What is Rule 701 and Why Is It Important for Startups?

As a startup, your team’s talent and knowledge are often irreplaceable. Anything you can do to hire and keep the right people can be key to helping your company thrive. Equity can be a great way for startups to retain valuable staff, advisors, and consultants. But if your business has limited funds, you may not be ready to register with the SEC (which is necessary for “going public”). That’s where Rule 701 comes in.

The Securities and Exchange Commission (SEC) created Rule 701 so companies could distribute stock options without the time and cost of registering the stock in compliance with the Securities Act. If a startup is allocating stock or stock options, then the securities regulations require that the assets involved must be either registered or exempt from registration. Rule 701 allows companies to offer equity to service providers up to a certain limit before being required to make certain disclosures.

Note: This article is intended to serve as a high-level overview of this safe harbor exemption and the requirements for Rule 701. We recommend consulting with professional legal advisors before taking any action with regard to your employee stock options.

Background: What is Rule 701?

After the first big drop in the stock market in the early 1900s, the US Congress created the Securities and Exchange Commission (SEC) and started the Securities Act of 1933. This Act says that any type of stock — or something that can be turned into stock — must be registered with the SEC before it can be sold legally. This includes the kind of stocks and options that plan managers deal with every day – even though most managers at private companies haven’t thought about having to register their awards with the SEC. Luckily, there are exceptions to this law.

Rule 701 is a safe harbor exemption issued by the SEC that lets private companies offer stock options to employees without having to register the offering. This provides a great opportunity for startups looking to reward their hard-working employees in a legal manner. However, as with any regulation or rule, certain conditions must be met for the offering to be considered valid. These requirements can range from specific disclosure requirements for companies wishing to take advantage of Rule 701, such as documenting and communicating essential information about their offerings. It’s important for startups leveraging Rule 701 to clearly understand its complexities and how it works to stay compliant.

Who is Rule 701 for?

To qualify for an exemption from Rule 701, the firm distributing the securities cannot be bound by the reporting obligations of Section 13 or 15(d) of the Securities Exchange Act of 1934. When a company

becomes subject to reporting under the Exchange Act, it can no longer use Rule 701 for new securities offerings. However, it’s still allowed to sell securities that were already offered by means of Rule 701.

The Rule 701 exemption allows businesses to easily set up incentive compensation plans that provide employee equity incentives in compliance with regulations, saving both time and money on administrative costs. Furthermore, stock option offers can provide long-term benefits if employees hold onto their shares until they reach a certain price target, which could result in significant gains if done properly.

Requirements for Rule 701 stock options

There are certain conditions that must be met for the Rule 701 exemption to apply to your company’s securities.

  1. The award must be issued through either a written agreement for payment or a plan for providing a benefit. The reason for the issuance must be for remuneration for actual services offered to the issuer, its parent business, or a majority-owned subsidiary. A plan is not restricted to only being granted to Rule 701 eligible recipients. Thus, not all payments made under a written contract or plan are automatically eligible for the Rule 701 exemption.
  2. Rule 701 states that only real people can get special awards, and the person receiving the award must be actively working for the company when the award is given. So, while people who work as consultants can get these awards, consulting companies can’t. Similarly, some trustees can get them, but the trusts themselves can’t. The rule also covers certain family members of those who can get the awards, if they got the awards as gifts or through family legal matters. Insurance agents who work only for this company, even if they aren’t employees, can also get these awards — however, people whose main job is to advertise or raise money for the company cannot.
  3. Eligibility for a Rule 701 award is determined by three essential tests. Test #1 sets a limit of $1 million for the total value of outstanding options and sales made under Rule 701 in the last year. Test #2 restricts the issuance of new awards and outstanding awards granted in the past year to be no more than 15% of the total amount of the same type of stock. Finally, Test #3 caps the combined value of outstanding options and Rule 701 sales at 15% of the company’s total assets, as indicated in the most recent balance sheet not older than the end of the last fiscal year. By satisfying these tests, a private company can confidently grant securities to employees under Rule 701 without the need for SEC registration.

Companies need to understand and abide by these requirements. This will help ensure you remain compliant with Rule 701 and avoid potential penalties or other legal action from the SEC.

Astrella software can help manage employee stock options and stay compliant with Rule 701 guidelines, making it an invaluable tool for startups looking to provide equity incentives without running afoul of regulations.

Challenges of leveraging Rule 701 for startups

Taking advantage of Rule 701 can be a great way for startups to offer stock options to their employees, but it’s important to be aware of its associated challenges. One of the main challenges of leveraging Rule 701 is the cost associated with administering the program. Startups must ensure they have the

necessary resources and personnel to track transactions and remain compliant with regulations. Plus, navigating the complex regulations set forth by Rule 701 can be difficult and time-consuming for those unfamiliar with them.

Additionally, startups must ensure that their employees are adequately informed of their rights regarding stock options issued under Rule 701. This includes informing them of any restrictions or requirements that may apply and ensuring they understand how stock options work in general. Furthermore, when issuing stock options under Rule 701, companies must document all transactions carefully to comply with SEC regulations. This includes keeping detailed records of any option grants or exercises, and maintaining records related to option pricing and vesting schedules.

The benefits of using Rule 701 for startups and employees

Startup employees can reap several benefits by taking advantage of Rule 701. Firstly, Rule 701 enables them to receive equity compensation, such as stock options or restricted stock units, without the need for the company to register the securities with the SEC, making the process faster and less burdensome. This allows employees to become direct stakeholders in the company’s success, aligning their interests with the company’s long-term growth.

Equity compensation through Rule 701 also offers the potential for significant financial gains if the company experiences successful exits, like IPOs or acquisitions. It can act as a valuable incentive, motivating employees to contribute to the company’s growth and success. Lastly, Rule 701 can be instrumental in attracting and retaining top talent, as it presents an opportunity for employees to participate in the company’s value creation and future success, creating a stronger bond between the team and the startup’s vision.

Essentially, Rule 701 provides a cost-effective way for startups to offer stock options to their employees without needing to register them as securities. However, the tools you use will determine how time- and energy-consuming it is to track these stock options accurately.

Take a demo to see how Astrella helps startups simplify equity management.

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