Rule 701: An Overview of Securities for Companies and Startups‍

Casey Fenton


January 26, 2024

In the late 1980s, amidst a backdrop of rapid technological advancements and the rise of Silicon Valley, startups faced a quandary: how could they attract top talent in a competitive landscape without extensive capital reserves? The solution, forged in the corridors of power, was Rule 701. A provision that revolutionized the way startups and companies compensate their teams. 

This article invites you, as an employer, to discover how this decades-old rule might just be the game-changer your business needs today.

Introduction to Rule 701

Rule 701 is more than just a clause in a financial manual. It's a provision of the Securities Act that operates as a lifeline for many private companies. It provides a specific exemption for these entities to issue securities—like stocks, options, or other equity instruments—to their employees, consultants, and advisors. This is done as compensation, without needing to go through the traditional and often tedious process of registering these securities with the Securities and Exchange Commission (SEC).

The Rationale Behind It

The late 1980s was a time of burgeoning technological advancement. Silicon Valley was on the rise, and startups were sprouting up, pushing boundaries and redefining industries. But there was a problem: how could these startups, with limited capital, attract and keep the best talent? The traditional ways of compensation, with just salary and benefits, often couldn't match the lucrative offers from established players in the market.

Enter Rule 701, designed to level the playing field. It allowed these emerging companies to offer something just as valuable as a high salary: a stake in the company's potential success. Equity compensation, in the form of shares or options, could be given without the encumbrance of full registration. This not only helped companies save money and time but also allowed them to lure in top talent with the promise of sharing in the company's future success.

Key Provisions of Rule 701

Navigating Rule 701 requires an understanding of its core provisions. It isn't a blanket license for companies to distribute securities willy-nilly. Instead, it offers specific guidelines to ensure that the issuance is both beneficial for companies and provides a safety net for those receiving the securities.

1. Cap on Securities Offered

At the heart of Rule 701 is a limitation—companies cannot simply issue unlimited securities. The rule stipulates that the total value of securities offered must not exceed the highest of three criteria:

  • $1 million;
  • 15% of the company’s total assets; or
  • 15% of the outstanding securities being offered.

This provision ensures a balanced approach, allowing companies flexibility while also ensuring that the issuance doesn't disproportionately dilute company ownership.

2. Nature of the Securities

Once issued, these securities aren't immediately open for free trade. They are, in legal jargon, 'restricted securities'. This means that, unless these securities are registered or fall under another exemption, they cannot be sold in the public market. This provision ensures a level of stability and prevents a potential flood of these securities into the market, which could affect the company's stock price and market perception.

3. Mandatory Disclosure for Larger Offerings

Rule 701 provides an additional layer of protection for recipients of these securities. If a company’s offerings exceed certain values (historically set at $10 million, though this may change based on adjustments), the company is mandated to offer additional disclosures. These disclosures typically include detailed financial statements and a comprehensive breakdown of the risks associated with the securities being offered. This ensures that as the scale of issuance grows, the recipients are better informed about their investment's health and risks.

These provisions underline the intent behind Rule 701: to give companies, especially startups, the tools they need to grow while ensuring transparency, protection, and stability in the larger market ecosystem.

For Whom is Rule 701?

Rule 701 is not a one-size-fits-all provision. Instead, it has been tailored with precision to meet the needs of a specific demographic within the corporate world. So, who stands to benefit the most from this rule?

1. Emerging Private Companies

If you are part of an emerging private company, Rule 701 is like a tailor-made suit, designed to fit your unique needs. With traditional fundraising avenues often wrought with complexities, offering securities as compensation can be a strategic maneuver. This rule facilitates the process, ensuring you can compete with bigger entities in the talent market.

2. Startups

Startups are often characterized by their innovative ideas, boundless energy, and unfortunately, limited resources. In the initial stages, cash is king, and sometimes, there might not be enough of it to go around. Rule 701 provides a workaround. Allowing startups to offer equity compensation without the regular registration hoops helps these enterprises conserve cash while attracting and retaining the talent necessary for their growth and success.

3. Growing Businesses with Equity Compensation Plans

Perhaps you're past the startup phase and are now a growing business, looking to scale and expand. As you evolve, so do your compensation strategies. If equity compensation is on the cards—either to bring in new talent or to reward and retain existing stars – Rule 701 is your ally. It streamlines the process, allowing you to keep your focus where it truly matters: on growth and expansion.

How Does Rule 701 Work?

