New employees of startup companies are often compensated with stock incentives as part of the recruitment process. Equity compensation can include stock options and restricted stock. Under SEC rules, anytime a company issues securities, it is required to register the securities offered unless the transaction qualifies for an exemption from registration. Rule 701 of the Securities Act of 1933 allows private companies to offer their own securities as part of written compensation agreements without registration. This exemption enables startup companies the ability to offer equity compensation to employees, directors, general partners, trustees, officers, and certain advisors and consultants without having to comply with federal securities registration requirements.
To take advantage of Rule 701 a company will need to meet the following conditions:
• the purpose of the offering cannot be to raise capital;
• the securities must be offered under a written compensatory plan;
• the maximum total sales (not offerings) of stock during a twelve-month period do not exceed the greater of (i) $1 million, (ii) 15% of the issuer's total assets, or (iii) 15% of all the outstanding securities of that class; and
• the company must deliver to all investors a copy of the written compensatory plan.
For total sales over $5 million during a twelve-month period to the specified class of people above, companies must disclose additional information, including risk factors, copies of the plans under which the offerings are made, and certain financial statements. Companies relying on Rule 701 do not need to make an SEC filing or pay any federal filing fees. Transactions exempt from registration under Rule 701 are not exempt from state securities laws, anti-fraud, civil liability, or other provisions of federal securities laws. Before issuing securities to a new hire, a company should understand the specific requirements under Rule 701 and applicable state laws.
The maximum total limit is based on actual sales, not just offers. In measuring sales, all options granted during any consecutive 12-month period are considered part of the aggregate sales. In the case of options, the $1 million limit is calculated by multiplying the option exercise price times the number of options granted. For restricted stock or compensatory stock purchases, calculations are made as of the date of sale. Fifteen percent of the total assets of the issuer is measured based on the issuer’s most recent annual balance sheet date. In calculating outstanding securities for the 15% rule, all currently exercisable or convertible options, warrants, rights, and other securities are treated as outstanding. The rule also requires that if stock is provided in exchange for employee or consultant services, the value for the purposes of the exemption calculations is the price of the stock provided, not the amount of compensation foregone.
Except for providing a copy of the benefit plan or contract under which the options or securities are awarded, there are no specific disclosure requirements under Rule 701 for sales up to $5 million in a 12-month period.
There are special requirements when issuing equity to consultants and advisors under Rule 701. Specifically, you can only issue equity compensation to “consultants and advisors” if they are natural persons (not business entities), they provide “bona fide services” to the company, and the services are not in connection with any offer or sale of securities in a capital-raising transaction. The test to determine whether a consultant and advisor qualifies for the Rule 701 exemption is based on a facts and circumstances test. Persons displaying significant characteristics of "employment," such as the professional adviser providing bookkeeping services, computer programming advice, or other valuable professional services may qualify as eligible consultants or advisors, depending upon the particular situation. Rule 701 does not allow exemptions for offers to securities promoters, franchisees, independent agents, and similar individuals. The key factor is that the activities of the person have "employment characteristics.” A person in an employment-like relationship with a company though technically acting as a non-employee but who provides services that traditionally are performed by an employee, with compensation paid for those services being the primary source of the person's earned income, would qualify as an eligible person under the exemption.