You hear two stories about how private companies raise money to grow. One is that the regulations on them are too restrictive, depriving the nation of innovation and jobs. The other is that the regulations are too loose, harming naïve investors.
A new study makes a pretty strong case for the “too loose” story, at least in the case of one class of investors: employees of those private companies. You might not think of employees as investors, but they definitely are if they are paid with stock options, warrants or other forms of equity compensation.
Employees can be surprisingly uninformed about the value of the stock options they’re granted, even if the options account for a big share of their compensation. Their lack of knowledge exposes them to potential mistreatment by their employers, who can structure compensation in a way that benefits top management and big outside investors at the expense of rank-and-file workers.
This is more than a niche problem. Since the 1980s there have been more and more exemptions from the securities laws that were enacted during the Great Depression to protect investors. It’s easier now for companies to stay private and withhold financial information, so they do. Around 10 years ago, people started calling a privately held start-up company that’s valued at $1 billion or more a unicorn, because unicorns are rare — in reality, nonexistent. But there are now more than 650 of them in the United States, so “unicorn” is a misnomer. (Maybe “can of corn”?)
The new study I mentioned, “Equity Illusions,” is by Yifat Aran of the University of Haifa and Raviv Murciano-Goroff of Boston University’s Questrom School of Business. It was published on July 28 in The Journal of Law, Economics and Organization.
The study found that when it comes to pay, start-up employees “commonly respond to economically irrelevant signals and misinterpret other important signals.” That’s based on a survey they conducted involving responses from more than 1,000 U.S. employees with a bachelor’s degree or more.
“Only 36.4 percent of the respondents understood what a stock option is, only 28.3 percent recognized the different risk levels of stock options and restricted shares, and only 18.3 percent grasped the basic characteristic of venture capital finance as convertible preferred stock,” they wrote. “Even more disturbing is respondents’ unawareness of their own limitations: Respondents were 67.3 percent more likely to be wrong than right on equity compensation questions, yet they were unaware of their own lack of knowledge.”
It would be nice if personal finance education could solve the problem, but it can’t, because some necessary information simply isn’t available. For example, the authors wrote, employees tend to be impressed when they’re given options on a large number of shares. But the number of shares they get is irrelevant unless they know the total number of outstanding shares, so they can calculate their personal stake in the company — is it 1 percent or .0001 percent? Private companies don’t have to disclose that information under Rule 701, an exemption from the Securities Act of 1933 that was adopted by the Securities and Exchange Commission in 1988.
Employees who quit a start-up typically have only 90 days to exercise their stock options. But as long as the company remains private, the shares they get aren’t sellable. They can get hit with a big tax bill for a gain they haven’t realized. There are loans available to pay for exercising the options and paying taxes, but their costs can eat up 40 percent to 50 percent of the upside. This was always a problem, but it’s growing now that companies are staying private longer, Aran told me.
The logic of exempting private companies’ stock option issuance from the Securities Act of 1933 is that the options aren’t really an investment subject to securities law; they’re just a form of pay. But the survey by Aran and Murciano-Goroff found that lower-level employees do view the option grant as an investment. “More sophisticated employees are more likely to view it as a lottery ticket,” they wrote.
In a follow-up email, Aran wrote to me that while equity-based compensation for employees “at least ostensibly” aligns the interests of employees and owners, in reality “market practices commonly diverge from this idealistic characterization in a manner that is unfavorable to employees.”
Alexandra Thornton, a senior director at the Center for American Progress, told me that she advocates a simple, clean solution to the problem: Cash compensation only for employees of start-ups, outside of a small circle of managers. “Rule 701 shouldn’t exist,” she said. “Whatever good things there may be, the bad outweighs the good, substantially. It’s particularly a problem for employees who aren’t as high-level.”
The counterargument to Thornton’s proposal is that private companies will be starved for funds if they have to pay their workers entirely in cash. That view is part of a bigger argument that regulations intended to protect investors have inadvertently choked off entrepreneurial companies. At a House hearing in February to consider several prospective deregulatory measures, members of Congress were told the story of Shawna Stepp-Jones, a single mother in Baltimore who couldn’t raise funds to create a tumble dryer for wigs and hair extensions. She finally resorted to raising the money by becoming a surrogate mother, the members were told by McKeever E. Conwell II, the managing partner of RareBreed Ventures.
Another concern: Start-ups could lose employees or customers if extensive disclosure rules reveal their vulnerabilities. “In general transparency is good, but transparency has real costs,” Will Gornall, an assistant professor of finance at the University of British Columbia’s Sauder School of Business, told me.
On the other hand, America’s network of angel investors, venture capitalists and other funders is probably the world’s best. Capitalism won’t grind to a halt if investors — including workers who become investors in their employers through no choice of their own — gain or regain some protections. I tend to agree with Thornton, who told me, “It’s just a wrong assumption to think that because they’re inside the company, they have enough information.”
The Readers Write
Thank you for educating your readers about the various legal and ethical opinions concerning the sale, use, barter, and transfer of human biological samples and (often genomic) data. We have ways of tracing the supply chains for many things (organic food, electric cars, solar panels) but not major biomedical breakthroughs. Until such a system exists, there’s no way to know whose argument is stronger, and by doing nothing, society is stumbling blindly into the “you don’t own your own body” perspective.
You wrote about marriage. I was 15 years old when I looked across the dance floor and saw this beautiful creature who I knew would be my wife forever. That was 65 years ago. We couldn’t marry for six years, until she graduated college and started supporting us as a teacher as I started med school. There’s no dollar price I can put on our marriage. I know this. Every weekend our kids and grandkids visit happily. My wife and I sleep soundly every night. We have experienced pain. Who hasn’t? But we stick it out.
Steve Jobs’s words in your Quote of the Day are clearly the words of a man for whom waste meant nothing. The best cabinet and chair makers don’t use mahogany on the backs or undersides of cabinets. They use secondary woods (pine and poplar) for the bones of the furniture and for backsides and drawers. This compromises neither the structural integrity nor the beauty of the finished piece.
Colorado Springs, Colo.
Quote of the Day
“Macroeconomists want their math hard enough to make them look smarter than sociologists, but not too hard that they can’t get clean-looking solutions.”
— Noah Smith, Substack post, Nov. 7, 2022