There are two contrasting narratives about how private companies raise capital for growth. One argues that regulations are too restrictive, stifling innovation and job creation. The other claims that regulations are too loose, leaving naive investors vulnerable.
A recent study supports the latter perspective, especially concerning a particular group of investors: employees of private companies who receive compensation in the form of stock options or equity. While employees may not be seen as traditional investors, they are effectively investing in the company when they receive such forms of compensation.
Surprisingly, many employees lack awareness of the true value of the stock options they receive, even if these options make up a significant portion of their compensation. This lack of knowledge exposes them to potential mistreatment by their employers, who can structure compensation to benefit top executives and outside investors at the expense of rank-and-file workers.
This issue extends beyond a minor concern. Over the years, there have been increasing exemptions from securities laws enacted during the Great Depression to safeguard investors. With more relaxed regulations, private companies can avoid disclosing financial information, making it easier for them to remain private. The rise of privately held start-ups valued at over $1 billion, often referred to as “unicorns,” demonstrates this trend.
Data Study Highlights Employee Ignorance of Stock Options
The study titled “Equity Illusions” by Yifat Aran of the University of Haifa and Raviv Murciano-Goroff of Boston University’s Questrom School of Business sheds light on the issue. It reveals that start-up employees often respond to irrelevant signals and misinterpret significant cues regarding compensation. The results are based on a survey involving more than 1,000 U.S. employees with at least a bachelor’s degree.
The findings indicate that only 36.4% of respondents fully understand what stock options are, and just 28.3% recognize the varying risk levels of different kinds of stock options and restricted shares. Furthermore, only 18.3% grasp the basic characteristics of venture capital finance, such as convertible preferred stock. Most concerning is the respondents’ lack of awareness of their own limitations, as they were 67.3% more likely to answer equity compensation-related questions incorrectly without recognizing their lack of knowledge.
Unfortunately, personal finance education alone cannot rectify this issue because certain essential information is not readily available. For instance, employees are often impressed when granted options on a substantial number of shares. However, the number of shares holds little significance unless employees have access to information on the total number of outstanding shares. This knowledge is crucial for determining their personal stake in the company. Yet, private companies are not required to disclose this information under Rule 701, an exemption from the Securities Act of 1933.
Another concerning aspect is the limited window for employees to exercise their stock options after leaving a start-up. Typically, they only have 90 days to take action. However, if the company remains private, the shares they receive are not sellable. As a result, employees may face significant tax obligations for gains they have not realized. While there are loans available to cover the costs of exercising options and paying taxes, these loans can consume 40% to 50% of potential gains. This problem is compounded by the growing trend of companies staying private for extended periods.
New Perspective on Stock Options and Regulations
The exemption of private companies’ stock option issuance from the Securities Act of 1933 is based on the premise that these options are not investment instruments subject to securities law but rather a form of compensation. However, Aran and Murciano-Goroff’s survey suggests that lower-level employees do perceive the option grant as an investment. More sophisticated employees tend to view stock options as lottery tickets.
Ultimately, while equity-based compensation may, in theory, align the interests of employees and owners, actual market practices often deviate from this ideal. Employees are frequently left at a disadvantage as their lack of knowledge enables practices that favor owners and higher-level management at their expense.
One proposed solution to address this issue is to restrict start-ups’ compensation to cash-only for employees outside a small circle of managers. Alexandra Thornton, a senior director at the Center for American Progress, advocates for this approach. She argues that the risks associated with stock options outweigh any potential benefits, particularly for lower-level employees.
However, counterarguments suggest that forcing companies to rely solely on cash compensation could inhibit their ability to secure funds. Proponents of this view argue that investor protection regulations, which unintentionally hinder entrepreneurial companies, need to strike a balance. They contend that America’s network of angel investors and venture capitalists is among the best globally and that capital flow will not cease if additional protections are introduced. The assumption that employees possess sufficient information due to their proximity to the company is also challenged.
The Readers Write
Thank you for shedding light on the ethical and legal discussions surrounding the sale, use, bartering, and transfer of human biological samples and genomic data. While we possess supply chain tracing systems for various products, we lack such systems for major biomedical breakthroughs. Without such mechanisms, we stumble into a perspective that questions personal ownership of one’s own body.
– Misha Rashkin, Hayward, Calif.
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– Jerry Frankel, Plano, Texas
Steve Jobs’s quote emphasizes his disregard for waste. From a professional standpoint, the finest furniture makers prioritize using primary woods for visible components while utilizing secondary woods for structures and hidden areas. This approach ensures both structural integrity and aesthetic appeal. It serves as a reminder to optimize resources without compromising quality.
– Lorraine Burns, Colorado Springs, Colo.
Quote of the Day
“Macroeconomists want their math hard enough to make them look smarter than sociologists, but not too hard that they can’t get clean-looking solutions.” – Noah Smith
