What is Rule 701 and Why It is Important if You Have Stock Options

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 is a safe harbor exemptionRule 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.

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:

• $1,000,000 (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:

1. A summary of the material terms of the employee benefit plan;
2. The risks associated with the investment; and
3. GAAP compliant financial statements, including the latest balance sheet and the statements of income, cash flows, and capitalization for the preceding two fiscal years.

This information is incredibly important to ensure that stock option holders can make an informed decision prior to exercising.
For additional information on how the SEC interprets Rule 701, see Question 271 at this SEC release.

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.