If you are a non-public company granting stock options or other compensatory equity awards to employees or consultants, you need to be familiar with Rule 701 and worry about complying with it. Rule 701 is the federal securities law exemption for compensatory equity issuances. If you are unfamiliar with the securities law in general, what you need to know is this--you can't sell stock or issue stock options without either registering the securities with the Securities and Exchange Commission (a very expensive proposition), or availing yourself of an exemption from the registration requirement. You also have to worry about state securities law exemptions with regard to stock options or other compensatory equity award issuances. (In Washington, this exemption is found at RCW 21.20.310(10).)

Rule 701 is the federal exemption from registration for compensatory equity awards granted pursuant to written compensatory benefits plans or written compensation agreements. Rule 701 is a broad exemption. There are no forms that need to be filed with the SEC, or any fees that need to be paid to the SEC, but Rule 701 does have conditions and limitations.

You need to be aware that among other limitations Rule 701 has strict mathematical limits that you cannot exceed, and special disclosure requirements that are triggered once the value of the equity awards you grant under Rule 701 exceed $5M during any consecutive 12-month period.

What are Rule 701's mathematical limits?

Under Rule 701, the aggregate sales price or amount of securities sold or options granted in reliance on the rule during any consecutive 12-month period cannot exceed the greater of the following:

  • $1,000,000 (calculated by multiplying the option exercise price times the number of options granted, in the case of options);
  • 15% of the total assets of the issuer, measured at the issuer's most recent annual balance sheet date (if no older than its last fiscal year end); or
  • 15% of the outstanding amount of the class of securities being offered and sold in reliance on the rule, measured at the issuer's most recent annual balance sheet date (if no older than its last fiscal year end).

As a practical matter, what does this mean? Before every set of option grants you need to make sure that you are operating within these mathematical constraints. In addition, if you have granted more than $5M in equity awards during any 12 month period, you will have specific disclosure obligations. You can find Rule 701 here.