Rule 701, established by the Securities Act of 1933, allows private companies to issue equity to employees, consultants, and advisors as compensation without needing to register the offering with the SEC. This exemption is particularly beneficial for startups looking to attract and retain talent through equity compensation. Basically, Rule 701 allows smaller startups to offer equity to employees without being required to disclose the same level of financial information that public companies must provide.

Why is Rule 701 Important for Employees?

The importance of Rule 701 lies in its disclosure requirements for employees who seek to exercise stock options. If a company issues more than $10 million in securities in a 12-month period, employees who are exercising options must receive key financial disclosures. These disclosures ensure that employees have access to detailed information about the company's financial health, which allows them to make informed decisions before purchasing stock through their options.

The key disclosures required for employees exercising options include:

• Financial statements: Information on the company’s financial status, providing transparency into its overall health.
• Summaries of the stock plans: Details about the terms of the securities being offered.
• Risk factors: Insight into potential risks associated with owning the company’s stock.

These disclosures are critical for employees to assess the potential risks and rewards of exercising their options, especially when the company exceeds the $10 million threshold in equity issuance. Before exercising your stock options, it’s essential to determine whether your company qualifies for the Rule 701 exemption. If the company exceeds the exemption threshold, you should receive the full Rule 701 disclosure. This disclosure will equip you with the necessary financial information to make an informed decision about your equity investment, ensuring that you understand the associated risks and rewards before proceeding.

Does My Company Qualify for Rule 701 Disclosures?

If your company has issued stock options to you, it’s important to know whether you are entitled to receive Rule 701 disclosures. These disclosures are required if:

1. The company has exceeded $10 million in equity issuance: If the total value of securities issued over a 12-month period surpasses $10 million, the company must provide financial disclosures to employees before they exercise their options. Larger companies with higher strike prices and more employees are more likely to exceed the thresholds that trigger Rule 701 disclosures (In 2018, the SEC raised the disclosure threshold under Rule 701 from $5M to $10M in equity sales during a 12-month period, easing compliance for growing startups).
   • A good way to check if your company qualifies is to take the number of new hires in past year times the current fair market value times 4,000 (or another conservative estimate of the average employee's option grant). This should give a conservative estimate for the total amount of equity issued in the past year, if that number is greater than $10M, then your company likely is required to issue rule 701 disclosures.
   • In addition to the $10 million threshold, Rule 701 imposes two other key limits that could require a company to provide disclosures:
     • If the total value of securities issued in a 12-month period exceeds 15% of the company's total assets, as measured from its most recent annual balance sheet.
     • If the securities issued represent more than 15% of the company’s outstanding shares in the relevant class, based on the most recent annual balance sheet.
2. You are exercising stock options: Disclosure requirements under Rule 701 apply specifically to employees who are converting their options into stock. These documents, including financial statements and risk factors, help you evaluate the risks of purchasing company shares.
3. The company is non-reporting: Publicly traded companies are not subject to Rule 701, but if you’re in a private company, this exemption could apply.

Understanding these conditions will ensure you receive the necessary information before making an equity investment in the company. For the full legal text, see SEC Rule 701 and Cornell Law’s Rule 701 summary. For a deeper legal perspective, see Cooley’s Rule 701 guide.

Where can I find Rule 701 Disclosures?

If your company uses Carta, they will often include Rule 701 disclosures in your equity portal. Otherwise, it is recommended to contact the stock admin or whoever is in charge of handling employee equity.

Why Companies Need to be Aware of Rule 701

As startups stay private longer and in situations where a private company is growing rapidly the Rule 701 reporting requirements need to be monitored carefully. Officers and directors of venture-backed companies must pay attention to the Rule 701 thresholds otherwise they may face issues with the SEC. For example, in March 2018, the SEC assessed a $160,000 penalty against Credit Karma for failure to comply with Rule 701.

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Written by Jordan Long, Marketing Lead at ESO Fund