Companies commonly issue securities to employees pursuant to an employee benefits plan. This equity compensation is intended to incentivize long-term performance and retention. Equity awards come in various forms, including stock options, restricted stock units (RSUs), and performance stock units (PSUs). The securities issued to employees pursuant to these benefits plans are restricted securities, meaning they cannot be freely resold without being registered or qualifying for an exemption from registration under the Securities Act of 1933.

Rule 701 of the Securities Act provides an exemption for certain securities sold to employees, directors, consultants, and advisors of the company. This exemption is only available to private companies. It allows private companies to sell up to $1 million of securities to employees pursuant to an employee benefits plan. Companies that can satisfy certain financial tests are eligible to sell a greater total value of securities under Rule 701. Specifically, a company can set a threshold dollar value that is less than 15% of its total assets or total outstanding shares. However, companies that sell more than $10 million of securities to employees pursuant to Rule 701 in any 12-month period are subject to enhanced disclosure requirements. This includes providing financial statements, risk factors, and a summary of material terms of the compensation plan to individuals that recently purchased securities from the company.

Employees that have purchased Rule 701 shares are eligible to resell the shares in reliance on Rule 144, but without compliance with some of its restrictions. Rule 144 under the Securities Act provides a safe harbor for the resale of restricted securities if certain conditions are met, including manner of sale, holding period, volume limitation, and current public information requirements.

Individuals deemed to be “non-affiliates” of the company, which are usually employees in non-executive roles, may sell their Rule 701 shares in reliance on Rule 144 without compliance with the current public information, holding period, or volume limitation requirements. Individuals that are classified as “affiliates” of the company, which usually includes executive officers and directors, may sell their Rule 701 shares in reliance on Rule 144 without compliance with the holding period requirement. Rule 701 shares are still subject to any lock-up arrangements and could only be resold once such lock-up period expires.

For private companies that eventually become public companies through an initial public offering (IPO), a 90-day rule applies. Beginning 90 days after the IPO date, non-affiliates are permitted to sell their Rule 701 shares pursuant to Rule 144 without the holding period limitation.

Companies seeking to rely on the Rule 701 exemption should carefully monitor compliance with its requirements. Private companies that do not comply with the Rule 701 requirements can face enforcement actions and costly fines from the Securities and Exchange Commission (SEC). The most frequent way companies miss their Rule 701 compliance obligations is when they issue more than $10 million of securities pursuant to a compensation plan but forget about the enhanced disclosure requirements.