A “unicorn” in Silicon Valley lingo is a private company that has achieved a valuation of $1 billion or more. During the first dot-com craze in the late 1990s, such creatures were truly imaginary, as companies rushed to go public in the relatively early stages of growth. More recently, unicorns have become startlingly common, as successful companies wait longer and longer to go public.
One important reason for the growing number of unicorns, Professor Abe Cable persuasively argues in a recent article, is the ability of private companies to issue increasingly large numbers of compensatory stock options to employees without triggering onerous disclosure obligations under federal securities laws.
A company issuing a similar volume of stock options to a similar number of non-employees would typically have to register the securities with the Securities and Exchange Commission, becoming a public company in the process. The registration process requires extensive disclosures about the company’s business and financial condition. A common justification for these requirements is that they are necessary to protect ordinary investors. Exemptions from the disclosure obligations typically extend only to sales in which purchasers are deemed “sophisticated,” or otherwise able to look after themselves. The exemption of employee stock options is based at least in part on the assumption that employees are able to look after themselves—after all, they work at the issuing company and should have a better sense of its prospects than an (ordinary) outside investor.
Professor Cable argues that this assumption of investing competence among employees is likely to be justified when applied to small start-ups. It is likely much less justifiable, however, when it comes to employee number 10,001 at a large unicorn. There is little reason to believe that such an employee is all that well placed to understand the company’s prospects better than an outside investor. The problem is more than theoretical: a number of unicorns have seen their valuations tumble, leaving the stock options of late-hired employees—with strike prices set at prior, higher valuations—essentially worthless.
If Professor Cable is right that late-hired unicorn employees are not really better positioned to comprehend risks or to protect themselves than ordinary outside investors—and he offers compelling arguments to support this position—then the law’s differential treatment of employee stock options at large private companies is hard to justify. Professor Cable’s primary aim in the piece is to shine a light on a problem that had lurked in the shadows of the legal literature, but he also outlines several potential ways to address the problem, from rolling back exemptions for employee stock options to more modest, marginal changes to the law.
Professor Cable’s jaunty and incisive look at employee compensation at mature start-ups should be on the reading list of everyone concerned about the gold-rush mentality of Silicon Valley’s current tech boom.