What Is the Rule 701 Exemption?

Perhaps this should go without saying, but a company cannot simply issue whatever equity it wants to on a whim. There are certain regulations that must be followed. Oftentimes, these regulations have been around for a very long time and for very good reason. But it’s difficult to craft a regulation that makes sense for every single situation in which a company wants to offer or sell equity, which is why certain exemptions exist as well. Rule 701 is one such exemption, and it’s one that could save your startup a lot of time and money.

Rule 701 allows certain startups and private companies to issue up to $10 million in securities to employees during a consecutive 12-month period—without the requirement to also provide them with extensive financial statements and risk disclosures. This exemption enables many startups to issue employee equity even if they can’t afford the expense and heavy lawyering involved in drafting and issuing the aforementioned disclosures.

In this guide, we’ll review the basics of Rule 701—why it exists, which companies and situations it applies to, and (if applicable) how to ensure that your company is compliant. Securities exemptions like Rule 701 can be confusing and quite situational, so we recommend supplementing the advice in this guide with the wise counsel of your company’s legal experts. 

• What is Rule 701?
• Which companies can rely on the Rule 701 exemption?
• What are companies required to disclose under Rule 701?
• How the 12-month window works with Rule 701
• What happens if a company fails to comply with Rule 701?
• Recent changes and amendments to Rule 701
• Compliance with Rule 701 made easy

What is Rule 701?

Rule 701 is a federal safe harbor exemption. It exists to save certain companies the expense and general hassle of registering stock options issued to employees. (In addition to employees, the Rule 701 exemption also covers equity grants made to consultants and advisors, provided they are natural persons and provide bona fide services to the issuing company, its parents, or its subsidiaries). 

To understand why Rule 701 is necessary, it helps to take a step back and understand why registration of stock options and other securities is a thing in the first place. 

We mentioned earlier that certain regulations and reporting requirements govern the issuance of equity to the public. One of the most integral pieces of legislation for securities regulation is the Securities Act of 1933. Section 5 of the Securities Act states that a company can’t offer or sell any securities to the public without first registering the securities with the Securities and Exchange Commission (SEC). The logic here is presumably that registration allows investors to obtain crucial information about the company’s finances, and gives the SEC a chance to review the company’s disclosures. 

But registering securities and preparing investor disclosures can be expensive and time-consuming (in some cases, prohibitively so). Recognizing this—and recognizing that the offering and sale of securities as employee compensation is different from other types of equity issuance (e.g. to investors as part of a capital-raising transaction)—the SEC created Rule 701. 

So, to tie this all together, Rule 701 is a federal exemption that enables eligible private companies to issue up to $10 million worth of equity compensation to employees—without the need for burdensome disclosures. 

Unfortunately, an “in short” definition doesn’t always suffice in the world of federal securities laws. Let’s take a deeper look at some of the criteria the SEC uses to determine a company’s eligibility under Rule 701.

Which companies can rely on the Rule 701 exemption?

For a non-reporting company of any size to rely on the exemption provided by Rule 701, its total sales of securities over a consecutive 12-month period must be below a certain threshold. (When we say “non-reporting company,” we mean a company that isn’t required to file reports with the Securities and Exchange Commission.) In practice, this means that the greatest of the following must be true:

• The aggregate sales price sold under Rule 701 is less than $1 million
• The aggregate sales price sold under Rule 701 is less than 15% of the total assets of the issuer, measured as of the date of the issuer’s most recent balance sheet; or
• The number of the issuer’s securities sold under Rule 701 is less than 15% of the outstanding amount of the common shares, measured as of the date of the issuer’s most recent balance sheet.

This may not be the case for long. Amendments and changes to Rule 701 have been enacted or proposed before; a recent amendment proposal to increase flexibility for non-reporting companies calls for the $1,000,000 dollar cap to be doubled to $2,000,000 and the asset cap to be raised from 15% to 25%. We’ll cover some of these amendments and proposed changes later.

Which companies do not qualify for the Rule 701 exemption?

The Rule 701 exemption is not applicable or available to all companies. It is not available to public companies and/or “Exchange-reporting companies,” i.e. companies that are required to file reports periodically with the SEC under section 12, 13 or 15(d) of the Securities Exchange Act of 1934.

What are companies required to disclose under Rule 701?

As noted above, a company may be exempt from providing disclosures to security holders if it sells less than $10 million in equity compensation to employees, consultants, and advisors within a 12-month period. Remember: these securities are exempt from registration and disclosure because they are compensatory securities offered and sold under employee benefit plans.

