Understanding Rule 701: Equity Compensation for Private Companies

For private companies, particularly those in their early-stages, equity compensation can be a powerful tool to attract and retain talent. Rule 701 under the Securities Act of 1933 offers private companies a way to issue equity without going through costly SEC registration, provided the offering meets certain requirements. Here’s a closer look at how Rule 701 works, who’s eligible, and what private companies should consider as they issue equity under this exemption.

What is Rule 701?

Rule 701 allows private, non-reporting companies to issue equity to employees, directors, officers, and certain consultants in a compensatory context without the need for SEC registration. This is a valuable exemption for companies that are building their workforce with equity-based incentives and want to avoid the administrative burdens of SEC filing.

Key Definitions

• Compensatory Securities: Equity issued under Rule 701 must be for compensation purposes only, not for capital raising. These securities need to be part of a formal, written plan or contract that’s structured to incentivize employees, directors, officers, or eligible consultants.

• Eligible Participants: Rule 701 permits equity issuance to employees, directors, officers, general partners, and trustees if the issuer is a business trust. Consultants and advisors may also qualify if they meet specific requirements—namely, that they are natural persons providing bona fide services, not related to capital-raising efforts.

Issuance Limits for Rule 701

Rule 701 is designed to give private companies flexibility while preventing misuse of the exemption. To comply, companies must keep their issuances within these limits over any 12-month period:

1. The greater of $1 million in aggregate sales price or fair market value of the securities issued

2. 15% of the company’s total assets, based on the latest balance sheet

3. 15% of the outstanding class of securities offered under the plan​​.
   

These thresholds allow private companies significant flexibility while maintaining limitations that prevent misuse of the rule, however, private companies need to closely monitor their Rule 701 issuances to ensure compliance, especially since exceeding these thresholds could trigger additional regulatory requirements, possible fines, and rescission rights that could derail a planned IPO.

Special Considerations for Consultants and Advisors

Consultants and advisors eligible under Rule 701 must meet specific conditions:

• Natural Persons Only: Eligible consultants and advisors must be individuals, not acting as agents for other parties.

• Bona Fide Services: Services provided must be directly related to the company’s business, excluding capital-raising activities like promotion or marketing.

• Employee-Like Services: The services should be similar to those performed by employees, aligning with Rule 701’s purpose of rewarding contributions integral to the company’s success.

Disclosure Requirements Under Rule 701

One major benefit of Rule 701 is its simplified disclosure requirements, but companies will need to provide additional information to participants if the total value of securities issued exceeds $10 million in any 12-month period. Required disclosures include:

• Plan or Contract Information: A copy of the stock plan or a summary of the material terms.

• Financial Statements: GAAP or IFRS-compliant financial statements, audited and dated within 180 days of the sale.

• Risk Factors: A summary of risks associated with holding these securities, especially liquidity concerns in a private company setting.

These disclosures not only meet regulatory requirements but also help participants understand the risks and potential value of their equity awards.

Resale Restrictions for Rule 701 Securities

Securities issued under Rule 701 are “restricted securities,” meaning they aren’t immediately eligible for public resale. If the company eventually goes public, Rule 701 provides certain conditions for reselling these securities:

• 90-Day Waiting Period: For non-affiliates, shares can generally be sold 90 days after the company becomes subject to SEC reporting requirements, aligning with Rule 144’s resale rules.

• Affiliates vs. Non-Affiliates: Non-affiliates enjoy greater freedom to resell their shares post-IPO, while affiliates—like executives and directors—remain subject to Rule 144’s limitations on volume and sale method.

For companies planning an IPO, it’s common to implement contractual lock-up periods that further restrict the resale of Rule 701 shares to maintain stock stability immediately following the public listing.

Example of Rule 701 in Action

Consider a private company, TechHub Inc., which uses Rule 701 to compensate employees with stock options. TechHub has recently completed a funding round and is eager to offer more equity grants to its expanding team. Here’s how Rule 701 might apply:

• Issuance Limits: TechHub’s latest balance sheet shows total assets of $6 million. Under Rule 701, TechHub can issue the greater of $1 million or 15% of total assets in stock options. Since $1 million is higher than $900,000 (15% of total assets), TechHub’s issuance limit is $1 million within a 12-month period.

• Tracking Issuances: To stay within Rule 701 limits, TechHub monitors the cumulative value of securities issued under this exemption. This is especially important if the total reaches or exceeds $10 million, as this triggers additional disclosure requirements.

• Disclosure Requirements: If TechHub’s rapid growth causes Rule 701 issuances to surpass $10 million, the company must provide employees with audited financial statements, a copy of the stock plan, and an outline of potential risks.

• Post-IPO Resale: Should TechHub go public, employees holding Rule 701 securities may sell their shares 90 days after the IPO, respecting any underwriter lock-up periods and remaining Rule 144 resale rules for affiliates.

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