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.
