The Lure of Equity Compensation
For decades startups have offered equity to lure talent — at below market salaries — with the promise of future wealth. During the dot.com boom that began in 1995 and peaked in March 2000, the Nasdaq Composite stock market index rose by 440% closing at an all-time high on March 10, 2000, creating employee-millionaires and even billionaires at many IPOs. Of course, for those who did not or could not diversify their holdings, much of that wealth disappeared as the Nasdaq Composite declined nearly 80% by October 2002.
Despite the ups and downs of the subsequent decade, which included the 2008 financial crisis, equity compensation continued to lure talent hoping the boom would return. On October 23, 2015, the Nasdaq Composite finally re-achieved its March 2000 peak — a bear market had returned. But what about the promise of wealth from equity compensation? Changes in accounting rules and in market condition raise significant doubts of an employee-millionaire resurgence, suggesting that, on average, employees should negotiate for cash compensation instead of equity when they can.
The Decline of Stock Options and the Rise of Restricted Stock
In the 1990s and early 2000s, stock options comprised approximately 75% of equity compensation. But stock options began to decline in popularity, decreasing to approximately 25% of equity compensation by 2015.[i] This decline is generally attributed to three factors:
An Accounting Rule Change. The most significant factor in the declining use of stock options was a change in an accounting rule. At the end of 2004, the Financial Accounting Standards Board released a revision to its rule governing the accounting for stock based compensation.[ii] For the first time, companies were required to book an expense for stock options granted to employees and others under their equity compensation plans. Until this rule change, stock options were the preferred form of equity grant because of their favorable accounting treatment (no associated expense). The change in accounting rules leveled the playing field between stock options and other types of equity compensation, such as restricted stock, which already required booking an expense.
The 2008 Financial Crisis. Triggered by the banking crisis, the Dow Jones Industrial Average dropped from approximately 11,000 in July 2008 to approximately 6,500 in March 2009.[iii] As the market declined, more and more companies restructured their equity compensation plans. In many cases, underwater (out-of-the-money) stock options were exchanged for other forms of equity grants that had value to the employee even in a declining or slow growth market.
The Dodd-Frank Act. In 2010, Dodd-Frank gave shareholders a say on executive compensation. In response, Institutional Shareholder Services, Inc. (“ISS”), the preeminent proxy advisory firm in the U.S., recommended that at least 50 percent of equity compensation awards should be performance based — i.e., earned or paid out based on measurable performance targets. Failure to meet this 50 percent threshold would likely result in ISS recommending a no-vote on those board members serving on the compensation committee.
Today, as a result, stock options no longer represent the dominant form of equity compensation. Surveys in the last few years show that about 50 percent of equity compensation awards are in the form of performance shares or performance share units. About 25 percent is made up of restricted shares or restricted share units, and just 25 percent is stock options.[iv]
Post-IPO Stock Prices Diminish the Value of Equity Compensation
A study of U.S. technology IPOs from 2010 to 2018 found that between months five and seven after their first day of public trading, about 65% of technology IPOs were trading below their IPO price.[v] The study offered two possible explanations.
Unicorns. Several privately-held technology companies made the decision to delay their initial public offerings and instead raise money through successive rounds of venture capital funding. For several of these venture-backed companies, massive pre-IPO valuations resulted. Companies valued over $1 billion were called Unicorns.[vi] With IPOs timed to take advantage of the maximum valuation possible, maintaining that valuation post-IPO, particularly with Unicorns still running at a loss, proved impossible. This pattern has repeated for companies like Lyft, Uber and SmileDirectClub.
The Lock-up Period. The period of underperformance between months five and seven post-IPO corresponds to increased share supply and selling pressure following the expiration of the lockup period imposed by IPO underwriters on employees and venture capital investors (typically 180 days post-IPO).
Has the Equity Compensation Promise of Wealth Become Illusory?
While some employees make real money — Uber’s IPO was obviously quite profitable for employees — most equity compensation grants from startup companies end up being worthless. Seventy-five percent of venture-backed startups fail before achieving a liquidity event (an IPO or sale of the company).[vii]
Even if a startup is successful, for Unicorn companies the delay in conducting an IPO also delays the ability of employees to cash in on their equity compensation. In the past, a typical startup would take about 4 years to go public, but with the broader availability of private equity, startups today are staying private longer — an average of eleven years.[viii] So Unicorn employees are generally frustrated about the long period of time they must wait to cash in on their equity compensation.
