Unicorn Stock Options—Golden Goose or Trojan Horse?

Anat Alon-Beck is the 2017-2019 Jacobson Fellow in Law and Business at New York University School of Law. This post is based on a recent paper by Dr. Alon-Beck.

Eight years ago, the idea that a venture capital (VC) backed startup could reach an aggressive valuation of over $1 billion without going public was inconceivable. But today the Wall Street Journal, Fortune Magazine, CNNMoney and CB Insights, each keeps a list of such companies and their valuations, and the list keeps growing. With the decline in the U.S. market for initial public offerings (“IPOs”), which is caused in part by the availability of new private capital sources, there is a rise in the number of privately held firms that are valued at $1 billion or more (“unicorns”).

The U.S. has the largest concentration of unicorns in the world. Whereas, in the recent past, startups tended to go public or be sold approximately four years after founding, today the average time to IPO or sale is eleven years. In a recent paper, Unicorn Stock Options—Golden Goose or Trojan Horse?, I argue that by staying private and not pursuing an IPO or sales transaction, the unicorns are delaying liquidity events for their shareholders, including employees. In the new economy, knowledgeable employees contribute to the firm’s intangible assets.

I address the challenges faced by unicorn firms as repeat players in competitive technology markets, and the consequences of failing to meet their employees’ expectations, which has resulted in labor contract renegotiations. To attract, engage and retain talent, unicorn firms must find ways to continue to offer them equity (and a promise of equity) and facilitate liquidity opportunities.

Traditional employee equity contracts were not designed to prevent the heretofore unforeseen contingency that the startup will remain private for a longer timeframe, which triggers conflicts between the parties. According to incomplete contracting theory, this conflict, which results from the new market dynamics, new startup financing models and changes to unicorn startup governance arrangements, subjects employee equity compensation agreements to renegotiation. Specifically, the major unicorn common shareholders (typically, the founders) have greater power vis-à-vis preferred shareholders and minority common shareholders to oppose a sale and keep the company private longer.

Unicorn firms are dealing with high turnover rates of knowledgeable employees, despite the fact that they generally offer their employees a competitive salary combined with high annual equity awards. In the past, many talented individuals chose to work for a startup company, for a below-market cash salary combined with a substantial stock option grant, and a dream of cashing out for a large sum of money after an initial public offering of the startup’s stock. Yet, today, due to “lock-in” and illiquidity of unicorn shares, employees are faced with a dilemma—if their options are expiring, then they must choose between forfeiting or exercising them. Because unicorn pre-IPO valuations are very high, many employees find that their options are prohibitively expensive due to liquidity constraints and tax concerns.

There is a heated debate in Silicon Valley on whether the use of the so-called “golden handcuffs,” the 90-day stock option exercise period applicable to departing employees, is fair or efficient due to the new market dynamics. At a minimum, the golden handcuffs “lock in” employees who may prefer to work for a younger startup with more cutting-edge technology and can thereby reduce the innovation necessary for a growing economy.

The shift in unicorn employees’ expectations is evident from employees’ bad mouthing their employer and making public complaints, which cause not only a reputational damage to their employers, but also higher costs of monitoring the labor force. Thanks to online data sites, such as Glassdoor and PaySa, there are many public reports on unicorn employee complaints. In an effort to deal with these complaints, various interest groups, including the National Venture Capital Association, have been lobbying Congress. Their lobbying undertakings resulted in changes to tax and securities laws. This paper presents recent regulatory and legislative developments, specifically, the Economic Growth, Regulatory Relief, and Consumer Protection Act and the Tax Cuts and Jobs Act. It provides constructive criticism to these developments.

There has been relatively little discussion in the literature on how the changes to the U.S. capital markets and recent legislation affect the unicorn firm as a repeat player in competitive technology markets, where companies aggressively compete for talent, i.e., knowledgeable employees. My paper fills that gap. I explore how U.S. technology companies engage in a “war for talent” that will continue to define and outline their competitive landscape for years to come.

The U.S. Securities and Exchange Commission (“SEC”) is also aware of these challenges. In a recent interview with the Wall Street Journal, SEC chairman Jay Clayton, indicated that his agency is now exploring new rules that can make it easier for unicorns “to compensate their workers by giving them stock in the company.” [1]

My paper offers the following possible solutions. First, new equity-based compensation contracts for the different types of employees and critiques them. Second, alternatives to the traditional liquidity mechanisms, and critiques them. Third, urgent amendments and comprehensive reform to the current regulatory and legislative models are needed to remove legal barriers to private ordering. Finally, by providing employees with liquidity and adequate disclosures that can improve efficiency and reduce information asymmetries.

These recommendations are in line with increasing equitable and more sustainable employee participation to improve the prospects for unicorn companies. Liquidity opportunities and information will encourage employees to continue to exchange their creativity and hard work for the sweat equity needed for the game-changing innovations necessary for American competitiveness in the global marketplace.

The complete paper is available for download here.

This paper is dedicated to my amazing mentor Lynn Stout, Distinguished Professor of Corporate and Business Law at Cornell Law School, who will be sorely missed.


1Dave Michaels, SEC Chairman Wants to Let More Main Street Investors In on Private Deals, Wall St. J. (August 30, 2018), https://www.wsj.com/articles/sec-chairman-wants-to-let-more-main-street-investors-in-on-private-deals-1535648208.(go back)

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