Why Private Companies Should Know About Rule 701 – Options, RSAs and RSUs

Maybe you’ve been granting options and restricted stock from your equity incentive plan for a while now. Perhaps you and your team have developed a good process – you renew your 409A at the appropriate intervals for US grants and handle pricing carefully in other jurisdictions, then pass along the terms of any promised equity award to your legal counsel, who ensure all grants are properly approved by the board and reviewed for compliance with applicable securities and other laws. Until now, you’ve likely been compliant with US federal securities laws without much effort.

But US securities law compliance gets trickier as the valuation of your company increases – and as the frequency, size and strike price of your equity grant packages to US recipients grow. This is where Rule 701 comes into play.

Basics of Rule 701

Anytime you grant stock options, or other incentive-based equity, you are selling securities. In the United States, in order to sell securities, those securities must be registered under the Securities Act of 1933 (e.g., through a registration statement on Form S-1) unless there is an exemption allowing for the sale of those securities without registration. This is relevant not only for US-based companies, but also for companies outside the US issuing equity to service providers who are “US persons” for these purposes.

Rule 701 is the primary US federal securities law exemption for offers and sales of compensatory awards – e.g., options, restricted stock awards (RSAs), restricted stock units (RSUs), etc. – by a private company to its employees, directors, officers, consultants, advisers, and other individuals providing bona fide services to the company (or any of its subsidiaries), that are issued pursuant to a compensatory benefits plan such as an equity incentive plan.

The availability of Rule 701 comes with certain quantitative limits. Early-stage companies usually operate well within these limits. However, later-stage private companies should understand the limits of the exemption and start monitoring before additional requirements kick in to avoid inadvertently failing to comply with Rule 701.

What are the limits of Rule 701?

To rely on Rule 701, the aggregate sales price of securities offered and sold during a 12-month period using this exemption must be at least one of the following:

• Less than $1 million in total value.
• Less than 15% of the total assets of the issuer (as of the most recent balance sheet date).
• Less than 15% of the outstanding amount of the class of securities being offered and sold (as of the most recent balance sheet date).

Note: The 12-month period can begin on any date during the calendar year – it does not need to be tied to the calendar year or the company’s fiscal year. However, once you select a date, you must stick to that date for future analyses.

Aggregate sales price means the sum of all cash, property, notes, cancellation of debt, or other consideration received or to be received by the issuer for the sale of the securities.

For example, to determine the aggregate sales price of options granted, you would multiply the total number of shares underlying the options granted under Rule 701 during the selected 12-month period by the strike price per share at the time the grant is made (i.e., when the board approves it), regardless of when the option becomes exercisable. The calculation is not impacted by any number of unvested shares and options that are returned to the pool upon the termination of service providers.

With respect to other securities, the aggregate calculation is made on the date of sale, which may be a bit more nuanced. Your legal counsel can assist with a detailed Rule 701 analysis to provide insight into whether you are approaching the limit, and can walk you through additional considerations for repriced, canceled or forfeited awards.

Although it is important to monitor Rule 701 compliance continuously, signs that it is time to consider a detailed Rule 701 analysis include:

• You have a high 409A valuation.
• Your company’s valuation is approaching $1 billion.
• Your board is regularly approving large option grant packages or is hiring one or more senior executives.
• You are hiring aggressively and/or making a large number of “refresh” grants.
• You begin issuing RSUs.
• You have conducted a repricing of your outstanding stock options recently.

If you are approaching or potentially exceeding the limits of Rule 701, your legal counsel can advise you on the available approaches to ensure compliance with securities laws.

What is ‘enhanced disclosure’ and when is it required?

Rule 701 also requires that, if the aggregate sales price of securities sold under this exemption during any consecutive 12-month period exceeds $10 million, companies must provide “enhanced disclosure” to security holders.

What: Components of enhanced disclosure

The company must deliver the following information to security holders as part of its enhanced disclosure package:

1. Plan FAQ – A summary of the material terms of the compensatory benefit plan or contract, and there are special considerations that may apply to security holders outside the US, which your legal counsel can advise you on.
2. Risk factors – Information about the risks associated with the investment in the company’s securities sold pursuant to the compensatory benefit plan or contract.
3. Financial statements – Dated no more than 180 days before the date of the sale of securities, which must include various details and be prepared in accordance with generally accepted accounting principles (GAAP), though not necessarily audited if the company doesn’t otherwise have audited financials readily available.
   • The date of sale for disclosure purposes may be the date of exercise (for stock options), the date the award is granted (for RSUs), or the date the stock is issued and sold (for RSAs), but always check with your legal counsel to confirm.

Who: It depends

Speak with your legal counsel about best practices regarding which security holders must receive the enhanced disclosure.

When: Before the date of sale

The timing of when enhanced disclosure must be provided to security holders and in what form/medium the information is provided will vary depending on your company’s unique circumstances. To ensure that the enhanced disclosure is delivered “a reasonable period of time before the date of sale” as required by Rule 701, always confirm timing of option grants with legal counsel prior to making grants; this is especially important for grants to new hires, since the delivery of enhanced disclosure for new hires may require a longer lead time than delivery to current employees. For options, the date of sale is the exercise date, but sometimes companies provide enhanced disclosure at the time the option is granted. For RSUs, the date of sale is the date of grant. Be sure to discuss with your legal counsel the timing of the delivery of the enhanced disclosure to avoid failure to comply with Rule 701.

How: Delivery, notice, continuous access

Enhanced disclosure can be delivered electronically – for example, through an internal company portal or attached as a document to electronic certificates in an electronic cap table platform. However, the company must provide security holders with timely and adequate notice that the enhanced disclosure is available. Once access has been provided to security holders, they must have continuous access to enhanced disclosures substantially equivalent to personal retention (i.e., even after options are exercised and after leaving the company).

What happens if I don’t comply with Rule 701?

In recent years, the Securities and Exchange Commission (SEC) has conducted periodic audits to ensure Rule 701 compliance and has assessed fines on private companies for noncompliance. SEC enforcement actions or demands for failure to comply can be significant and costly distractions for private companies. For companies planning to go public, failing to comply with Rule 701 may resurface during the IPO process and garner unfavorable press and attention from the SEC.

Seek out the advice of legal counsel right away if it is possible that you are nearing or have exceeded the limits of Rule 701, or if you are at or near the $10 million threshold and have not provided enhanced disclosure to security holders.

Special thanks to Partner Calise Cheng for her contributions to this article.