The promise of equity no longer aligns the interests of workers and startup founders

(written by lawrence krubner, however indented passages are often quotes). You can contact lawrence at: lawrence@krubner.com

This essay is fantastic:

Sure enough, companies like Snapchat and Palantir have adopted policies that either vest employee options over a longer period of time (five years in the case of Palantir) or back-weight the bulk of vesting later in an employee’s tenure (Snapchat vests only 10% the first year, 20% in the second, 30% in the third, and 40% in the fourth). Still, while this adjustment may strike VCs and founders as a reasonable tradeoff, lengthening the time workers are expected to remain bound to the company doesn’t exactly scream “employee friendly” — particularly when it could be argued that the Unicorn phenomenon at least partly driving today’s longer time-to-exit is very much the result of particular management and investor choices, not necessarily anything the employee has any control over.

Perhaps what modern Silicon Valley really needs is a different vehicle for equity compensation — one that behaves like a stock option but more honestly acknowledges the long road many startups today have to justify their valuations and provide liquidity to employees. One such alternative was popularized by Facebook, which became a sort of proto-Unicorn back in 2007 after a strategic investment by Microsoft jolted the company’s private valuation from $525 million to $15 billion. Since a private company’s option strike pricing is tied, per the tax code, to its fair market value, and an option’s value lies in the appreciation of the company’s stock value above it’s strike price, and since living up to (let alone surpassing) its stratospheric new valuation seemed at the time to be a tall order for Facebook, Facebook suddenly found itself in the difficult position of being unable to grant options with enough upside to attract potential new employees.

Facebook’s response to this crisis was to start issuing employees Restricted Stock Units (RSUs) instead of stock options. Unlike options, RSUs aren’t simply guarantees of the opportunity to later buy stock at a particular price, they’re full-value proxies for the company’s stock — stock coupons, if you will. Like options, RSUs generally vest over a period of years and cannot be sold without the company’s agreement (ergo the “restricted” modifier). Unlike with options, however, an employee doesn’t need to come up with cash to “exercise” RSUs within a certain period of time upon leaving the company — he or she already owns all vested shares outright. Because there is no exercise price to be paid, an RSU can technically never be “underwater” in the way an option can if the company’s valuation declines (as Facebook’s subsequently did by $5 billion). As long as the company is worth something, RSUs are worth something.

On the face of it, RSUs seem to offer a better option for today’s breed of startup. They still provide for Thiel’s all-important alignment of the employee’s success with the company’s but are less likely to be rendered totally worthless if the company doesn’t manage to live up to an inflated private valuation. They still encourage loyalty since the employee has a reason to stick around throughout the vesting period, but they don’t impose a potentially onerous exercise cost on employees who leave before a liquidity event. They address a number of emerging problems in today’s startup environment but don’t necessitate a complicated reassessment of the equity value equation, as the proposals for reforming options are generally perceived to do. RSUs also have another key benefit that is attractive to scrutiny-shy Unicorn management: the SEC doesn’t consider employees with RSUs investors the way it does employees with stock options — which means that rapidly expanding companies can avoid running afoul of an SEC rule that requires companies with over 500 investors to be subject to the same financial disclosure rules as public companies. Indeed, this last point was another major reason Facebook adopted RSUs back in 2007, and part of the reason RSUs have today become common among larger private startups like Uber.

Unfortunately, RSUs lack one important attribute of stock options: deferred taxation. While in general options are only taxed upon exercise (which, assuming the employee doesn’t leave early, usually coincides with liquidity), RSUs are taxed as soon as they vest. This means that employees with RSU grants are continuously accumulating illiquid but taxable income based on the company’s current fair market value. This can prove disastrous for employees who have already paid taxes on RSUs whose values have declined precipitously. Employees of defunct Unicorn Good Technologies, for example, saw their RSU valuation decline so far that one told the New York Times that after taxes “Employees essentially ended up paying to work for the company.”

Gotchas like this are why odds are, if you ask a VC how to reform equity compensation, he or she will likely suggest it’s a matter best left up to the suits in Washington. And indeed, as VC Fred Wilson observes, if the IRS clarified its position on a legally ambiguous scheme that defers receipt of an RSU’s underlying stock until liquidity, we might be onto something. Minnesota Rep. Erik Paulsen recently provided some hope of this by introducing the “Empowering Employees through Stock Ownership Act,” which would allow employees to defer taxation on an option or RSU for up to seven years. Still, while tax reform would be a good start, in the age of the Unicorn, one can’t help but wonder if there’s something amiss in the startup-employee contract that would be better addressed by a different branch of finance than accounting — the one that deals with ethical notions like “moral hazard.”

Despite all of the high-minded rhetoric about equity aligning incentives, it has become increasingly apparent in recent years that structural changes in the startup business are driving the interests of Silicon Valley’s elite and their labor force further apart. The dearth of liquidity opportunities arising from today’s dramatically longer road to an exit tends to be far less of a concern for VCs and founders than for employees. Unlike employees, who generally have limited visibility into important equity-related matters such as fund-raising, growth, and acquisition offers (Good Technologies reportedly declined an $825 million acquisition before eventually being acquired for half that), founders and investors are the ones whose speculatory enthusiasm and utopian optimism is pushing companies into uncharted financial territory in the first place. The megalomaniacal zeal driving Unicorn fever has certainly been know to filter down through the ranks, but, as in any cult, the level of faith demanded of the followers tends to be greater than that of the leaders. The preferred stock held by investors and founders is a bit like a guaranteed place on the first lifeboats off the Titanic, while employees with mere common stock are left to fend for themselves in steerage. Management alone can OK pre-IPO liquidity opportunities such as secondary offerings and stock buybacks (something they’re generally reluctant to do because of the complications they can create), and founders are often able to arrange liquidity options for themselves that are never offered or even disclosed to employees (David Byttow and Chrys Bader-Wechseler, founders of flash-in-the-pan app sensation Secret, were famously allowed to sell $3 million worth of restricted stock to new investors right before their company tanked; Snapchat founders Evan Spiegel and Bobby Murphy have each pocketed $10 million). While Unicorn CEOs are often effectively making high stakes, one-way bets on world domination with their positions already relatively secure, their employees are, in many ways, the ones whose outcomes are most at risk.

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