The Silicon Valley ecosystem has changed profoundly since the dizzying heights of the dot-com era. Consider two of that era’s iconic companies: Yahoo! and eBay. At the time of their IPOs, both of these companies were mere infants by today’s standards. Yahoo reported having 49 employees, net revenue of only $1.3 million, and a total market capitalization of about $400 million.  eBay reported having 76 employees, annual net revenue of less than $20 million, and a market capitalization of approximately $700 million.

Google and Facebook ushered in a new era of mature startup. At the time of its 2004 IPO, Google reported having nearly 2,300 employees, annual revenue of approximately $1.465 billion, and a market capitalization of about $27.5 billion.  At the time of its 2012 IPO, Facebook reported having over 3,500 employees, annual revenue of approximately $3.7 billion, and a market capitalization of about $101 billion.  The trend continues today as the list of billion dollar startups (unicorns) swells.

What caused this pronounced change in the Silicon Valley landscape? In a recent essay, I argue that part of the story is a deliberate choice to accommodate the mature startup by relaxing regulation of equity compensation.

Historically, private placement regulations were interpreted narrowly when it came to stock sales to employees. The seminal private placement case, Securities and Exchange Commission v. Ralston Purina, decided by the U.S. Supreme Court in 1953, held that sales to a broad class of employees were not presumptively exempt from registration requirements. Starting with an obscure Securities and Exchange Commission task-force report written in the dot-com era, however, the SEC and Congress began enacting generous registration exemptions for equity compensation. Under these relaxed regulations, mature startups have issued eye-popping amounts of equity compensation to a wide range of employees. Prior to its IPO, Facebook issued equity compensation covering approximately 961.5 million shares of illiquid, private-company stock having a market value (at the eventual IPO price) of approximately $36.5 billion.

My essay asks a fundamental question: Are such broad exemptions for equity compensation consistent with private-placement principles?  There are reasons for doubt in this era of mature startups.

Startup employees may very well have advantages over other investors in a startup’s early stages.  Employee number five presumably works on essential functions, occupies a good vantage point for monitoring management, and is economically aligned with founders.

Can the same be said of employee number 5,000?  As startups mature, they presumably grow in organizational complexity.  In this environment, an employee may play a hyper-specialized role with less visibility to monitor company progress.  Late arriving employees also have a different – and usually less advantageous – place in a company’s capital structure than do employees hired earlier particularly if they receive stock options with exercise prices pegged at a relatively high stock value.  Already, we are seeing news reports of unicorns selling for nine figures without any substantial payout to employees (Steven Davidoff Solomon describes the situation here).  One wonders whether employees are situated to make informed decisions about a capital structure layered with the complex preferred stock terms of today’s late-stage financing environment.

It is somewhat surprising that equity-compensation regulation hasn’t received more attention from legal scholars.  While there are insightful analyses of mature startups and the challenges they pose to regulatory structures, this key origin of the mature startup is largely unexamined.

This post comes to us from Professor Abraham J. B. Cable at UC Hastings College of the Law. It is based on his recent essay, “Fool’s Gold? Equity Compensation & the Mature Startup,” available here.