Imagine that you get a job offer at your dream company. You start to negotiate the contract and everything sounds great except for one detail — your future employer refuses to say in what currency your salary would be paid. It could be U.S. dollars, euros, or perhaps Japanese yen, and you are expected to take a leap of faith and hope for fair pay. It sounds absurd, but this is exactly how the startup equity compensation market currently operates.
The typical scenario is that employers offer a number of stock options or restricted stock units (RSUs) as part of an offer letter, but do not mention the company’s total number of shares. Without this piece of information, employees cannot know whether their grants represent a 0.1% ownership stake, 0.01%, or any other percentage. Employees can ask for this information, but the employer is not required to provide it, and many startups simply don’t.
But that’s not the end of it. Due to lack of proper disclosure requirements, employees are completely oblivious to the most salient form of startup valuation information — data describing the firm’s capitalization table and aggregate liquidation preferences (which determine, in case the company is sold, how much money will be paid to investors before employees receive any payout). By not accounting for the debt-like properties of venture capital financing, employees tend to overestimate the value of their equity grants. This is especially relevant to employees of unicorn companies because the type of terms that are common in late-stage financing have a dramatic and often misleading impact on the value of the company’s common stock.
What have regulators done to fix this? Not much. Under the current regulation, the vast majority of startups are exempted from providing any information to their employees other than a copy of the options plan itself. A small percentage of startups that issue their employees more than $10 million worth of securities over a year period are required to provide additional disclosures including updated financial statements (two years of consolidated balance sheets, income statements, cash flows, and changes in stockholders’ equity). These disclosures are likely to contain sensitive information about the startup but are only remotely related to the question of valuation that employees want answered. The company’s most recent fair market valuation and the description of the employee’s anticipated payout across various exit scenarios would convey far more useful information.
The problem with the current regulation is not merely that it provides employees with either too much or too little information—it is both and more. As the lyrics of Johnny Mathis and Deniece Williams’ song go, it is “too much, too little, too late.” The regulation mandates the disclosure of too much irrelevant and potentially harmful information, too little material information, and the disclosure is delivered in a timeframe that does not permit efficient decision-making by employees (only after the employee has joined the company).
This situation is unhealthy not only for employees themselves but also for the high-tech labor market as a whole. Talent is a scarce resource that companies of all sizes depend on. Lack of information impedes competition and slows down the flow of employees to better, more promising, opportunities. In the long run, employees’ informational disadvantage can erode the value of equity incentives and make it all the more difficult for startups to compete for talent.
In an article I published in the Columbia Business Law Review, titled, “Making Disclosure Work for Startup Employees,” I argue that these problems have a relatively easy fix. Startups that issues over 10% of any class of shares to at least 100 employees should be required to disclose employees’ individual payout according an exit waterfall analysis.
Waterfall analysis describes the breakdown of cash flow distribution arrangements. In the case of startup finance, this analysis assumes that the company’s equity is sold and the proceeds are allocated in a “waterfall” down the different equity classes of shares, according to their respective liquidation preferences, until the common stockholders finally receive the residual claim, if any exists. While the information the model contains can be extremely complicated, the output is not. A waterfall model can render a graph where for each possible “exit valuation” plotted on the x-axis, the employee’s individualized “payout” is indicated on the y-axis. With the help of a cap table management platform, it is as simple as pressing a few mouse clicks.
This visual representation will allow employees to understand how much they stand to gain across a range of exit values even if they don’t understand the math and legal jargon that operate in the background. Armed with this information, employees would not need the traditional forms of disclosures now mandated by Rule 701, and startups could be relieved of the risk that the information contained in their financial statements would fall into the wrong hands. Critically, I also argue that employees should receive this information as part of the offer letter – before they choose whether to accept a job opportunity that includes an equity compensation component.
Earlier this year, the SEC released proposed revisions to Rule 701. The proposal includes many developments – among them the introduction of an alternative to the disclosure of financial statements. For startups that hit the threshold of issuing employees over $10 million worth of securities, the proposal allows choosing between disclosing financial statements and providing an independent valuation report of the securities’ fair market value. According to the proposal, the latter should be determined by an independent appraisal consistent with the rules and regulations under Internal Revenue Code Section 409A.
This is a step in the right direction — fair market valuation is far more useful to employees than the firm’s financial statements. However, the disclosure of a 409A valuation in and of itself is just not enough. It is a well-known secret in Silicon Valley that 409A valuations are highly inaccurate. Because the appraisal firm wishes to maintain a long-lasting business relationship with the company, and given that the valuation is based on information provided by the management team and is subject to board approval, the startup maintains nearly full control over the result. Therefore, the company’s 409A valuation has informational value only when it includes the waterfall analysis that was used to generate the outcome. Moreover, the SEC’s proposal still allows the vast majority of startups (as long as they avoid the $10 million threshold) to offer equity grants without providing any meaningful disclosures.
For over 30 years, the SEC has almost completely deregulated startup equity compensation in order to accommodate the ever growing need of startups to rely on equity in the war for talent. However, the SEC has and still is paying little attention to the other side of the employment equation—employees’ need for information regarding the value of their equity compensation. The time is ripe to revisit the protection of employees in their investor capacity under the securities regulatory regime.