Issuing Equity to Employees, Consultant, and Advisors: Section 4(a)(2) vs. Rule 701 Exemptions

melacksamson
Apr 9
6 min read

Companies issuing equity to consultants, advisors, and employees must determine the appropriate exemption under federal securities laws. Section 4(a)(2) of the Securities Act of 1933 and Rule 701 provide distinct frameworks for issuing stock without registration, each with specific eligibility requirements, disclosure obligations, and resale restrictions. Selecting the appropriate exemption ensures compliance and minimizes regulatory risk while aligning with company objectives.

Section 4(a)(2): Private Placement Exemption

Section 4(a)(2) exempts private transactions from registration requirements. Companies utilizing this exemption must ensure that issuances do not constitute a public offering and that recipients possess the financial sophistication necessary to assess investment risks. This exemption is generally used for private placements rather than compensatory equity awards.

Eligibility: Restricted to accredited or sophisticated investors capable of evaluating investment risks.
Disclosure Requirements: No mandatory disclosures exist, but issuers typically provide risk-related information to reduce legal exposure.
Resale Restrictions: Stock issued under Section 4(a)(2) qualifies as restricted securities and requires either registration or another exemption for resale. Rule 144 imposes a one-year holding period before restricted securities may be resold.
Use Case: More commonly used for raising capital from investors rather than issuing compensatory equity awards

Click here for further information on Private Placements/Section 4(a)(2) on the U.S. Securities and Exchange Commission's website.

Rule 701: Equity Compensation Exemption

For private fund sponsors and capital raisers, the no-action letter represents a meaningful reduction in compliance burdens. The enhanced flexibility in verification procedures lowers legal and operational costs, minimizes onboarding delays, and allows managers to operate with greater efficiency in their capital formation strategies.

This updated framework also reflects the realities of today’s capital markets. By reducing the administrative overhead typically associated with accredited investor verification, fund managers are better positioned to reach a wider pool of investors without compromising compliance integrity.

Rule 701 facilitates stock issuance as compensation for employees, officers, directors, consultants, and advisors. This exemption permits non-employee service providers to receive equity awards if they perform bona fide services unrelated to capital raising. Rule 701 is particularly useful for startups and pre-IPO companies looking to attract and retain talent through equity-based incentives.

Eligibility: Available to employees and qualifying service providers, including consultants and advisors.
Disclosure Requirements: No disclosure required unless aggregate issuances exceed $10 million within a 12-month period, in which case financial statements and risk disclosures must be provided.
Resale Restrictions: Rule 701 securities remain restricted under Rule 144. If the company goes public, stockholders may sell their shares 90 days post-IPO, subject to volume and other limitations.
Use Case: The preferred exemption for granting stock-based compensation to non-investor service providers, particularly in early-stage companies.

For further information on Rule 701- Employee Benefit Plans, please visit this article published by the U.S. Securities and Exchange Commission.

Key Differences Between Section 4(a)(2) and Rule 701

Purpose: Section 4(a)(2) applies to private placements for investors, while Rule 701 is designed for equity compensation to employees, consultants, and advisors.
Eligibility: Section 4(a)(2) is limited to accredited or sophisticated investors, whereas Rule 701 applies to a broader range of service providers.
Disclosure Requirements: Section 4(a)(2) has no mandatory disclosure requirements, though providing risk disclosures is best practice. Rule 701 mandates disclosures if issuances exceed $10 million within a 12-month period.
Resale Restrictions: Stock issued under Section 4(a)(2) is restricted and requires a one-year holding period under Rule 144 before resale. Rule 701 securities remain restricted until 90 days post-IPO under Rule 144.
Common Use for Consultants: Section 4(a)(2) is rarely used unless the consultant qualifies as an accredited investor. Rule 701 is the preferred method for stock-based compensation.

The following image provides a clear depiction of the differences between Section 4(a)(2) and Rule 701.

Key differences between Section 4(a)(2) and Rule 701

Rule 144 Holding Period Considerations

Rule 144 governs the resale of restricted securities, including stock issued under Section 4(a)(2) and Rule 701. The holding period differs depending on the exemption used:

Section 4(a)(2): Recipients must hold stock for at least one year before selling under Rule 144.
Rule 701: Stock remains restricted until 90 days after the company goes public. Before that, shares cannot be resold unless another exemption

Selecting the Appropriate Exemption

Companies must evaluate multiple factors when choosing between Section 4(a)(2) and Rule 701 for issuing stock to consultants and advisors. Making the correct selection ensures compliance with securities regulations while optimizing equity compensation strategies.

