Rule 701 is a safe harbor exemption created by the SEC that requires qualified companies to provide certain information to prospective purchasers (optionees).
Generally, if a startup company issues stock or stock options, securities laws require that those securities either be registered (which is time consuming and expensive) or be exempt from registration. Most private venture backed companies raise money based on an exemption from registration. What many people don’t realize is that the same rule applies to stock options issued by the company to employees—the offering must be registered or there must be an exemption from registration in place. Rule 701 is a safe harbor exemption created by the Securities and Exchange Commission (SEC) that allows companies to issue stock options without the time and expense of registration of the stock under the Securities Act.
Rule 701 only applies to private companies. To qualify under the exemption, the company must issue securities pursuant to a written compensatory benefit plan (such as a stock option plan) only to employees, directors, consultants and advisors.
Rule 701 is a safe harbor exemption
Under Rule 701, the aggregate sales price or amount of securities sold or options granted in reliance on the rule during any consecutive 12-month period cannot exceed the greater of the following:
- $10,000,000 (calculated by multiplying the option exercise price times the number of options granted, in the case of options);
- 15% of the total assets of the issuer, measured at the issuer’s most recent annual balance sheet date; or
- 15% of the outstanding amount of the class of securities being offered and sold in reliance on the rule, measured at the issuer’s most recent annual balance sheet date.
What this means is that before every set of option grants, the company needs to make sure that it stays within these limits so that it can preserve the safe harbor exemption.
Disclosure requirements under Rule 701
Rule 701 is important because if a company expects that the total aggregate sales price of stock options issued during any consecutive 12-month period will exceed $10 million, then Rule 701 requires the company to provide certain information to prospective purchasers (i.e., stock option holders who are exercising their options).
The rule requires that the company provide the following information to each purchaser:
- A summary of the material terms of the employee benefit plan
- The risks associated with the investment
- GAAP compliant financial statements; including the latest balance sheet, the statements of income, cash-flows, and capitalization for the preceding two fiscal years.
Why Employees Need to be Aware of Rule 701
So what does this all mean if you work at a private company and own stock options? If your company issues more then $10M in equity to employees over a 12 month basis, they are required to supply the Rule 701 disclosures listed above to any option holder looking to exercise their options. Whether you are bullish on the company or not, it is worth getting this information, if available, as it will assist in your decision of whether or not to exercise your stock options. 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.
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.