Many would describe the era we are living in as a “startup bubble.” Not only has the number of startup companies increased dramatically, but many startups have also achieved record-breaking valuations. Alibaba, an e-commerce site, recently went public at a valuation of $21 billion, while Facebook’s IPO raised $16 billion. Yet experts say that 90% of startups fail, and even startups that do succeed often do so only after many years.

Many early startups don’t have enough capital to pay market rate salaries. To incentivize employees, many startup businesses give their employee “options” to receive shares in the business when the company becomes publicly traded. Yet a business may not go public for many years, and in the meantime, options in a pre-IPO company are “restricted securities” under Rule 144(a)(3) and generally may not be sold. Furthermore, many of these options contain a lock-up period, which prohibits the employee from selling their options for a set amount of time. Instead, startup employees have developed alternative solutions. Some employees have sold an interest in their securities as a security-based swap. In this structure, the employee sells the right to buy the options at a future event, generally when the company has either gone public or been sold to another company.

Security-based swaps, also known as derivatives, are heavily regulated by the Securities and Exchange Commission (the “SEC”). The Dodd-Frank Act amended section 5 of the Exchange Act to require that a registration statement be filed for all security-based swaps with anyone who is not an “eligible contract participant.” Furthermore, Dodd-Frank amended section 6 of the Securities Act to require that all swaps with those who are not “eligible contract participants” be traded on a nationally registered and regulated exchange. The definition of an eligible contract participant may vary under the circumstances, but it generally requires one to have between $5 and $10 million to invest on a discretionary basis.

The SEC has recently cracked down on violators of these derivative regulations. In July 2015, the SEC charged Sand Hill Exchange and its founders, Gerrit Hall and Elaine Ou, for violating the above provisions. Sand Hill Exchange enabled employees of pre-IPO startups to sell swaps based on their options. Sand Hill allowed anyone to buy or sell these swaps regardless of their income, net worth, or amount in discretionary investments. Thus, they violated section 5 of the Exchange Act and section 6 of the Securities Act. Hall and Ou were required to shut down the exchange and refund all of their users’ monies.

Yet, as noted in a Wall Street Journal article describing the SEC’s probe into Sand Hill, a number of sites still exist that seem to allow employees to sell derivatives of their pre-IPO options. These exchanges pose a danger to the investing public. Many people are caught up in the hype regarding technology startups and desperately want to get their hands on shares in these companies. But many of these investors are not sophisticated and do not understand the many risks associated with these options. Even a sophisticated investor may have a difficult time ascertaining the correct valuation of a startup.

Many pre-IPO businesses operate pre-revenue, and thus any valuation is based on guesswork. Companies can inflate the estimated valuation by over-estimating their market size, projecting high user rates and fewer expenses. Since pre-IPO companies don’t need to file financial statements with the SEC, it is easy to exaggerate their finances to the public.

Furthermore, major investors usually receive special preferences and conditions when they invest in startup companies. Most large investors receive “anti-dilution” provisions, which ensure that they will be protected if a future raise in capital is done beneath a certain threshold valuation. Similarly, major investors will receive “liquidation preferences,” so that if the company fails, they will receive their money back before any other shareholders. Some of these liquidation preferences even promise investors two or three times the value of their investment back at liquidation. Since these investors are protected from a future loss of value they are more willing to agree to inflated valuations without significant due diligence into the company’s actual value.

Beyond the general risk of purchasing shares in a pre-IPO business, security-based swaps are an extremely risky instrument. These instruments only obtain value if the specified liquidation event occurs. Since a large percentage of startups never achieve a liquidation event, the chance of the security ever having any value to an investor is minimal. Furthermore, since there is no established exchange for such securities, they are very illiquid. Thus, an investor who needs capital or rethinks the soundness of this investment will have an extremely hard time selling these derivatives. Thus, investors in swaps based on pre-IPO options are at a significant risk of losing the entire value of this investment.

The SEC’s Advisory Committee on Small and Emerging Companies has recently issued a recommendation that the Commission make it easier for employees in startups to sell their options. The Advisory Committee noted the value of startups, and the importance of giving employees options to incentivize hard work and attract talent. Rule 144 under the Securities Act only allows sale of a restricted security where many detailed requirements are met (public disclosure, a holding period, sale through a “market maker,” etc.). Due to these requirements, many small business employees are not able to take advantage of Rule 144 and thus cannot sell their options.

The Advisory Committee has thus proposed that the Commission codify the “4(1½) exception” that is sometimes allowed at common law. The 4(1½) exception is based on Section 4 of the Securities Act, which allows an issuer of securities to sell restricted securities to a select group of buyers under specific circumstances. The proposed rule would allow employees of startup business to take advantage of this exception even though they are not issuers.

As noted by the Advisory Committee, the JOBS Act has allowed startups to push off their IPO date, thus making it necessary to provide employees with a means of obtaining some profit from their options. This rule establishes a procedure under which employees can sell their options. This rule can potentially mitigate the risk of employees selling their options as highly risky derivative contracts.

In addition, the 4(1½) exception is strictly regulated and restricts the potential investors to whom an employee may sell their options. As the exception currently stands, issuers may only sell a limited amount of restricted securities to investors who are sophisticated enough to understand the risk, and only after the potential purchaser is provided with information regarding the security. Thus, employees selling their options through the 4(1½) exception will likely be selling to investors who understand, and can bear, the risks.

Allowing employees to sell their options to anyone who wishes to buy would expose many innocent investors to undue risks. On the other hand, barring any sale of such options has led employees to sell their options as derivatives, which only increases the riskiness of the security. Employees should be able to obtain value from their options, yet the SEC should attempt to regulate and closely monitor these investments. The 4(1½) exception would allow the SEC to accomplish these goals effectively while continuing to incentivize small business’ growth and development.