Rules for Granting Employee Stock Options

To issue any equity, a company needs to either (a) register with the SEC as a public company, or (b) issue the equity under an “exemption” from the registration requirement.1 Registration is expensive. Exemptions are cheap, but have some quirks and limitations.

Rule 701 is the exemption that lets startups issue stock or options to their employees. The gist of Rule 701 is that a company can issue equity (1) to an employee or service provider (2) as compensation, (3) under an equity plan, (4) but not too much equity.

1. Employee or Services Providers.

“Rule 701” can only be used to issue equity to a service provider. This might be an employee, a director, a contractor, a consultant or an advisor.

2. As Compensation

The equity must be issued as “compensation” for the services of an employee or contractor. Rule 701 doesn’t work for investors, but other exemptions often do.2

3. Under a Written Plan or Compensation Contract

The startup needs to issue the equity under a “written compensatory benefit plan” or a compensation contract. The plan would be a long-ish document prepared by a lawyer and approved by the startup’s board and shareholders.

4. Not Too Much Equity

How much equity can you issue under rule 701? During any rolling 12-month period, the total aggregate sales price of the equity cannot exceed the greatest of:

  • $1,000,000
  • 15% of the startup’s total assets, or
  • 15% of the outstanding common stock 3

There are 3 different limits, and you get to pick whichever limit is the highest.

For a young startup with a low share price, just confirm you’re under the $1,000,000 limit. Multiply the exercise price of the options by the number of options, and confirm you’re under the limit. This limit covers all options issued over any rolling 12 month period.

5. A few more rules…

  • Equity grants made under rule 701 must still comply with state securities laws (“Blue Sky” laws).

  • Only the issuer (i.e., the startup itself) can use the Rule 701 exemption. An employee who has received the shares cannot use the rule to re-sell the shares.

  • this blog post only scratches the surface of the option grant rules. I’ve tried to cover the most common issues. There are many more rules, especially when large option grants are involved.

17 CFR 230.701 - Exemption for offers and sales of securities pursuant to certain compensatory benefit plans and contracts relating to compensation. RTFM

What Should Start-up Founders Know About Rule 701?. Arina Shulga, 2015.

The Open Guide to Equity Compensation. Joshua Levy, 2017.

What I Wish I’d Known About Equity Before Joining A Unicorn. Anonymous, 2017.

What Is Rule 701 and Do I Need To Worry About It? Joe Wallin, 2015.

Rule 701 Math: The 15% of Shares Test. Joe Wallin, 2015.

Rule 701 Refresher and Updates, Goodwin Proctor, 2018.

Holloway Guide to Equity Compensation. Long and detailed guide to Stock options, RSUs, job offers, and taxes.

  1. This registration requirement is Section 5 of the Securities Act of 1933. 

  2. e.g., Rule 506(b) of Regulation D. 

  3. Technically, 15% of the amount of whatever class of securities is being offered pursuant to Rule 701. That “class” will generally be common stock.