Equity Compensation Basics with Rule 701

by Kristen Duffeler

Young and growing businesses are often reliant on a core group of dedicated employees.  In the early days of a startup, business owners often consider granting these key employees equity or phantom equity. Equity and phantom equity are useful for mature businesses as well, as they can promote employee retention and alignment of an employee’s and a business’ goals. Equity compensation can even be useful in some circumstances when cash is tight, An equity compensation strategy can increase compensation without hurting cash flow, provide motivation to maximize performance, and encourage employee retention.

What is Rule 701?

However, even these small “inside” equity grants are not beyond the reach of the Securities and Exchange Commission, which requires that all securities be registered (i.e. “going public”) unless an exemption is available.  In the case of grants to employees, a commonly used exemption the Rule 701 exemption.  Rule 701 is part of the Securities Act of 1933 and provides an exemption from federal (but not necessarily state) registration for securities issued to employees and certain other service providers (i.e., contractors).  Unlike many other available exemptions, it does not require that all or most recipients be accredited investors.  Rule 701 allows private companies to provide employees with equity-based compensation, including stock options, restricted stock and phantom stock.

How Much Stock Can I Issue Using Rule 701?

To qualify for the Rule 701 exemption, equity grants must be made under “a written compensatory benefit plan” adopted by the company.  The aggregate sales price or amount of securities that can be issued in a 12-month period using the Rule 701 exemption is the greatest of: (i) $1 million; (ii) an amount equal to 15% of the total assets of the company; or (iii) 15% of the outstanding amount of the class of securities being offered and sold under the Rule. The 12-month period can be a fiscal year, or a given rolling 12-month period.  However, once the applicable period is selected, it must be used consistently going forward.

Issuers using Rule 701 must provide recipients with a copy of the applicable compensatory benefits plan. However, unless the issuance will exceed $10 million, no other disclosure requirements typically apply.  As a final benefit, issuances made in reliance on Rule 701 are not subject to integration with any other offers or sales.  That is, if you offer securities as part of a crowd funding effort, for example, those issuances do not “count” toward the dollar limits under Rule 701, and vice versa.

While adopting a qualifying compensatory benefit plan can be a large undertaking, once in place, Rule 701 provides an attractive vehicle for making equity grants to employees.