Eligibility Requirements of Rule 701

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According to Rule 701, private companies can sell securities through equity-based compensation plans to employees, advisors, or consultants without having to register the securities with the SEC. To make the issuance of stock-based compensation easy and flexible for private companies, SEC introduced Rule 701 in 1988. While to qualify for Rule 701, private companies need to adhere to certain conditions and requirements, and thus in this article we will discuss and analyze the eligibility requirements of Rule 701.


What is Rule 701?

Since 1988, the SEC has permitted private companies to issue stock-based compensation plans, such as stock options, phantom stocks, or restricted stock their employees, advisors or consultants without registering their securities with the SEC. While there is a maximum cap of $10 million that a private company can issue in 12 months under Rule 701. It is important to note that the securities issued through Rule 701 are considered restricted securities, and they cannot be sold publicly until the company becomes subject to public reporting requirements of federal securities laws. In addition to the maximum cap, private companies must sell securities worth at least $1 million to qualify for Rule 701.


How does Rule 701 work?

Based on Rule 701, private companies can issue and sell securities under an equity-based compensation plan. To qualify for this exemption, private companies must meet the various requirements and conditions. While there are no forms or applications to be filled or submitted with the SEC. Before issuing securities, private companies should ensure that their compensation plans are compliant with Rule 701 including the maximum and minimum cap, whether or not the securities are being issued through stock-based compensation plans, and a few disclosure requirements under Rule 701.

Therefore, it is vital to review Rule 701 disclosures requirements and ensure that the company will meet the requirements to sell stock-based compensation plans to employees, advisors or consultants implying that the securities will not be listed publicly.


Rule 701 safe harbor exemption

The purpose of Rule 701 is to provide greater flexibility for private companies in selling their securities to employees, advisors or consultants without having to abide by the complicated registration process required by the Securities Act. The aggregate selling price of the issued securities and the total number of options granted in line with the rule may not, under the safe harbor provisions of Rule 701 for any successive 12-month period, exceed the following amounts:

1. $10,000,000, which is calculated for stock options by multiplying the number of options issued by the strike price.

2. 15% of the issuer's entire asset base at the time of the most recent annual balance sheet date.

3. 15% of the total outstanding value of the type of securities that have been offered for sale in line with the regulation as of the issuer's most recent annual balance sheet date.


The importance of Rule 701 for private companies

Now that we have a brief understanding of what Rule 701 is and how it works, we need to take into consideration the importance of Rule 701 for private companies. Here are a few key points why Rule 701 is important for any private company:

1. Rule 701 provides greater flexibility to private companies in issuing equity-based compensation plans in the sense that they are not required to register their securities with the SEC. As a result, there is less paperwork and compliance burden on private companies.

2. Rule 701 places no restrictions on the types of securities that can be issued under equity-based compensation plans. Therefore private companies are free to issue any type of compensation plan including stock options, restricted stock, phantom stock, etc.

3. The expenses related to issuing securities under Rule 701 are far lower than the expenses of issuing securities under full SEC registration because there are no compliance and legal fees required under Rule 701.


Requirements for Rule 701

Well, there are a few requirements for Rule 701 but, there are certain things that you need to pay attention to when selling securities under this rule. These requirements are some clauses or conditions that are required for Rule 701 to be applicable. The requirements for Rule 701 mainly include the maximum cap of $10 million, the minimum limit of $1 million, 15% of assets or outstanding value of the issuer, and the securities must only be issued through stock-based compensation to qualify for the rule. Therefore, if you intend to sell securities under Rule 701, you should ensure that your plans are compliant with these requirements.


When does Rule 701 apply?

Rule 701 provides for an exemption for private companies from having to register their securities with the SEC wherein their securities are issued under an equity-based compensation plan. Nonetheless, there is a maximum cap of $10 million and the minimum amount of securities that may be sold under Rule 701 is $1 million in 12 months. During this period of one year, securities can be issued through stock-based compensation plans ensuring that they will meet the Rule 701 requirements. As a result, there is no specific time as to when Rule 701 may apply to a private company and it can be applied whenever the private company wishes to issue securities until the requirements are met.


Rule 701 disclosure requirements

Rule 701 requires for disclosure of certain information as far as the plan is concerned, the risk factors, and some financial statements. Below mentioned are some of the disclosure requirements under Rule 701 that private companies should know:

1. An outline of the important provisions of the employee equity compensation plan. The detailed outline includes the details of the employee equity compensation plan including the maximum aggregate amount of securities, the type of plan issued and the total number of securities sold.

2. Investing risks that are associated with the equity plans. The risks have to be disclosed clearly and understandably as well as a description of the steps taken by the company to reduce these risks.

3. Financial statements that comply with GAAP, including the most recent balance sheet, income statement, cash flow statement, and capitalization statements for the prior fiscal years.


Eligibility Requirements for Rule 701

Under Rule 701, there are certain eligibility requirements for private companies to be able to sell their securities under equity-based compensation plans and likewise qualify for the exemption. Here are the eligibility requirements for Rule 701:

1. A private company must not be a public reporting company because Rule 701 specifies that the exemption from registration is not available to public reporting companies, and thus it only applies to private companies.

2. Securities must be issued under a written compensatory benefit plan that complies with Rule 701 to be eligible for the exemption from registration. This means that the equity plan must be legally binding and a written agreement must exist between the company and the employee.

3. The equity plan must be communicated to all eligible employees because they must be aware of their obligations to the plan. Hence, it should be communicated clearly and understandably.

4. The securities must be issued either to employees, consultants, or advisors who are typically involved in the ownership, operation, or management of the business. These equity plans are a reward for the services of these individuals.

5. The amount of securities issued must not exceed the limit of $10 million within any 12 months. In addition to this, the minimum amount of any security that may be issued is $1 million.

6. Other requirements that may apply to the securities issued under Rule 701 can vary from company to company. Depending on the circumstances, there may be other requirements that must be met by the company.

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