Even in successful IPO’s, the value of the equity compensation is often not life changing. Take the following example. A software engineer goes to work for Uber, receiving a grant of 40,000 Restricted Stock Units, vesting over four years, provided there’s a liquidity event. Suppose she even stays the whole four years and is there for the IPO, so all 40,000 shares fully vest. Seems like she should be rich now, perhaps. But here’s the math.
Uber issues her shares at the $45 IPO price, a face value of $1.8 million — enough for a modest retirement. But the tax consequences make all the difference. Because this is an outright grant, the entire proceeds are taxed as ordinary income. Applying a combined California and Federal tax rate of 52.65%, she owes $947,700 in income tax. Uber withheld the minimum 37% of the shares against taxes, in effect selling those shares for her at the IPO price, so she received only 25,200 shares but the withholding covered $666,000 of her taxes, leaving her owing $281,700. By the time she could sell them six months post-IPO, however, her 25,200 shares were only worth $27 each.
If she sold her remaining 25,200 shares at that $27 price to cover her tax obligations and diversify her holdings (a sensible strategy), she would net $680,400. After paying the $281,700 in remaining tax, she would have just $398,700 of her $1.8 million left after taxes. That’s a downpayment on an ordinary house in silicon valley — nothing more. Life changing, yes, but not at all a retirement by itself anywhere in the U.S. And, our hypothetical developer was working for a true Unicorn that went public at a valuation of $82.4 billion. How many start-ups ever achieve anything like that?
Notably, many Uber RSU holders have damage claims against Uber, because Uber’s acceleration of the settlement date, which created this particularly bad outcome, appears to be a clear breach of its RSU Agreements with Employees.
We counsel highly compensated individuals in employment transactions. And while we have nothing against equity compensation — we’re self employed ourselves, after all — we work to ensure our clients apply appropriate discounts to the value they place on that compensation component. As the above data illustrates, the employee is often much better off just getting market-based cash compensation, and having performance based compensation due as bonuses payable upon achieving measurable performance goals. Put another way, you should simply understand equity compensation for the highly uncertain and not so valuable thing it really is. Even if you are working for a Unicorn, you may not be getting at all what you thought.
Ray E. Gallo
Ray Gallo is a California litigator handling high profile business and employment cases. Current and former executive clients include Todd Lachman (formerly President of Mars Chocolate NA and Mars Global Petcare), Keith Ferrazzi (formerly CMO at Starwood), and Tad Smith (currently CEO at Sotheby’s). Tracy Tormey is a corporate and securities lawyer, formerly a partner at Oppenheimer, Wolff & Donnelly LLP, and General Counsel at EMAK Worldwide, Inc.
Learn more about these lawyers and the firm at https://gallo.law.
Among other projects, Ray and Tracy are representing qualified clients who incurred additional tax liability due to Uber’s acceleration of their RSU settlement date, which they believe breached the employees’ RSU agreements. See https://uberrsuclaims.gallo.law.
[i] “What has happened to Stock Options” by Joseph E. Bachelder, III, Harvard Law School Forum on Corporate Governance, October 2, 2014.
[ii] Financial Statement №123, Accounting for Stock-Based Compensation (Revised 2004).
[iv] “What has happened to Stock Options” by Joseph E. Bachelder, III, Harvard Law School Forum on Corporate Governance, October 2, 2014.
[v] “Lyft is Public. Uber is Next. Tread Carefully on Tech IPOs” by Anita Ragavan, Barron’s, May 8, 2019
[vi] “The Real Reason Everyone Calls Billion-Dollar Startups ‘Unicorns” by Rodriguez, Salvador, International Business Times, September 3, 2015.
[vii] “The Venture Capital Secret: 3 Out of 4 Start-ups Fail” by Deborah Gage, The Wall Street Journal, September 20, 2012
[viii] “Unicorn Stock Options — Golden Goose or Trojan Horse?” by Anat Alon-Beck, Case Western Reserve University School of Scholarly Commons, 2019.