Rule 701: the exemption that makes employee equity legal

What problem the rule solves

An option grant is an offer and sale of a security. Absent an exemption, offering securities requires registration, which is a public-company-scale exercise that no seed-stage company could run for a twelve-person team. Rule 701 is the exemption that makes ordinary employee equity possible: it lets a non-reporting company issue compensatory securities to its own people without registering them.

The rule is compensatory by design. It is not a capital-raising exemption and cannot be used as one — the consultant and advisor provisions specifically exclude services provided in connection with the offer or sale of securities in a capital-raising transaction. Money raised from investors runs through a different exemption entirely.

Who can be covered

Paragraph (c) sets the population. The plan or contract must be established by the issuer, its parents, its majority-owned subsidiaries, or majority-owned subsidiaries of the issuer’s parent, for the participation of their employees, directors, general partners, trustees where the issuer is a business trust, officers, or consultants and advisors — together with family members who acquire securities from those persons through gifts or domestic relations orders.

Consultants and advisors carry an extra set of conditions. They must be natural persons, so a grant to a consulting entity does not fit. Their services must be bona fide. And the two exclusions — services in connection with a capital raise, and promoting or maintaining a market for the issuer’s securities — are the ones that catch companies trying to compensate finders and promoters in stock.

The amount limitation

Paragraph (d) caps how much can be sold in reliance on the rule. The aggregate sales price or amount of securities sold during any consecutive 12-month period may not exceed the greatest of three measures. Note the framing: it is a rolling twelve-month window, not a fiscal year, and the test takes the greatest of the three, not the smallest.

The counting rules matter as much as the cap. Rule 701 counts option grants when the option is granted rather than when it is exercised, so a large grant made this year consumes capacity this year even if nothing is exercisable for another twelve months. A company that plans around exercise dates will measure the wrong thing.

The disclosure threshold

Paragraph (e) has two levels. At every level, the issuer must deliver to investors a copy of the compensatory benefit plan or the contract. Above a threshold, considerably more is required: if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $10 million, the issuer must deliver additional disclosure a reasonable period of time before the date of sale.

What Rule 701 does not do

It does not make the shares tradeable. Paragraph (g) states that securities issued under the rule are deemed to be restricted securities as defined in Rule 144, and that resales must comply with registration or an exemption from it. Ninety days after the issuer becomes subject to Exchange Act reporting, the rule relaxes: non-affiliates may then resell in reliance on Rule 144 without complying with paragraphs (c) and (d) of that rule, and affiliates without complying with paragraph (d).

It does not exempt anyone from the antifraud provisions. An exemption from registration is exactly that; misstatements to employees about the company or the securities remain actionable.

And it does not preempt state law. The preliminary notes to the rule say plainly that in addition to complying with the rule, the issuer also must comply with any applicable state law relating to the offer and sale of securities. Rule 701 securities are not covered securities for blue sky purposes, so state requirements apply on their own terms.

Blue sky, briefly

Every state has its own securities statute, and a compensatory grant to a person living in that state is an offer there. Most states provide some form of exemption for compensatory plans, but the exemptions are not uniform: some are self-executing, some require a notice filing, and some attach a deadline running from the first grant or first sale in the state.

The practical consequence is that a distributed team turns one federal question into a set of state ones. Which states matter depends on where the recipients live at the time of grant, which is a fact that lives in the company’s own records rather than in the rule. This is a genuinely specialised area and one of the clearest cases for securities counsel rather than a checklist.