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What is Rule 701?

By May 6, 2024No Comments

In the United States, securities offered to a company’s employees, consultants, or advisors, such as restricted stock or stock options, must be registered with the Securities and Exchange Commission (SEC) or qualify for an exemption from registration. For this purpose, startups often use the federal exemption known as Rule 701 for securities offered to service providers. This rule provides a registration exemption for compensatory benefit plans, like the equity incentive plans or stock plans companies use to grant stock options.

The total value or amount of securities sold by a company during any consecutive 12-month period in reliance on Rule 701 cannot exceed the greatest of the following:

(i) $1,000,000;

(ii) 15% of the total assets of the company, as of the company’s most recent balance sheet date (which can’t be older than the company’s last fiscal year end); or

(iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, measured at the company’s most recent balance sheet date (which can’t be older than the company’s last fiscal year end).

If a company expects to sell more than $10 million of securities under a Rule 701-exempted benefit plan within any consecutive 12-month period, it must provide disclosures to its service providers who might buy the securities under the plan. These disclosures, which should be given a reasonable time before the sale date, include a summary of the plan’s material terms, risk factors, and financial statements.

A company has the flexibility to select any consecutive 12-month period for measuring Rule 701 compliance. This could be a fixed period or a rolling 12-month period. However, once chosen, the company must apply it consistently.

As a company starts making substantial grants under its equity incentive plan, it is important to regularly monitor and measure compliance with Rule 701. When the company approaches the $10 million within 12 months threshold, it should consult with knowledgeable securities counsel to begin preparing the required enhanced disclosures and planning for the distribution of this sensitive information, including confidentiality precautions. Failure to comply with Rule 701 requirements can lead to penalties and even the loss of the exemption. Rule 701 does not preempt state securities laws, so companies must also ensure compliance with applicable state blue sky laws.

Author Foley Ignite

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