But what happens if a company sells more than $10 million in securities in a 12-month period? Well, the SEC says that the company is then required to provide certain disclosures to all security recipients within a reasonable period of time prior to the date of sale. These disclosures include (but may not be limited to):

• A copy of the compensatory benefit plan or contract
• A copy of the summary plan description required by the Employee Retirement Income Security Act of 1974 (ERISA), or a summary of the plan’s material terms if it isn’t subject to ERISA
• Detailed financial statements
• Risk disclosures related to the securities sold

As you can probably glean from the above list, these disclosures are nothing to mess around with! They can be expensive and time-consuming to prepare. This makes it all the more important to stay under the $10 million limit in aggregate securities sales across a 12-month period, if and whenever possible. Let’s take a look at what that actually means, in practice.

How the 12-month window works with Rule 701

There are a few questions that inevitably come up when trying to define how this whole “12-month window” thing works. The most common of these questions involves whether the 12-month window can be calculated based on a fixed or rolling period:

• A fixed period means that the 12-month window begins on a specific date and ends 12 months later. Oftentimes, this aligns with a calendar year or a company’s fiscal year.
• A rolling period means that the 12-month window is defined by the 12 months immediately preceding the date of the transaction in question. This means that the sales of securities within any given 12-month period cannot exceed $10 million if the Rule 701 disclosure requirement is not to be triggered. 

A company can decide whether to use either a fixed or rolling period in defining its 12-month window. But, while a company can choose between either, it can’t switch between the two. Once a choice is made, the company must continue to use the same definition of “12-month period” for all calculations moving forward. 

This may not seem highly consequential, but it can be. To use an extreme example, say a company were to issue securities worth $16 million across the month of December and no securities throughout the rest of the year. In this case, it would make sense for the company to use a fixed period that splits up the month of December into two separate windows, with $8 million worth of securities sold in each window. 

What happens if a company fails to comply with Rule 701?

The costs of complying with Rule 701 disclosure requirements can be a burden to a startup. But the costs of not complying aren’t fun, either. Failure to comply with the disclosure requirements of Rule 701 can lead to penalties from the SEC. 

The San Francisco-based fintech company Credit Karma learned this the hard way when the SEC deemed that it had failed to comply with disclosure requirements for stock options issued from October 1, 2014 through September 30, 2015. The SEC order relating to the case specifies that Credit Karma issued approximately $13.8 million in stock options to its employees in that time period, exceeding the $5 million disclosure threshold of Rule 701 at the time (the threshold has since been increased to $10 million). Even though Credit Karma did provide some financial information to employees, the SEC determined that this information was not complete as per the requirements of Rule 701. As a result, the company paid a civil money penalty of $160,000 to the SEC to settle the case. 

All of this is to say that compliance is important! The SEC generally keeps busy and may not take enforcement action against a small startup trying its best to comply, but the costs of noncompliance can be steep and are best avoided.

Recent changes and amendments to Rule 701

In several of the previous sections, we alluded to the fact that there have been some changes and amendments made to Rule 701 in recent years. Some of these changes and amendments are still proposals that have yet to be enacted, but could be soon. 

2018 changes to Rule 701

In July 2018, the SEC adopted an amendment to Rule 701 as mandated by the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018. This amendment increased the aggregate sales price, or amount of securities sold, during a consecutive 12-month period from $5 million to $10 million. 

This means that, under Rule 701, companies don’t need to provide the aforementioned list of disclosures to stock recipients unless their total securities sold amounts to more than $10 million in a 12-year window.

You can read the full text of the SEC action here.

Recently proposed amendments to Rule 701

Though not yet issued as a final rule, the SEC has also considered adopting other amendments intended to make Rule 701 more flexible and helpful to modern startups. Highlights of these proposals include:

• Expanding the group of workers to whom securities can be bought and sold. Specifically, a proposed amendment seeks to include “platform workers” (i.e. workers providing services in the gig economy) in this group moving forward.
• Revising the additional disclosure requirements for exempt transactions in excess of $10 million. A list of related proposals seeks to relax the requirements and make compliance less costly and more beneficial. For example, in the case of a new hire receiving restricted stock units (RSUs), the disclosure would be considered timely if it was delivered within 14 calendar days after employment begins. This particular requirement seeks to limit potential leaks of sensitive information by not providing disclosures to new hires prior to the actual start of their employment.
• Raising caps for the amount of equity that can be issued in a consecutive 12-month period. As mentioned in an earlier section, this proposal would increase flexibility for non-reporting companies. It calls for the $1,000,000 dollar cap to be doubled to $2,000,000 and the asset cap to be raised from 15% to 25%.

All of this is to say that securities regulation is not static. To its credit, the SEC regularly attempts to respond to the shifting equity awards landscape with helpful amendments to its regulations.

Compliance with Rule 701 made easy

Wondering if the equity compensation your company has issued is exempt under Rule 701? Pulley has a Rule 701 calculator that makes it easy to check if your company qualifies for the Rule 701 exemption. To find it, just Select Compliance > Rule 701 in the left-hand taskbar on Pulley.

You can find more information about using Pulley to check for Rule 701 compliance in our Help Center. And if you have any additional questions about Rule 701 compliance and how Pulley makes it easy, click the button below to schedule a call with us today.