Stock Options of Adhesion

When regulators and scholars call for increased regulation of mature startups, they often invoke recipients of employee stock options as a motivating concern. At first blush, the concern is understandable. Despite their impressive technical skills, startup employees are young and likely inexperienced in financial matters. They probably do not actively negotiate or fully understand their stock option agreements. Certain features of standard Silicon Valley equity grants—such as an exercise price equal to fair market value on the date of grant, the requirement to exercise within 90 days of being terminated as an employee, and a ten-year expiration date—can force a decision to exercise when stock is still illiquid and of uncertain value. Some of these concerns are amplified when companies stay private longer and accumulate complex capital structures that make the economics of an option even more opaque.

On the other hand, the overall market for equity compensation seems to work. Startups must compete with established tech companies for coveted talent, and equity compensation is thought to be an important reason why. Based on the impressive employment growth at VC-backed companies, startups seem to be holding their own. How can that be? How do outmatched and passive startup employees fare well enough to maintain the flow of human capital to Silicon Valley and other entrepreneurial hubs?

In ‘Stock Options of Adhesion’, I draw on a long-standing literature that theorizes how consumer ‘contracts of adhesion’ (website terms of use, product warranties, and the like) respond to market pressure even when the average consumer is passive and uninformed. I argue that the mechanisms identified in this literature likely operate in the market for equity compensation. To give just one example, contract scholars have argued that product warranties for consumer goods might improve over time because an informed minority of consumers bothers to read them, sellers in competitive markets pursue these marginal customers, and all consumers benefit through standardized contracts. While I have my doubts that happens much with consumer product warranties, it seems quite plausible that some repeat players in the startup employment market learn lessons as they cycle through startups. Other beneficial mechanisms might include strong reputational markets, occasional exposure of overreaching through public scandal, and lenient enforcement of facially one-sided contract rights in the name of boosting employee morale.

Of course, a theory like this is hard to prove. I do think, however, that some recent developments over the last decade suggest the market is in fact responsive to the needs of startup employees. One example is the shift to restricted stock units (RSUs), which have a ‘built in’ value because they do not have an exercise price like a stock option. This feature suits the current environment where companies stay private longer and may plateau or decline in value in later stages of their private-company tenure. Another example is company liquidity programs through which companies or VCs purchase some portion of employee equity prior to a liquidity event, marking a major shift from the historical arrangement of mutual lock-in (no participant in the startup gets liquidity before all participants get liquidity). To be clear, these changes in equity compensation practices are not acts of charity. They suit the needs of startups and VCs as well as employees. But this is how competitive markets work.  When circumstances change, market practices evolve in mutually beneficial ways.

If this optimistic view is right, then we are not facing the kind of widespread market failure that would justify a new securities law regime for mature startups. Instead, policy makers should go right to the source of the system’s sharper corners: tax law. The specter of 409A drives companies to offer stock options with exercise prices at grant date fair market value (rather than less risky in-the-money options) and imposes difficult time limits on RSUs. The rules for incentive stock options sometimes force difficult exercise decisions within 90 days after termination of employment and at 10 years after grant date. 

There are all sorts of favorable tax rules for founders and investors. Why then do rank-and-file employees have to suffer from so many tax traps and distortions? In the aggregate, equity compensation works, but we could still make things easier for the startup workforce.

_______________

By Abraham Cable (UC Law San Francisco)

The ECGI does not, consistent with its constitutional purpose, have a view or opinion. If you wish to respond to this article, you can submit a blog article or 'letter to the editor' by clicking here.