Rule 701 Guide for Private Companies

How Rule 701 Works for Private Companies

For private companies, particularly those in 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 is a closer look at how Rule 701 works, who is eligible, and what private companies should consider when issuing stock options or selling restricted stock under this exemption.

What Is Rule 701?

Rule 701 allows private, nonreporting companies to issue equity to employees, directors, officers, and certain consultants in a compensatory context without the need for SEC registration. This exemption is valuable for companies building their workforce with equity-based incentives while avoiding the administrative burden of SEC filings.

Key Definitions

• Compensatory securities: Equity issued under Rule 701 must be for compensation purposes only, not for capital raising. These securities must be part of a formal written plan or contract structured to incentivize employees, directors, officers, or eligible consultants.
• Eligible participants: Rule 701 permits equity issuance to employees, directors, officers, general partners, trustees if the issuer is a business trust, and certain family members of these individuals. Consultants and advisors may also qualify if they meet specific requirements, including being natural persons providing bona fide services unrelated to capital-raising activities.

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 issuances within these limits over any 12-month period.

The greater of:

• $1 million
• 15% of the company’s total assets, based on the latest balance sheet
• 15% of the outstanding class of securities offered under the plan

These thresholds allow flexibility while maintaining safeguards against misuse. Private companies must closely monitor Rule 701 issuances to ensure compliance. Exceeding these thresholds can trigger additional regulatory requirements, potential 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 and not act as agents for other parties.

• Bona fide services: Services must be directly related to the company’s business and must not include capital-raising activities such as promotion or marketing.

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

Disclosure Requirements Under Rule 701

A major benefit of Rule 701 is its simplified disclosure requirements. However, companies must 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 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, including liquidity concerns in a private company

These disclosures help meet regulatory requirements and ensure 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 are not immediately eligible for public resale. If the company goes public, Rule 701 provides certain conditions for resale:

• Rule 144 resale timing: For nonaffiliates, Rule 701 shares may be resold under Rule 144 beginning 90 days after the company becomes subject to SEC reporting requirements, subject to the applicable conditions of Rule 144. This timing does not replace any applicable holding period requirements but reflects when Rule 144 becomes available following the company’s transition to reporting status.

• Affiliates vs. nonaffiliates: Nonaffiliates have greater freedom to resell shares post-IPO, while affiliates, such as executives and directors, remain subject to Rule 144 limitations on volume and method of sale

Companies planning an IPO often implement contractual lock-up periods to further restrict resale and maintain stock stability following the public listing.

Example of Rule 701 in Action

ExampleCo Inc. is a private company that uses Rule 701 to give employees stock options. After a recent funding round, it plans to offer equity to more team members.

• Issuance limits: ExampleCo has $6 million in assets and $4 million in outstanding securities. Under Rule 701, it can issue the greatest of $1 million, 15% of assets, or 15% of outstanding securities. Since 15% of assets is $900,000 and 15% of outstanding securities is $600,000, the limit is $1 million in a 12-month period.

• Tracking issuances: The company tracks total issuances, especially as it approaches $10 million in a 12-month period, which triggers additional disclosure requirements.

• Disclosure requirements: If total issuances go over $10 million, ExampleCo must provide participants audited financial statements, the stock plan document, and disclosures explaining the risks associated with investing in the company’s stock.

• Post-IPO resale: If ExampleCo goes public, employees may sell shares 90 days after IPO, but sales may still be limited by lock-up agreements and Rule 144 for affiliates.

For more resources, visit the Private Company Stock Plans section on NASPP.com