SEC Rule 701: A Word of Caution on Equity Awards. Startup Founders: This Means You.

Startup founders routinely use equity compensation as a tool for bringing in talent that believes in the startup’s business and the potential for this equity to have value in the future.

Thus, these founders will issue contractors and employees various shares and options, subject to miscellaneous milestones and vesting periods, often without realizing that they are issuing securities.

In general, all securities offered in the U.S. must be registered with the SEC or must qualify for an exemption from registration requirements.

Rule 701 provides an exemption from registration requirements for certain securities offerings made to employees, consultants and advisors, and is available to companies—such as startups– that are not publicly traded, considered investment companies under the Investment Company Act of 1940, or otherwise subject to SEC reporting requirements under the Exchange Act of 1934.

To rely on the registration exemption afforded by Rule 701, securities issued to employees and other advisors and consultants must be issued or granted pursuant a written compensatory benefit plan.  In addition, the aggregate sales price or the amount of securities sold under Rule 701 during any consecutive 12-month period must not exceed the greatest of:

  • $1 million;
  • 15% of total assets of the issuer (measured as of the date of the issuer’s most recent balance sheet); or
  • 15% of outstanding amount of the class of securities being offered and sold under Rule 701 (measured as of the date of the issuer’s most recent balance sheet)

Rule 701 is available to consultants and advisors, provided that they: are natural persons (as opposed to entities); provide bona fide services to the company; and that the services don’t involve promoting the sale of the company’s securities.

When relying upon Rule 701, the company is required to deliver a copy of the compensatory benefit plan to all eligible recipients.  If the aggregate sales price of securities sold by the issuer in reliance on Rule 701 exceeds $10 million during any 12-month period, then the company must comply with additional disclosure requirements that include risk factors, financial statements and other information.

As with other unregistered securities, the securities offered under Rule 701 are deemed “restricted securities” as defined in Rule 144.

In addition to Rule 701 considerations, equity compensation securities likely involve deferred compensation subject to section 409A of the Internal Revenue Code, and may thus subject the founder and award recipient to significant tax consequences and potential penalties.

Launching a startup is complex and involves various legal and regulatory considerations. Contact our firm today for a consultation regarding your desired structure.