What Are the Rule 701 Exemption Requirements?

Rule 701 of the Securities Act of 1933 provides a “safe harbor” exemption, allowing private companies to offer securities as compensation without undergoing the costly and time-consuming process of registering with the Securities and Exchange Commission (SEC). This federal exemption is specifically designed to facilitate equity compensation for employees, consultants, and advisors. The rule permits the issuance of stock options, restricted stock units (RSUs), and other equity awards under a formal, written compensatory benefit plan. Rule 701 is intended for compensatory purposes only and cannot be used as a method for raising capital from the public.

Issuer and Recipient Eligibility

Eligible Issuers

The Rule 701 exemption is available to private companies not subject to the reporting requirements of the Securities Exchange Act of 1934. The rule cannot be used by investment companies, such as mutual funds, that are registered or required to be registered under the Investment Company Act of 1940. A company that voluntarily files reports with the SEC or does so based on a contractual obligation may still be eligible to use Rule 701. The distinction is whether the company is mandated to report under federal securities law.

Eligible Recipients

Securities issued under Rule 701 must be granted to specific categories of individuals and entities providing bona fide services to the company. Eligible recipients include employees, directors, general partners, trustees, and officers of the issuer. The exemption also extends to the same personnel at the issuer’s parent company or its majority-owned subsidiaries. Consultants and advisors may also receive securities, but they must be natural persons, meaning individuals rather than business entities. These individuals must be providing genuine services that are not connected to the offer or sale of securities in a capital-raising transaction.

Aggregate Sales and Issuance Limits

To maintain compliance with Rule 701, a company must track the aggregate sales price of securities sold within any consecutive 12-month period. The total value of securities sold during this window cannot exceed the greatest of three distinct calculations. The 12-month period can be a fixed period, like a fiscal year, or a rolling window, but the company must apply its chosen method consistently.

The first test is a fixed dollar amount of $1,000,000. A second option allows a company to issue securities valued up to 15% of its total assets, based on the issuer’s most recent balance sheet date. For example, if a company’s latest balance sheet shows total assets of $10 million, its issuance limit under this test would be $1.5 million for the subsequent 12-month period. This test is often beneficial for asset-heavy companies, and a private, wholly-owned subsidiary may use its parent company’s assets for this calculation if the parent guarantees the subsidiary’s obligations.

The third test limits the aggregate sales price to 15% of the outstanding amount of the class of securities being offered, measured as of the issuer’s most recent balance sheet date. For instance, if a company is issuing common stock and has 10 million shares of common stock outstanding, it could issue securities with an aggregate sales price up to the value of 1.5 million shares. The value is determined by multiplying the number of shares by the exercise price or fair market value at the time of the grant.

Disclosure Obligations

Specific disclosure obligations are triggered if the value of securities sold under Rule 701 exceeds a significant threshold. If the aggregate sales price of securities sold during any consecutive 12-month period exceeds $10 million, the company must provide a detailed disclosure package to each recipient. This requirement was updated by the Economic Growth, Regulatory Relief, and Consumer Protection Act.

The required information must be delivered to each recipient a reasonable period of time before the date of sale, which for stock options is the date of exercise and for RSUs is the date of grant. A primary component of this package is a copy of the compensatory benefit plan or the specific contract under which the securities are offered. If the full plan is not provided, a summary of its material terms is required.

Another element of the disclosure is information about the risks associated with the investment. This often takes the form of a risk factors section, similar to what would be found in a public offering prospectus, outlining potential risks to the company’s business and the value of its securities.

Finally, the company must provide financial statements. These statements must be prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) and include a balance sheet, statements of income, cash flows, and changes in stockholders’ equity. The financial statements must be dated no more than 180 days before the sale of the securities. The financials do not need to be audited if the company does not otherwise have audited statements.

Status of Securities After Issuance

Securities issued under Rule 701 are considered “restricted securities” under the Securities Act. This classification means they are subject to certain resale limitations and cannot be freely traded on the open market.

However, Rule 701 provides a unique benefit for resale when a company goes public. Unlike other restricted securities that require a six-month or one-year holding period under Rule 144, securities issued under Rule 701 become eligible for resale 90 days after the issuer becomes a reporting company, such as after an IPO.

The ability to resell is slightly different for non-affiliates versus affiliates of the company. Non-affiliates, such as rank-and-file employees, can sell their shares freely after the 90-day period, provided they use a broker for the transaction.

Affiliates, such as directors and executive officers, are also able to sell after the 90-day period without a holding period, but they remain subject to Rule 144’s other requirements. These include volume limitations on the amount of stock they can sell in any three-month period, specific manner of sale requirements, and the filing of Form 144 with the SEC for sales exceeding certain thresholds.