Accredited vs. Non-Accredited Recipients: Section 4(a)(2) applies exclusively to accredited or sophisticated investors, while Rule 701 accommodates a broader range of service providers.
Resale Restrictions: Rule 701 securities remain restricted until 90 days post-IPO, whereas Section 4(a)(2) imposes a one-year holding period before resale.
Compliance Burden: Rule 701 simplifies compliance for compensatory stock grants, while Section 4(a)(2) requires issuers to assess investor sophistication and risk tolerance.
Disclosure Obligations: Section 4(a)(2) does not impose disclosure requirements, whereas Rule 701 mandates disclosures if issuances exceed $10 million within a year.
Company Stage and Strategy: Startups and growing private companies typically benefit from Rule 701 due to its focus on employee and consultant compensation. Established private companies engaging in selective fundraising may find Section 4(a)(2) more appropriate.

When to Use Rule 701

Rule 701 represents the preferred option for stock-based compensation in most cases. Companies should utilize this exemption when:

The recipient provides bona fide services and is not investing capital.
The company remains private and wishes to issue equity without complex investor qualification requirements.
The company intends to minimize disclosure burdens while staying within the $10 million annual issuance threshold.
The goal is to attract and retain talent through equity-based compensation rather than seeking outside investment.

As far as international services or business, foreign consultants qualify under Rule 701 if they provide genuine, service-based contributions rather than acting as investors. However, companies must also ensure compliance with local securities laws in the consultant’s country, as some jurisdictions impose restrictions on receiving equity compensation from foreign entities. Clear documentation of the consultant’s role and services can help mitigate regulatory

When to Use Section 4(a)(2)

Section 4(a)(2) serves as an alternative when:

The recipient qualifies as an accredited or sophisticated investor.
The company seeks to avoid Rule 701’s disclosure requirements for issuances exceeding $10 million.
The company operates as a later-stage private entity engaging in selective private placements.
The stock grant functions more as an investment transaction rather than as compensation for services.

Risks of Misuse of Section 4(a)(2) and Rule 701

Companies frequently misapply exemptions, leading to compliance risks. Common mistakes include:

Assuming Section 4(a)(2) Covers All Equity Grants: Some issuers mistakenly believe this exemption can be broadly applied to stock grants, but it is limited to private placements with accredited or sophisticated investors. Equity compensation requires a different exemption, such as Rule 701.
Exceeding Rule 701 Limits: Companies sometimes issue more than $10 million in equity compensation within a 12-month period without providing the required disclosures, exposing them to SEC scrutiny and legal liability.
Failing to Document Bona Fide Services: Rule 701 applies only when stock is issued as compensation for actual services performed. Mischaracterizing stock grants to unqualified recipients can lead to enforcement actions.
Overlooking State and Foreign Laws: Rule 701 preempts state securities laws but does not override foreign regulations. Companies issuing equity to non-U.S. consultants must ensure compliance with local securities laws.
Ignoring Resale Restrictions: Employees and consultants may assume they can sell their shares immediately, but resale restrictions under Rule 144 impose significant limitations.

Liquidity Considerations for Private Companies

If a company does not plan to go public, equity recipients face liquidity challenges. Issuers should consider:

Right of Repurchase (Buyback Plans) – Companies may repurchase shares to provide liquidity for stockholders.
Secondary Market Sales – If permitted, stockholders may sell shares in private transactions.
Alternative Exit Strategies – Acquisitions or mergers may convert equity into cash or other securities.
Contractual Transfer Restrictions – Companies may impose additional restrictions on resale to control the ownership structure.

Conclusion

Rule 701 generally offers a more practical exemption for companies granting equity as compensation, whereas Section 4(a)(2) remains suitable for sophisticated investors and private placements. Companies must align exemption selection with operational needs and compliance obligations. Evaluating company size, recipient eligibility, liquidity concerns, and disclosure obligations ensures informed decision-making. In addition, the information presented in this article is helpful when issuing equity using an online Capitalization table management software such as Carta because such softwares will often ask what exemption or rule the equity is being issued under at which point you can refer back to this article!

Ultimately, consulting legal counsel ensures adherence to regulatory requirements and mitigates securities law risks, allowing businesses to structure equity compensation effectively while maintaining compliance.

For further information and legal expertise, please visit our website or schedule a meeting with Keiretsu’s Brianna Gonzalez here!

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