule 701 are “restricted” securities, and cannot be resold unless they are registered with the SEC or are resold pursuant to another exemption (such as Rule 144).
5. Offering and sale under Rule 701 must still comply with any applicable state “blue sky” laws.
6. Rule 701 equity may be offered and sold only pursuant to a written compensatory benefit plan (or compensation contract). The Rule defines “compensatory benefit plan” as “any purchase, savings, option, bonus, stock appreciation, profit sharing, thrift, incentive, deferred compensation, pension or similar plan.” This means that the startup should invest into developing an equity compensation plan early on in its existence.
7. The Rule is not applicable to transactions entered into for capital-raising purposes.
8. For equity offered and sold to consultants or advisors, several special rules apply. The Rule is only available to them if they are 1) natural persons; and 2) they provide bona fide services to the company which are not connected to any offering or sale of securities in a capital-raising transaction and which are not intended to promote or maintain a market in the issuer’s securities (whether directly or indirectly).
What else do you need to know about Rule 701?
1. Aggregation Limits
Over the course of any rolling 12-month period, the total aggregate sales price or amount of securities sold may not exceed the greatest of:
1) $1 million;
2) 15% of the issuer’s total assets, as measured on the date of its most recent balance sheet (if no older than its last fiscal year end); or
3) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the Rule (again as measured as of the date of its most recent balance sheet).
There is no (theoretical) limit to the amount of money that can be raised pursuant to Rule 701, provided that whatever amount raised remains within the aforementioned limits. However, there are some enhanced disclosure requirements when the aggregate sales price or amount of securities sold exceeds $5 million in any consecutive 12-month period.
2. Disclosure Requirements
1. For aggregate offerings equal to or less than $5 million, the company must deliver to the recipients only a copy of the compensatory benefit plan or compensation contract.
2. For aggregate offerings exceeding $5 million, the company must, in addition to a copy of the compensation plan/contract, provide in a reasonable amount of time prior to sale:
- A summary of the material terms of the plan (or, if subject to ERISA, a copy of the summary plan description required by that Act);
- Information about risk factors associated with the investment in the offered securities; and
- Financial statements (prepared in accordance with GAAP) required by Part F/S of Form 1-A under Regulation A, including at a minimum the company’s latest balance sheet as well as statements of income, cash flows, and stockholder equity for the preceding two fiscal years (or for the period of the issuer’s existence, if less than such a period). Note that audited financial statements must be provided only if the company has already prepared them; the company need not undergo a financial audit to comply specifically with these disclosure requirements.
Rule 701 can be a very useful and relatively inexpensive tool for start-up companies wishing to provide equity compensation to their employees, directors, and others. There are no SEC reporting requirements, and the disclosure requirements are, in general, not particularly onerous. At the same time, the Rule does impose a number of limitations and exclusions which the company must carefully abide by. The company should always have a knowledgeable attorney to develop or review any proposed Rule 701 compensation plan to ensure compliance with its requirements.
This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.