Bargaining Inequality: Employee Golden Handcuffs and Asymmetric Information

Anat Alon-Beck is Assistant Professor at Case Western Reserve University School of Law. This post is based on her recent paper, and is part of the Delaware law series; links to other posts in the series are available here.

Unicorn valuations are notoriously inaccurate and well-documented in the finance literature. Silicon Valley’s dirty little secret is that a company can achieve a unicorn valuation by providing extensive downside protections to late-stage investors. Employees of these large, privately held companies do not have access to fair market valuation or financial statements and, in many cases, are denied access to such reports, even when requested.

Unicorn employees are granted equity as a substantial part of their compensation, however due to the inferior position of employees in comparison to the start-up founders and other investors, information shedding light on the value of their equity grants is often withheld.

Start-up founders, investors, and their lawyers sometimes systematically abuse equity award information asymmetry to their benefit. My paper, Bargaining Inequality: Employee Golden Handcuffs and Asymmetric Information, forthcoming in Maryland Law Review sheds light on the latest practice that compels employees, who are not yet stockholders, to waive their stockholder inspection rights under Delaware General Corporation Law (“DGCL”) Section 220 as a condition to receiving stock options from the company.

Perhaps the clearest indication of this new practice is the recent amendment to the National Venture Capital Association legal forms, which is intended to standardize a contractual “waiver of statutory inspection rights.” This waiver is designed to contract around stockholder inspection rights and prevent employees from accessing information about the value of their stock.

This paper puts forward competing arguments and policy considerations for and against such a waiver. It fills the gap in the case law and evaluates whether a contract between the company and its employees, which operates independently and outside the charter or bylaws, can modify or eliminate the mandatory inspection rights expressly set forth in the DGCL. The resolution on this issue will have tremendous influence on corporate law, litigation, and practice.

Contractual Innovation

This latest development is an ongoing trend to deprive tech employees from information about their investment in the firm that they work for. It all started when the social-networking company—Facebook, now Meta, was in violation of our securities laws when it passed the shareholders of record threshold at the end of 2011.

Facebook and other tech companies successfully lobbied Capitol Hill and Congress to increase the number of shareholders of record and exclude employees. Prior to the JOBS Act, when employees exercised their stock options, they were considered “holders of record” and when the company reached 500 holders of record, private companies were compelled to provide disclosures as if they were publicly listed.

Thus, employees were protected as investors by our securities laws and private companies were not able to withhold information from employees as they grew in valuation and number of workers. Following the JOBS Act, employees are no longer considered holders of record. According to Rule 701(e) of the Securities Act of 1933, companies are exempt from disclosing detailed financial information to employees unless the total amount of securities they sell to employees over a 12-month period exceeds $10 million. This trend that started with our securities laws, is now creeping into our state corporate laws.

My paper demonstrates that following a recent Delaware case, Biederman vs. Domo, unicorns adopted a new, pervasive practice that compels their employees to waive inspection rights. Relying on a hand-collected data set consisting of the SEC’s public filings, I found that unicorn firms require their employees to waive their inspection rights under DGCL Section 220 as a condition to receiving stock options from the company.

Employees sign a waiver clause titled “Waiver of Statutory Information Rights,” in which they waive their inspection rights of the following materials: company stock ledger, a list of its stockholders, other books and records, and the books and records of subsidiaries of the company. The waiver remains in effect until the first sale of the company’s common stock to the public occurs.

Delaware law is clear that stockholders’ inspection right is not without limits. It is less clear to what extent it may be contractually limited and, more importantly, whether employees, as future minority stockholders, can contract away their information rights entirely. DGCL Section 220 was designed to protect stockholders that require information to value their stock holdings, especially in the context of a private corporation, with no access to a liquid market. I argue that ex ante efforts to limit employee stockholder inspection rights via private ordering do not fit with the goals of corporate law.

The Asymmetric World

Information is power. Investment in private markets is risky and plagued with information asymmetry. Information asymmetry creates entrepreneurial and market opportunities for firms to compete because they are not required to disclose information to the public on their financials, fair market value or strategy. Information asymmetry can also generate a market failure if not managed properly by the firm.

The paper questions the basic allocation of power between boards and stakeholders—including rank-and-file employees—under U.S. corporate law. Employees of a venture-backed startup can become shareholders in the firms that they work for because they are offered equity as part of their compensation. These options commonly require a large out-of-pocket investment on the part of employees to convert to stock. After the employees exercise their options, they become a minority, common shareholder.

Unicorn firms do not provide their minority common stockholders and stock option holders— specifically, their employees—with information on their stake in the company, which could improve efficiency and reduce information asymmetries. Most employees of large, private unicorn firms are not in a position to monitor their company’s progress. Founders and managers may not share the same economic incentives as rank-and-file employees. There are no bargaining advantages for employees over other sophisticated investors, like venture capitalists. For the most part, these individuals are not sophisticated investors, are not represented by legal counsel, and cannot bargain for access to information.

Workers Go to Court

Employees are turning to the courts to gain access to information on their company. Why courts? To invoke their statutory shareholder inspection rights.

Stockholder inspection rights are fundamental to the governance of a corporation. DGCL Section 220 provides protection to stockholders by allowing them to exercise their ownership rights and inspect the books and records of a Delaware corporation. In Delaware, this ownership right cannot be eliminated or limited by a provision in a corporation’s certificate of incorporation or bylaws. But there is ambiguity in the case law about waiving these rights by contract.

In Cedarview Opportunities Master Fund v. Spanish Broad. Sys., Inc., Delaware court held that this ownership right “cannot be eliminated or limited by a provision in a corporation’s certificate of incorporation.” But, there is ambiguity in the case law about waiving these rights by contract.

Can employees (who are not yet stockholders) waive this right by entering into a contract with the corporation such as a stock option agreement? And, in the event of litigation, would a Delaware court side with management or employees? The Delaware Court of Chancery has yet to answer these questions.

In a recent case, JUUL Labs, Inc. v. Grove, the Delaware court noted that it was not deciding whether waivers of a stockholder’s statutory inspection rights under Section 220 in JUUL Labs’ form agreements would be enforceable. There is a lot of ambiguity in the case about a potential resolution on this issue.

One thing is clear, unicorn employees will continue to turn to the courts to compel their companies to open up their books and records. The paper also presents evidence that unicorn firms prefer to incorporate in Delaware. Thus, any Delaware court decision on this issue will determine the rights of hundreds of thousands of unicorn employees across the U.S. Therefore, the paper calls on the Delaware courts and legislature not to allow unicorns to modify or eliminate the mandatory inspection rights expressly set forth in the DGCL. Delaware law is and should continue to serve as a valuable tool for minority stockholders and stock option holders (employees) who are questioning the value of their shares.

The complete paper is available for download here.

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