How does Rule 701 help distribute employee stock?
Rule 701 applies to private companies regarding certain sales of securities made to compensate workers, consultants, and advisors are excluded under Rule 701. Exchange Act reporting firms are not eligible for this exemption. Under this exemption, a corporation of any size can sell at least $1 million in securities.
A corporation can sell even more if certain calculations based on assets or the number of outstanding securities are met. If a corporation sells more than $10 million in securities in a 12-month period, it must make certain financial and other disclosure to the individuals who received shares during that period. Securities issued under Rule 701 are “restricted securities” that cannot be freely traded until registered or the holders qualify for an exemption.
Rule 701 is an essential tool to help employees and employers distribute stocks. However, not many people truly understand how it works. Therefore, In this article, we will look at what is this Rule 701, what it does, and how employees may get benefits from owning it.
What is the Rule 701?
The Securities and Exchange Commission (SEC) established Rule 701 to allow corporations to issue stock options without the time and expense of registering the shares under the Securities Act. Rule 701 applies only to private companies.
To qualify for the exemption, the corporation must offer securities only to employees, directors, consultants, and advisers under a written compensatory benefit plan (such as a stock option plan).
The aggregate sales price or amount of securities sold or options granted is dependent on Rule 701 and cannot exceed the larger of the following during any successive 12-month period:
- $10,000,000 (calculated by multiplying the option exercise price by the number of options granted in the case of options).
- 15% of the issuer’s total assets as of the most recent annual balance sheet date.
- Or 15% of the outstanding amount of the class of securities being offered and sold is dependent on the rule as of the most recent annual balance sheet date.
This means that before each set of option grants, the corporation must ensure that it maintains below these restrictions in order to maintain the safe harbor exemption.
Why Employees Need to Understand how it works?
So, what does all of this mean if you work for a private company and have stock options? If your company distributes more than $10 million in stock to employees in a 12-month period, they must provide the Rule 701 disclosures specified above to each option holder seeking to exercise their options. Whether you are a fan of the firm or not, it is worthwhile to obtain this information if it is available, as it will help you decide whether or not to exercise your stock options.
To see if your organization qualifies, multiply the number of new recruits in the previous year by the current fair market value multiplied by 4,000 (or another cautious estimate of the average employee’s option grant). This should provide a conservative estimate of the total amount of equity issued in the previous year; if that number exceeds $10 million, your company is likely compelled to provide rule 701 reports.
How employees may get benefits from owning it?
By learning and understanding how Rule 701 works, employees would know when they should exercise their rights to the stocks they own. This may be a good thing for an employee in a case where he is in need of an emergency for cash. Rule 701 allows the employee to sell his/her stocks in exchange for equity.
Yes, although Rule 701 is not often exercised. Employees should know and understand how Rule 701 works in order to safeguard themselves.
Why Company need to be aware of how it works?
As startups remain private for longer periods of time, and in cases where a private firm is rapidly expanding, the Rule 701 reporting requirements must be closely observed. Officers and directors of venture-backed companies must be aware of the Rule 701 thresholds or face problems with the SEC. For example, in March 2018, the SEC fined Credit Karma $160,000 for failing to comply with Rule 701.
What if the Company made a Mistake?
A business owner may not have realized that they were subject to securities laws as a private firm. Because new firms are seeking more financing and waiting longer to go public these days, many are subject to Rule 701. If the business grants equity without a legitimate exemption, whether by mistake or on purpose and is found to be in breach of securities law, the repercussions can be severe.
To safeguard from any mistakes, the business owner may be required to spend money on cleanup, you may be fined, your future ability to raise capital may be jeopardized, someone may be held accountable for returning investment funds, and, in rare situations, civil and criminal charges may be made against the company and its officers and directors.
This is why some startups invest in a management team, either internal or external source, that manages how the company’s fund flows. This is to protect not only the business owner and investor but also the employees in the company.
Recent changes in Rule 701
The Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 required the SEC to modify Rule 701(e) to raise the aggregate securities sales threshold from $5M to $10M during a 12-month period. In essence, private corporations can now offer up to $10 million in securities to employees without making detailed disclosures.
Because the upper limit is higher, fewer organizations will be subject to the increased disclosure requirements. Preparing additional disclosures is difficult, and the adjustment will save a significant amount of time and money.
For any assistance and queries on how Rule 701 would work and regulate, reach out to Eqvista! We have an expert team that can help you with handling all your business needs, including valuations, filings, and cap table management.