Rule 701: The Complete Guide for Companies and Employees

Issuing equity is one of the most powerful ways for early-stage companies to attract and retain talent. Stock options, RSUs, and equity purchase plans allow companies to compete with larger, cash-rich companies by giving employees a stake in future upside.

But equity issuance comes with legal strings attached. In the U.S., every issuance of securities is subject to registration with the SEC unless a company qualifies for an exemption. That is where Rule 701 comes in.

What is Rule 701?

Rule 701 is a federal exemption under the Securities Act of 1933 that allows private (non-reporting) companies to issue securities to employees, directors, consultants, and advisors without registering with the SEC. 

It was first introduced in 1988 to reduce the legal and financial burden on early-stage companies that wanted to use equity as compensation. Without the exemption, companies would have been required to register each grant with the SEC.

To qualify for the exemption, the securities must be issued under a compensatory benefit plan. If a private company wants to sell securities to investors, those sales must either be registered with the SEC or qualify under a different exemption such as Regulation D.

Rule 701 thresholds and limits

Rule 701 sets limits on how much equity a company can issue in any 12-month period without triggering additional disclosure requirements. 

The exemption allows a company to issue securities up to the greatest of three tests:

• An aggregate offering price of $1Mn
• 15% of the company’s total assets (measured at the end of the most recent fiscal year)
• 15% of the outstanding securities of that class
  

These thresholds are designed to scale with company size. For very early-stage companies, the $1Mn ceiling is often the limiting factor. For companies with significant assets or a large base of outstanding shares, the 15% tests usually provide more flexibility.

In November 2020, the SEC proposed further amendments that would make these limits more generous:

• Increase the $1,000,000 cap to $2,000,000
• Raise the asset-based threshold from 15% to 25% of total assets
• Expand eligibility to include platform workers (gig economy participants)
• Simplify and ease disclosure requirements for issuances above the $10Mn threshold

Note: These amendments were only proposed by the SEC in November 2020 and have not yet been adopted. The current thresholds remain $1Mn, 15% of assets, or 15% of outstanding securities.

Rule 701 disclosure requirements above the $10Mn threshold

If a company issues more than $10 million in securities within a 12-month period, Rule 701 requires it to provide enhanced disclosures to everyone receiving equity. 

These disclosures are meant to ensure that employees, consultants, and other recipients have enough information to make an informed decision before accepting or exercising their awards.

The required disclosures include:

• Financial statements: Balance sheets and statements of income, cash flows, and stockholders’ equity prepared in accordance with U.S. GAAP or IFRS. These statements must be no more than 180 days old at the time of the sale or grant.
  
• Summary of the equity plan: A plain-language description of the stock option agreement or compensatory benefit plan under which the securities are being issued.
  
• Risk factors: A discussion of the material risks associated with holding the securities, similar to the disclosures that appear in offering documents for investors.

For foreign private issuers, there is an additional requirement: if financial statements are not prepared under U.S. GAAP or IFRS, they must be reconciled to U.S. GAAP before being shared with recipients.

How to decide the 12-month period for Rule 701

Companies must choose one method to calculate the 12-month window for Rule 701 issuances and apply it consistently going forward.

• Fixed period: A defined 12-month window, usually aligned with either the fiscal year or the calendar year. All issuances during that period are counted together. This approach is predictable and easier for planning because the start and end dates are set in advance.
  
• Rolling period: A shifting 12-month window that looks back from the date of each new issuance. This method can provide flexibility if issues are spread unevenly throughout the year, but it requires more careful tracking to avoid accidentally crossing the limits.

Most companies align the 12-month period with their fiscal year for simplicity. If equity grants are concentrated at certain times, such as year-end bonuses or large hiring cycles, a rolling period may help spread issuances across multiple windows and reduce the risk of breaching disclosure thresholds.

Calculate your Rule 701 thresholds with EquityList

Working through the Rule 701 tests by hand can be confusing. 

Inside EquityList, you can generate a Rule 701 Analysis Report that applies the thresholds to your company’s actual numbers and:

• Runs the three Rule 701 tests automatically (flat dollar cap, 15% of assets, 15% of shares)
• Flags whether you are nearing the $10 million disclosure trigger

Sign up to generate your Rule 701 Analysis Report

Rule 701 vs other SEC exemptions

It’s easy to confuse Rule 701 with other securities exemptions, but each serves a very different purpose.

a. Rule 701: Designed specifically for private companies issuing equity compensation to employees, directors, consultants, and advisors. It cannot be used for fundraising or investor sales.

b. Regulation D: Provides exemptions that allow companies to raise capital from accredited investors without going through a full SEC registration. This is the most common exemption used for venture financing.

c. Form S-8: Used by public companies to register securities granted under employee benefit plans. It streamlines the registration process so listed companies can continue issuing equity awards easily.

d. Regulation CF: Allows early-stage companies to raise money through equity crowdfunding platforms, giving retail investors access to startup investments under specific limits.

FAQs on Rule 701

1. What is Rule 701?

Rule 701 is a securities exemption under the Securities Act of 1933. It allows private companies to issue stock options, RSUs, or other equity awards to employees, directors, consultants, and advisors without registering those securities with the SEC. 

2. What is the 701 law?

The “701 law” is shorthand for Rule 701 of the Securities Act. It is a safe harbor that lets private companies compensate their teams with equity instead of cash, while staying compliant with securities regulations. Public companies cannot use it and must rely on a different mechanism (Form S-8).

3. What is the Rule 701 15%?

The 15% refers to two of the three possible tests used to determine how much equity a company can issue under Rule 701 in a 12-month period: 15% of total assets, or 15% of the outstanding securities of that class. A company can issue the greater of $1 million, 15% of assets, or 15% of outstanding shares.

4. Does Rule 701 apply to employee stock purchase plans (ESPPs)?

Employee Stock Purchase Plans (ESPPs) can qualify under Rule 701 as long as they are offered by private companies and structured as compensatory plans for employees. Public companies instead rely on Form S-8 to register ESPPs and other equity compensation programs.

5. Does Rule 701 apply to investors?

No. Rule 701 is strictly limited to compensatory equity awards. It cannot be used to issue securities to investors. For fundraising, companies must use other exemptions such as Regulation D (for accredited investors) or Regulation CF (for equity crowdfunding).

6. Does Rule 701 apply to foreign companies?

Yes, Rule 701 can apply to non-U.S. companies that issue equity to employees or service providers in the United States. In those cases, the company still needs to comply with Rule 701’s thresholds and disclosure requirements, even if it is headquartered abroad.