Navigating the intricacies of securities can be perplexing. But understanding Rule 701 can be broken down into a sequential process. Below are the steps to take note of:

Step 1: Identify the Need for Equity Compensation

Pinpoint why you want to offer securities. Is it to attract a pivotal new hire? Retain a top-performing team member? Or incentivize a consultant? Recognizing this need will give clarity to your approach and help you determine how much equity you wish to offer.

Step 2: Assess Your Eligibility

Not every company can just decide to use Rule 701. You need to be a non-reporting company, essentially one that isn't already obligated to file reports with the SEC. Ensure your business falls into this category before proceeding.

Step 3: Calculate Your Offering Limits

Now, crunch the numbers. Remember, there's a cap on how much you can offer. Rule 701 stipulates you can't offer more than the greatest of:

  • $1 million,
  • 15% of your total assets, or
  • 15% of the securities type you're offering.

Determining where you stand in relation to these ceilings will guide how much equity you can provide.

Step 4: Prepare Necessary Disclosures

If your equity offerings exceed certain thresholds (historically, this is set at $10 million but could vary), there's added homework. You'll need to prepare additional disclosures, ensuring those receiving the securities understand the company's financial health and any associated risks.

Step 5: Issue the Securities

With everything in place, you can now proceed to offer the securities to your employees, consultants, or advisers. These securities are not like standard shares, though; they're restricted. This means they can't be sold immediately in the public market unless they become registered or another exemption applies.

Step 6: Ongoing Compliance

Once you've issued the securities, the process isn't over. Ensure you keep detailed records and regularly review any changes to Rule 701 or related regulations. As your company grows and evolves, so might your obligations.

Understanding Disclosure Requirements

Rule 701 is not just about liberating companies from the intricate tapestry of securities registration; it also emphasizes the importance of transparency. As the value of securities offered under Rule 701 increases, so does the responsibility of the issuing company to disclose pertinent information. This ensures that recipients are not left in the dark and can make informed decisions about the equity they receive.

First and foremost, you must grasp the threshold that triggers these added disclosure requirements. Historically, when a company’s securities issuance under Rule 701 exceeds $10 million in a 12-month period, it crosses into the territory of mandatory disclosures. However, it's worth noting that these numbers can be adjusted, so always ensure you're referencing the latest figures.

What Needs to be Disclosed?

  • Financial Statements: If you surpass the threshold, you'll need to provide your recipients with your company's most recent balance sheet and income statement. These statements must be dated no more than 180 days before the securities issuance. It provides a snapshot of the company's financial health, enabling recipients to gauge the intrinsic value and potential risks of the securities they're receiving.

  • Risk Factors: Investing and equity compensation, by nature, involve risks. Companies are required to give a comprehensive breakdown of these risks. This could range from market volatility affecting stock prices to business-specific challenges that could hamper growth or profitability.

  • Plan Information: You must also provide details about the equity compensation plan under which the securities are being offered. This includes terms of the securities, exercise details (for options), and any other pertinent information that can influence a recipient's understanding and decision-making.

Ensure that these disclosures are given in a timely manner. Ideally, they should be provided before the recipient makes a commitment to receive the securities. This way, they have ample time to review, assess, and seek any external advice if needed. Similarly, regulations evolve, and the nuances of Rule 701 and its disclosure requirements can change. It's not a set-it-and-forget-it scenario. Companies need to stay abreast of any amendments to ensure continued compliance.

How Rule 701 Impacts RSUs (Restricted Stock Units)

Rule 701 doesn't merely pertain to conventional stocks or options; it extends its influence to Restricted Stock Units (RSUs) as well. RSUs, which represent a promise to give the holder shares or cash equivalent once certain vesting criteria are met, have become a popular tool for companies to incentivize and reward employees.

Under Rule 701, companies can issue RSUs without registering them, just as they would with other forms of equity compensation. This provides them the flexibility to structure compensation packages in diverse ways, tailoring them to specific employee needs or company objectives.

However, while issuing RSUs, companies must remain vigilant about the aforementioned disclosure requirements. Even though RSUs are not immediately tangible (they convert into actual shares later), if their aggregate value pushes the company past the disclosure threshold, those disclosures become mandatory.

The Rule That Makes Equity Ownership Possible

Rule 701 represents a thoughtful blend of flexibility and responsibility. By allowing emerging companies and startups to issue equity compensation without burdensome registration, it fuels innovation and growth. Simultaneously, the rule’s provisions for capping offers and requiring disclosures at certain thresholds underscore a commitment to transparency and protection. It's a dynamic regulation that, when properly understood and applied, can be a vital tool for businesses seeking to thrive in a competitive industry.

Should you need more guidance on issuing RSUs for company-worker alignment, reach out to Upstock for a demo today.

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Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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