Business planning

How Rule 701 Helps Private Companies Raise Capital?

To help private companies raise capital with less red tape, the SEC passed Rule 701. Probably you might have heard about stock-based compensation in private companies. Well, it is a form of equity benefit plan that provides employees with equity instruments such as stock options, restricted stock units, etc. that can help companies attract top talent. According to Rule 701, private companies can issue stock-based compensation without registration under the Securities Act. This means that private companies and their employees are not bound by the same disclosure or reporting rules that public companies must comply with under the Securities and Exchange Commission (SEC). This article will serve as a walk-through of how Rule 701 can help private companies raise capital with less red tape.

Rule 701

Well, Rule 701 was initiated by the SEC in 1988 to help encourage private companies to adopt equity-based compensation plans. In other words, Rule 701 permits private companies to offer stock-based compensation without registration under the Securities Act. It is essentially a registration exemption for securities whereby the maximum limit should be less than $10 million. Rule 701 is largely aimed at private companies and their employees.

Typically, the Rule 701 exemption is valid only for private companies where the issuance of securities takes place through equity-based compensation plans. The goal of Rule 701 is to exclude these issuers from the Securities Act’s rigorous registration, disclosure, and reporting requirements, which are designed for public companies. As a result of Rule 701, private corporations can raise money by issuing stock-based remuneration without having to comply with the SEC’s stringent rules.

What is Rule 701?

Rule 701 is a general exemption from the registration requirements of the Securities Act for certain sales of securities that is limited to private companies. In essence, Rule 701 addresses private companies’ capacity to provide stock-based remuneration without going through the entire SEC registration and disclosure process. The rule is intended to provide companies with more flexibility in raising funds in terms of stock-based compensation, and subsequently gain other benefits of offering equity compensation to employees. While it is important to note that this regulation is subject to several conditions and clauses.

How does Rule 701 work?

Rule 701 exempts certain securities including equity-based compensation from the exemption from registration under the Securities Act as long as it does not exceed the $10 million limit placed on the exemption. In addition to the maximum cap, the company must sell $1 million or more in shares annually to qualify for the exemption. While the working of this exemption is pretty straightforward, it does come with several conditions. Typically, with no forms to be filled or submitted to SEC, private companies can issue stock-based compensation plans without registration until the $10 million limit is reached.

Rule 701 disclosure requirements

Now that you have a general grasp of Rule 701, it is imperative to learn the disclosure requirements under Rule 701. Here are a few mandatory disclosures you must be aware of under Rule 701:

  1. Investment risks of stock-based compensation – A private company must explain various risks associated with the plan as well as the possible losses involved in investing in or creating stock-based compensation programs. The company must thus provide sufficient information regarding the risks involved.
  2. A brief description of the key stock-based compensation clauses – Private companies should provide complete disclosure of the terms of the stock-based compensation plan, particularly any applicable maximum or minimum quantities, vesting schedules, strike or exercise price, the type of equity plan issued, and other important information.
  3. Financial statements in compliance with GAAP – To provide complete disclosure under Rule 701, for the last two fiscal years, the recent income statement, balance sheet, cash-flow statements, and capital statements should be provided. These financial statements must be independently audited and approved by Generally Accepted Accounting Principles (GAAP).

Benefits of Rule 701

The benefits of using Rule 701 are numerous and can be summarized as follows:

  1. Cost and time savings from avoiding SEC registration – The main purpose of Rule 701 is to help private companies avoid the expensive, time-consuming, and onerous registration process associated with the Securities Act. In this regard, Rule 701 helps private companies save money, time and legal expenses in registering with the SEC. Thus, being exempt from the registration process, private companies can lower the costs and maximize the effectiveness of their equity-based compensation plan.
  2. Greater flexibility in offering equity compensation – Perhaps one of the biggest benefits of using Rule 701 is the increased flexibility in offering equity compensation. As a result of this exemption, private companies are free to offer stock-based compensation plans to employees without being bound by the same disclosure and reporting requirements associated with public companies’ registration process.
  3. Ability to attract and retain talent – It has been observed that private companies that use equity-based compensation plans are better able to attract and hold on to talented employees. As such, those private companies that have adopted such plans have been found to have higher average employee retention rates. As such, private companies can use Rule 701 to incentivize their employees, leading to increased productivity and greater employee satisfaction.

Use Cases for Rule 701

For many years, Rule 701 has allowed private companies to issue equity-based compensation plans without triggering the requirements of the Securities Act. As a result, private companies can offer attractive stock-based compensation plans at low costs. This exemption has been very useful in addressing the needs of private companies and their employees by offering a more flexible approach toward stock-based compensation. Below mentioned are a few areas where the exemption is particularly useful:

  1. Early-stage companies raising capital -, when shares of private companies are issued to employees through stock-based compensation plans, it not only helps to motivate and retain talent but also provides a substantial amount of capital in return. As a result, with the help of equity-based compensation plans, fundraising for private companies becomes easy and efficient.
  2. Established companies offering equity compensation to employees – As a private company grows and incurs future needs, it has been observed that there is a need for highly talented employees. Stock-based compensation plans come as an excellent way of meeting these needs and ensuring that the company remains competitive in the market, thus strengthening its long-term profitability. As such, due to the flexibility of Rule 701, established companies can offer equity compensation plans to both existing and prospective employees.
  3. Companies seeking to incentivize consultants or advisors – Remember, equity compensation or incentivize is not only limited to employees but can also be offered to consultants and advisors who contribute significantly to the growth and profitability of a private company. Regarding Rule 701, private companies can use their stock-based compensation plans to incentivize consultants and advisors by offering shares.

Rule 701 safe harbor exemption

Under Rule 701 safe harbor exemption, during any consecutive 12-month period, neither the total sales price of the securities sold nor the total amount of options issued by the regulation may exceed the following values:

  1. $10,000,000 which is determined, in the case of options by multiplying the option strike price by the number of options granted.
  2. 15% of the issuer’s total assets as of the date of its latest annual balance sheet.
  3. 15% of the outstanding value, as of the issuer’s latest annual balance sheet date, of the type of securities been offered for sale following the rule.

Why companies should know about Rule 701?

Well, Rule 701 is a special exemption provided by the U.S. Securities and Exchange Commission, which is the federal agency tasked with the creation and maintenance of securities exchanges. Probably after reading the benefits and uses of using Rule 701, you might have already understood the importance of this rule. The importance of equity compensation is growing rapidly each year. So, for a private company to set up a stock-based compensation plan, understanding the clauses, importance, and compliance with Rule 701 is essential. Lastly, the failure to abide by the exemptions granted by the SEC can lead to expensive fines and penalties.

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