Your startup just hired its tenth employee, and you want to offer stock options as part of the package. Then someone asks an uncomfortable question: is offering shares to your own team a securities offering — and does it need to be registered with the SEC? The answer to the first question is yes. The answer to the second is usually no, thanks to a federal exemption called Rule 701. But the exemption has limits, and one of them — a $10 million tripwire — forces growing companies to hand employees financial statements they may not want to share.
Here is how Rule 701 works, who it covers, where the caps sit, and what happens when you cross the disclosure threshold.
What Rule 701 Is
Rule 701 is an exemption under the Securities Act of 1933 that lets private companies — businesses not subject to SEC reporting requirements — issue securities to their own people as compensation without registering the offering. Stock options, restricted stock, restricted stock units (RSUs), and employee stock purchase plans can all be granted under it.
Three conditions have to hold for the exemption to apply:
- The company is private. Rule 701 is only available to issuers that are not required to file reports under the Securities Exchange Act. Once you go public, you graduate to Form S-8 instead.
- There is a written plan. Grants must be made under a written compensatory benefit plan or a written compensation contract, such as an employment agreement. A handshake promise of future equity does not qualify.
- The recipients are eligible people. Offers and sales can go only to the company's employees, directors, officers, general partners, trustees, and qualifying consultants and advisors — and, in limited cases, their family members through permitted transfers.
Miss any one of these and the exemption is unavailable for that grant, which is why lawyers treat the written plan and the recipient list as the first things to verify.
Who Counts as an Eligible Recipient
The employee and director categories are straightforward. The category that causes the most trouble is consultants and advisors, because it comes with two restrictions that surprise founders.
First, the recipient must be a natural person. A consultant who does work for you through their own LLC cannot have options titled in the LLC's name under Rule 701 — the grant has to go to the human being. This trips up startups regularly, because contractors often prefer to keep everything in their entity for liability or tax reasons.
Second, the services must be bona fide, and they cannot be connected to raising capital. A product designer, an engineering advisor, or a marketing consultant doing real work for the business qualifies. Someone helping you pitch investors in exchange for a cut of the raise does not — compensating capital-raising activity with securities is exactly the transaction the registration rules exist to police.
The recipient generally must also be an active service provider when the award is granted. A plan can cover people beyond the Rule 701 categories, but grants to anyone outside them simply do not get the exemption.
The 12-Month Issuance Cap
Rule 701 is not unlimited. During any consecutive 12-month period, the aggregate sales price of securities sold in reliance on the rule cannot exceed the greatest of:
- $1 million in aggregate offering price,
- 15% of the company's total assets, measured at the most recent balance sheet date, or
- 15% of the outstanding amount of the class of securities being offered, measured the same way.
The "greatest of" structure matters. An early-stage company with few assets and few outstanding shares still gets the $1 million floor. A well-funded startup with a large balance sheet or a big option pool gets headroom from the 15% tests instead.
How grants are valued for this calculation depends on the instrument. Options are generally measured by their exercise price — the strike price multiplied by the number of shares — not by their Black-Scholes value or any 409A valuation. Restricted stock and RSUs are measured by their value at the time of the award. Because option strike prices at early-stage companies are typically low, most startups can grant for years without approaching the cap — until a rising valuation and a hiring spree arrive at the same time.
One more scope note: the exemption covers only the issuer's own sales to its people. It does not cover resales — an employee who later sells those shares needs a separate exemption, such as Rule 144, or a registered offering.
The $10 Million Disclosure Tripwire
Separate from the cap is the disclosure rule in Rule 701(e), and this is the part that catches growing companies off guard.
Every Rule 701 recipient must receive a copy of the compensatory plan or contract. That is the baseline, and it applies from the first grant. But when the aggregate sales price of securities sold under Rule 701 during any consecutive 12-month period exceeds $10 million, the company must deliver an enhanced disclosure package to investors a reasonable period of time before the date of sale:
- A summary of the plan's material terms (or the ERISA summary plan description, if the plan is subject to ERISA),
- Information about the risks of investing in the company's securities, and
- Financial statements of the kind required in a Regulation A offering statement — in practice, U.S. GAAP financial statements current enough to satisfy those rules.
For an RSU, the SEC has confirmed that the "date of sale" is the grant date, so the package has to be in the recipient's hands a reasonable time before the grant — not bundled with the onboarding paperwork afterward.
The threshold used to be $5 million. Congress directed the SEC to raise it in the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018, and the SEC's final rule doubled it to $10 million that July, explicitly to let larger private companies run bigger equity programs without the cost and effort of producing offering-grade disclosure.
Note the asymmetry: the enhanced disclosure is triggered by sales, and the rolling 12-month window means a company approaching the threshold must track cumulative grants continuously, not just at fiscal year-end.
What Happens If You Get It Wrong
Rule 701 has no filing, no check-the-box election, and no cure provision. If you blow past the 12-month cap or skip required disclosure, the consequence is that the exemption simply was not available — the sales were unregistered, non-exempt securities offerings. That exposes the company to investor rescission claims: recipients can demand their money back (for options, effectively unwinding the transaction), plus potential enforcement exposure.
There is also a state-law layer many founders miss. Rule 701 is a federal exemption, and the securities sold under it are not automatically exempt from state blue-sky registration in every state where a recipient lives. Most states have their own exemptions for employee compensation plans, but they are not identical, so a company with option holders scattered across states should confirm each state's treatment rather than assuming the federal rule covers everything.
Common Mistakes to Avoid
Drawing the threads together, these are the errors that show up again and again:
- No written plan in place before granting. Board-adopted plan documents feel like paperwork until the exemption depends on them. Adopt the plan before the first grant, not after.
- Titling grants to entities. Options issued to a consultant's LLC fall outside the rule. Grant to the individual.
- Paying fundraisers in equity. Anyone compensated for promoting the company's securities or raising capital cannot receive Rule 701 shares for that work.
- Forgetting to count. Nobody tracks the rolling 12-month aggregate until the company is near the $10 million line — and by then, grants already made without the required advance disclosure are the problem.
- Delivering disclosure late. Handing over financial statements after the grant date misses the "reasonable period of time before sale" requirement entirely.
- Ignoring state law. Federal compliance plus an unexamined blue-sky gap is still a gap.
Tracking Equity Grants in Your Books
Equity compensation does not just create securities-law paperwork — it creates accounting entries that compound every pay cycle. Option grants need fair-value measurement and a vesting schedule. Exercises bring cash in and shares out. Forfeitures reverse expense. RSU settlements trigger withholding. Each event lands in the general ledger, and a spreadsheet that tracks grants separately from the books is where reconciliations go to die.
The practical fix is boring but effective: record every grant, vest, exercise, and forfeiture as a dated transaction in your accounting system, with the plan name and recipient class attached, so the ledger doubles as your rolling 12-month Rule 701 tally. When someone asks how close the company is to the $10 million disclosure threshold, the answer should be a query, not an archaeology project.
Keep Your Equity Ledger as Clean as Your Cap Table
As your team grows and your option pool deepens, the distance between "we grant equity casually" and "we can prove every grant was exempt" is just good record-keeping. Beancount.io provides plain-text accounting that gives you complete transparency and control over your financial data — every grant, exercise, and forfeiture as version-controlled, auditable transactions. Get started for free and see why developers and finance professionals are switching to plain-text accounting.
