SEC and Startup Equity Compensation Transparency
The Opaque World of Startup Equity Compensation
Consider receiving a job offer from a highly desired company. Contract negotiations proceed smoothly, yet a crucial detail remains unaddressed – the currency in which your salary will be paid. Would it be U.S. dollars, euros, or potentially Japanese yen? You’re asked to proceed with a degree of uncertainty regarding your compensation. This scenario, while seemingly improbable, mirrors the current state of the startup equity compensation landscape.
The Problem of Undisclosed Ownership
Typically, employers extend stock options or restricted stock units (RSUs) as part of a job offer, but often omit the company’s total outstanding share count. Without this vital information, employees are unable to determine if their grant represents a 0.1% ownership stake, 0.01%, or another proportion. While employees can request this data, employers aren’t obligated to provide it, and many startups choose not to.
Furthermore, a lack of comprehensive disclosure leaves employees unaware of critical startup valuation data, specifically the firm’s capitalization table and aggregate liquidation preferences. These preferences dictate how proceeds from a company sale are distributed, determining the payout order for investors versus employees. By failing to account for the debt-like nature of venture capital financing, employees frequently overestimate the true value of their equity grants.
Regulatory Shortcomings and Information Imbalance
What actions have regulatory bodies taken to address this issue? Relatively few. Current regulations largely exempt startups from providing employees with information beyond a copy of the options plan. Only a small percentage of companies issuing over $10 million in securities annually are required to provide supplementary disclosures, including updated financial statements.
These disclosures, while potentially sensitive, are only tangentially related to the valuation information employees seek. A recent fair market valuation and a projection of potential payouts under various exit scenarios would be significantly more beneficial.
The existing regulation suffers from a critical flaw: it provides both excessive, irrelevant information and insufficient, essential data. As eloquently stated in a song, it’s “too much, too little, too late.” The regulation mandates disclosures that are often unhelpful, withholds crucial details, and delivers information too late for effective decision-making.
Impact on the Tech Labor Market
This situation negatively impacts not only employees but also the broader high-tech labor market. Talent is a valuable and limited resource. A lack of transparency hinders competition and impedes the movement of employees toward more promising opportunities. Ultimately, this informational disadvantage can diminish the perceived value of equity incentives and complicate startups’ efforts to attract top talent.
A Proposed Solution: Exit Waterfall Analysis
In a published article in the Columbia Business Law Review, titled “Making Disclosure Work for Startup Employees,” I propose a straightforward solution. Startups issuing over 10% of any share class to at least 100 employees should be required to disclose individual employee payouts based on an exit waterfall analysis.
A waterfall analysis details the distribution of cash flow. In startup finance, this involves simulating a company sale and allocating proceeds down the different equity classes according to their liquidation preferences. The common stockholders receive any remaining funds. While the underlying calculations can be complex, the output is easily understandable.
A waterfall model can generate a graph displaying an employee’s potential payout for each possible exit valuation, plotted on the x-axis against the payout amount on the y-axis. Utilizing cap table management software, creating this model is a simple process.
Empowering Employees with Transparency
This visual representation allows employees to grasp their potential gains across a range of exit values, even without a deep understanding of the underlying mathematics or legal terminology. Equipped with this information, employees would not require the current disclosures mandated by Rule 701, and startups could mitigate the risk of sensitive financial information falling into the wrong hands.
Crucially, this information should be provided as part of the initial job offer – before an employee commits to a position with an equity component.
Recent SEC Proposals and Remaining Gaps
Earlier this year, the SEC proposed revisions to Rule 701, including an alternative to disclosing full financial statements. Startups exceeding the $10 million securities issuance threshold could choose between financial disclosures and an independent valuation report of the securities’ fair market value, determined by a 409A appraisal.
This represents progress, as fair market valuation is more useful to employees than financial statements. However, a 409A valuation alone is insufficient. It’s widely known in Silicon Valley that these valuations can be inaccurate, influenced by the company’s desire to maintain a positive relationship with the appraisal firm and the board’s approval process.
Therefore, a 409A valuation is most valuable when accompanied by the waterfall analysis used to generate it. Furthermore, the SEC’s proposal still allows most startups to offer equity without providing meaningful disclosures.
The Need for Employee Protection
For over three decades, the SEC has largely deregulated startup equity compensation to facilitate startups’ ability to attract talent. However, the SEC has largely overlooked the corresponding need for employees to have information regarding the value of their equity. It is time to re-evaluate the protection of employees as investors within the securities regulatory framework.
