In the early stages of the unicorn era, it seemed that Rule 701 under the Securities Act, which provides a generous exemption for private company equity compensation, might not be up to the task.  It is one thing to conclude that employee number 10 is close enough to the issuer to not need the Securities Act’s protections.  It is another thing when you get to employee number 5,000.  In a 2017 essay, I laid out these issues as I understood them at the time.

Since then, some scholars have advocated for considerably increasing the regulation of private companies on the basis of employee vulnerabilities, consistent with statements by at least one SEC commissioner.  Other scholars have argued for more targeted reform tailored to certain cognitive missteps that may hinder good decision making by employee option holders. As far as Rule 701 goes, I generally favored the latter.

What has struck me most recently, however, is how dynamic the startup ecosystem can be. It is fiercely competitive and constantly adapting.  For example,  companies have shifted in later stages from stock options to an instrument called a “restricted stock unit” (RSU)  RSUs mark an important adaptation to a period when companies stay private longer. For tax reasons, employee stock options have an exercise price equal to the underlying stock’s fair market value on the day the option is granted. For early employees, this exercise price is pretty trivial because it is low. As companies stay private longer, the exercise price grows considerably (because the company’s valuation grows) and becomes a complicating factor in deciding whether and when an employee should exercise. In some cases, an employee can suffer direct economic loss because of the exercise price. Moreover, an option is just inherently more risky than owning stock outright, in a corporate finance theory sense. An RSU helps on both fronts. An RSU mirrors a grant of outright stock. If the employee satisfies a service condition and the company exits, the employee receives a specified number of shares outright (no exercise price).

Secondary markets –  arrangements through which employees can now cash out a portion of equity awards – have also grown to be a key feature of startup compensation.  These markets have been around for a while, but they have formalized into company-sponsored “liquidity programs” that partially cash out employees at somewhat regular intervals. This is a big change from the implicit bargain of mutual lock-in for all constituents (founders, VCs, and employees) that once prevailed in Silicon Valley.

Putting these two trends together, the system seems to be evolving to meet the needs of startup employees, even though the employees themselves often appear passive or even confused or apathetic about the terms of their individual awards. And this is the puzzle that I take up in my new article “Stock Options of Adhesion.”  How do mostly passive and uninformed employees secure improvements in equity compensation practices on a market-wide basis?

To answer that question, I turn to a long-standing literature on consumer contracts of adhesion such as product warranties or website terms of use. For decades, contract scholars have offered theories for how passive and uninformed consumers might benefit from market competition and receive improvements to contract terms. There may be an informed minority that companies pursue through sweetening contract terms. Severely one-sided contracts may occasionally be exposed through litigation or scandal, creating reputational pressures. Even one-sided contracts might be enforced with lenience. Frankly, I have my doubts these forces do much to help consumers when they buy microwaves. But it seems plausible that they do operate in the market for tech talent, where the stakes for employees are higher, a nontrivial number of employees have experience, and reputational considerations loom large.

As for policy takeaways, I think this relatively optimistic perspective counsels against big changes in securities regulation. I don’t see the kind of large-scale market failure that warrants quasi-public status for startups. But I do think that some reform of tax law could soften the system’s sharp edges and create room for more innovation in structuring equity compensation. As just one example, current tax law effectively prohibits in-the-money options. Why exactly?  That might be just the right risk-reward profile for some employees.

As for what comes next, I am keeping my eye on the equity compensation cottage industries. Outfits like Carta are automating and standardizing award administration in ways that might help or hurt employees. Third-party financing sources are loaning money to, or otherwise partnering with, employees to share the risk (and reward) of option exercises. And, of course, there are the unknown unknowns, which keep this topic forever interesting.

This post comes to us from Professor Abraham Cable at UC Law, San Francisco. It is based on his recent article, “Stock Options of Adhesion,” available here.