What is Rule 701? Everything a Founder Should Know

Written By:
Team Qapita
May 28, 2023

Usually, when any company issues stock or stock options, securities law requires that they be registered and comply with full registration criteria, which is time-consuming and expensive. Either this orthe company should be exempt from registration using special provisions under the Securities Act.

Usually, these rules and regulations have been in place for a very long time to make sure companies issue stock options fairly and transparently and Equity distribution happens in compliance with all requirements.In reality, crafting rules and regulations that suit each type and condition in which equity is issued and sold is complicated. That is why various exemptions to the registration process exist. Rule 701 is such an exemption.

Rule 701 is asafe harbor exemption created by the Securities and Exchange Commission (SEC)that allows firms to issue stock options without the time and cost of stock registration under the Securities Act. Rule 701 permits some private businesses and startups to offer workers up to $10 million in securities over a single12-month period without giving them comprehensive financial statements and riskdisclosures. Several companies can issue employee stock because of this exception, even if they cannot afford the high costs and extensive legal work required to draught and distribute the disclosures typically needed for compliance.

What is Rule 701

According to Section 5 of the Securities Act of 1933, a company cannot offer or sell securities to the general public without first registering those securities with the Securities and Exchange Commission (SEC).The rationale behind this is that registration allows the SEC to assess thecompany's filings and gives investors access to vital information about the company's finances.

Usually, this registration process is very expensive and time-consuming, and to make sure that startups can offer ESOPs as employee compensation, SEC came up with Rule 701.

Rule 701 is a federal safe harbor exemption. It exists to spare certain businesses the cost and inconvenience of registering employee stock options. In addition to covering employees, the Rule 701 exceptionapplies to equity grants made to consultants and advisers, provided they are natural persons and render honest services to the issuing firm, its parents, orits subsidiaries.

Which Companies can Avail Rule 701 Exemption?

Not all firms qualify for or are eligible for Rule 701exception. Public corporations and/or "Exchange-reporting companies,"businesses obliged to submit periodic reports to the SEC in accordance withsections 12, 13, or 15(d) of the Securities Exchange Act of 1934, are noteligible for it. For any non-reporting company, that is, a company that is notrequired to submit reports to the SEC, to rely on Rule 701, their aggregatesale of securities within the 12-month period should be below a certainthreshold. The greatest of the following should be true

·       The total sales volume sold in accordance with Rule 701was less than $1 million.

·      When determined as of the date of the issuer's most recent balance sheet, the total sales price sold inaccordance with Rule 701 is less than 15% of the issuer's total assets; or

·      Less than 15% of the outstanding common shares, as of the date of the issuer's most recent balance sheet, of the issuer's securities were sold in accordance with Rule 701.

Disclosure Requirements under Rule 701

A company can redeem the exemption from providing disclosures to security holders if it sells less than $10 million in equity compensation to employees, consultants, and advisors within 12 months. If the total aggregate sales price of stock options issued during any consecutive12-month period exceeds $10 million, then Rule 701 requires the company toprovide certain information to prospective purchasers. These include:

·       A summary of the material terms of the Employee BenefitScheme

·       Risk associated with securities sold

·       GAAP-compliant financial statements, including the latest balance sheet, income statements, cash-flows, and capitalization for the preceding two fiscal years.

All these disclosures take months to prepare and are financially heavy on the company. To reduce this burden for the companies that issue securities worth less than $10 million, Rule 701 came in place.

Details regarding 12 Month Window Period

The 12-month timeframe may be determined using a rolling or fixed period:

·       A fixed period is when the 12-month window starts on a particular day and concludes on a day when this 12-month gets over. This frequently coincides with a calendar year or a business's fiscal year.

·       A rolling period is one in which the 12 months preceding the date of the transaction in issue serve as the definition of the 12-month window. This implies that to avoid the Rule 701 disclosure obligation being triggered, the sales of securities must total more than $10 million in any12-month period.

A company can choose which method to select while determining their 12 Month Window. Though once chosen, they can't switch between the two.

Why should Companies keep track of Rule 701?

Rule 701 reporting obligations need to be closely watched as startups tend to remain private longer, particularly when a private firm is expanding quickly. Officers and directors of venture-backed firms mustdiligently follow the Rule 701 criteria to avoid problems with the SEC. For instance, the SEC hit Credit Karma with a $160,000 fine in March 2018 forviolating Rule 701.

Team Qapita

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