Securities regulation framework for employee equity-based compensation at privately held firms
Keywords: Law JSD.

This dissertation develops a regulatory framework for employee equity-based compensation at start-up companies. At first glance, equity-based compensation represents a break from the zero-sum game that typically characterizes the relationship between the "labor share" and the "capital share" of income. Employee equity compensation, at least ostensibly, aligns employee and investor interests, creating a scenario in which both constituencies benefit from shareholder value maximization. My research brings a realistic approach to the study of this labor-capital alignment thesis and suggests that market practices commonly diverge from this idealistic characterization in a manner unfavorable to employees. My dissertation examines the economic and legal conditions that facilitated the creation and widespread adoption of broad-based equity compensation schemes among venture-backed companies throughout the 1970s and 1980s and the evolution of these conditions through today. As such, it acknowledges the benefits of equity-based compensation to employees, issuers, and regional economies under some conditions but also identifies specific economic and regulatory practices that compromise the aligned-incentive model, reinstate the labor-capital divergence, and compromise market efficiency. My approach offers a new dimension in the securities regulation debate, as it seeks to integrate labor market considerations with the capital market considerations that have traditionally guided the Securities and Exchange Commission (SEC). Thus, it proposes broader efficiency-based insights that cannot be derived from the traditional exclusive focus on capital market efficiency. Such a paradigm shift is warranted due to two long-term trends: American households are currently more likely to acquire direct holdings in securities through an employment relationship rather than by purchasing securities on the exchanges, and highly skilled human capital is rapidly replacing financial capital as the limiting factor in economic development and technological progress. Facilitating an efficient allocation of talent, alongside efficient allocation of financial capital, is, therefore, a worthy goal for the securities regulatory regime, which requires a reconceptualization of underlying theory and practice. The first part of my dissertation, Beyond Covenants Not to Compete: Equilibrium in HighTech Start-Up Labor Markets (STANFORD LAW REVIEW, 2018) examines an understudied aspect in the literature on employee mobility and innovation—the impact of employee stock options on talent allocation. The regional economies literature has long recognized the benefits that arise from the proximity of firms and skilled workers in industrial clusters ("agglomeration economies"). When workers and firms in the same industry are located near one another, specialists are readily available, knowledge tends to spill over from one firm to another, and firms experience higher rates of innovation and productivity. However, the question of why some regions successfully capture these benefits while similar regions fail to do so remains unresolved. In an influential 1994 book, AnnaLee Saxenian examined why innovation boomed in Silicon Valley while the Cambridge-Boston area, which initially seemed better positioned to make that leap, wound up lagging. She argues that a culture of job-hopping, common among Silicon Valley engineers, allowed for the rapid spread of knowledge across the industry cluster. Building on this observation, Ronald Gilson argues that the difference between the regions is not merely cultural but also legal: engineers in Silicon Valley are more mobile because, unlike other states, California does not enforce non-compete agreements (even when they are reasonable in purpose and scope). Gilson's hypothesis stimulated a vigorous intellectual and political movement, led by Orly Lobel, that asserts that if other regions wish to become similarly attractive to entrepreneurial talent and to induce economic growth, they should abolish non-compete agreements too. This "new wisdom" against non-compete enforcement is highly influential; however, it contrasts with a more traditional economic analysis of non-compete agreements. According to conventional wisdom, these agreements are needed to prevent competitors from poaching employees after the employer has invested in training and research and development, thereby taking a free ride on these investments. The theory predicts that without the ability to secure some level of exclusivity over their employees' services by employing a non-compete, employers' incentive to provide on-the-job training and invest in innovation will diminish. My research reconciles these two schools of thought by highlighting the role of another aspect of Silicon Valley's business culture—the norm of granting stock options to virtually all employees. This custom emerged during Silicon Valley's inception as an alternative model to the more centralized and hierarchical organizational culture of East Coast corporate America, which held that companies should reserve equity grants solely to senior management. My work suggests that Silicon Valley start-ups can capture the returns on their investments in training and innovation despite California's ban on noncompetes because stock options generate a retention incentive that offsets employees' incentive to free-ride on these investments. However, unlike noncompete agreements, stock options induce retention in a highly selective manner: they temporarily suppress the mobility of employees of successful private companies (because, due to tax considerations, employees holding valuable options wait for a liquidity event, such as an initial public offering or acquisition, to cash out), but they do not limit the earning potential and mobility of laid-off employees and of employees of unsuccessful companies (whose stock options are virtually worthless). Stock options thus create an efficient breach mechanism that channels employees of less successful firms toward more promising ones and prevents inefficient retention. I end this part of my dissertation with a cautionary note on the crucial role of liquidity in the constant development of start-up ecosystems. Due to the retention effect of valuable but illiquid equity grants, companies' current tendency to delay holding liquidity events, a tendency facilitated by recent changes in the private capital market and the regulatory environment, might overly restrict the mobility of employees of large private companies and impair the talent allocation mechanism that gave Silicon Valley its competitive edge. The second part of my dissertation, Making Disclosure Work for Startup Employees (COLUMBIA BUSINESS LAW REVIEW, 2019), continues this line of investigation. The securities regulation regime has traditionally focused almost exclusively on financial capital investments. However, the widespread and growing practice of providing equity compensation has transformed high-skilled labor from a pure employment relationship into one that involves a significant investment component. I argue that it is therefore time for securities regulators to catch up with market dynamics and address the challenges of human capital investments by start-up employees. The article establishes, both on theoretical and empirical grounds, that, similarly to financial capital investments, human capital investments are susceptible to agency problems and information asymmetry. It argues that the current framework—namely, Rule 701, adopted by the SEC in 1988—fails to address these concerns. The article offers an outline for better regulation of the relationship between private issuers and their equity-compensated employees by tailoring the disclosure requirements under Rule 701 to the distinct attributes of venture capital-backed firms. The last part of my dissertation, Equity Illusions (work-in-progress) is aimed at better understanding of how employees form investment decisions regarding equity compensation, the kind of information employees rely on and the type of fallacies that might pervade the market. In an online experiment conducted with a sample of more than 1,000 U.S. workers with at least a college-level STEM degree, I examine employees' financial literacy regarding equity-based compensation and employees' willingness to trade off cash compensation in exchange for start-up equity. The findings indicate that employees commonly respond to economically irrelevant signals and misinterpret other important financial signals. Thus, respondents demonstrated a greater demand for equity grants when the number of shares offered was relatively large, even though the ownership percentage was fixed. Furthermore, respondents were less likely to favor working for a company with a relatively high private market valuation when the company was described as a "unicorn" compared with a similarly valued company not labeled as such. These tendencies are associated with low level of financial literacy regarding equity-based compensation as measured by a novel three-item test developed in this study. The findings suggest that employees harbor a range of "market illusions" regarding start-up equity that can cause inefficiencies in the labor market and that sophisticated employers can legally exploit. The study's results raise serious questions about the protection of employees in their investor capacity in a market in which highly sophisticated repeat players—namely, venture capital funds and other private equity investors — interact with unorganized and uninformed retail investors