Regulating Startup Equity Compensation in the Unicorn Era

In a new book chapter titled ‘The RSU Time Bomb: Regulating Startup Equity Compensation in the Unicorn Era’, forthcoming in the Research Handbook on the Structure of Private Equity and Venture Capital (Broughman & de Fontenay eds, Elgar Publishing 2024) I explore the precarious nature of equity compensation in Silicon Valley, focusing on the double-edged sword that are double-trigger Restricted Stock Units (RSUs). The chapter contributes to the debate on corporate governance in privately held startups by examining how the trend of staying private for a longer period results in risk-shifting from companies to their equity-compensated employees. The chapter connects the challenges RSU holders face to the historical deregulation of startup equity compensation, and highlights the frequently overlooked impact of human capital considerations on the timing of Initial Public Offerings (IPOs) of venture capital-backed companies. Furthermore, the chapter offers practical solutions based on the Israeli legal framework for equity compensation, which uses an escrow system to navigate related tax complexities. These recommendations aim to create better conditions for both startups and their employees and, ultimately, strengthen tech ecosystems where equity compensation plays an important role.

Imagine dedicating years of your life to a company’s vision, enticed by the promise of equity compensation that could one day turn into a windfall. Now, picture that promise vanishing into thin air, not through any fault of your own, but because of a ticking clock set by industry standards and market unpredictability. This is the high-stakes scenario faced by countless employees in Silicon Valley’s vibrant tech industry, where the promise of equity awards hangs in the balance, subject to the discretion of company founders and the ebbs and flows of the market.

Double-trigger RSUs, a staple in the compensation packages of Silicon Valley’s growth-stage startups, are structured to vest and convert to common stock upon the satisfaction of two conditions. The first trigger is the employee’s sustained service over a period, often leading to incremental vesting over time. The second is a liquidity event, typically the company’s IPO or acquisition, which means that the stock becomes liquid, allowing employees to sell part of their shares to cover any associated taxes.

The prevailing industry standard for double-trigger RSUs, though not mandated by law, sets a seven-year expiration date. This timeframe is carefully chosen to comply with the ‘substantial risk of forfeiture’ requirement detailed in Section 409A of the Internal Revenue Code, which allows employees to defer taxes on their equity compensation on certain conditions. These seven years were once considered a generous timeframe for a company to go public. However, market dynamics have rendered IPO timelines increasingly unpredictable, transforming this once ample period into a potential financial precipice for employees. Employees holding double-trigger RSUs face a significant risk: if their company doesn’t go public or isn’t acquired within the established seven-year period, their RSUs could expire. This critical window frames a period of uncertainty and highlights the stakes involved in equity compensation strategies.

The contrasting experiences of companies like Stripe, Airbnb, and Foursquare demonstrate the various outcomes that can result from these strategies. In March 2023, Stripe, the digital payments behemoth, undertook a bold and unprecedented move by raising an astonishing $6.5 billion in a funding round where the company’s valuation decreased compared to its previous round. This marked one of the largest venture deals in history and was urgently aimed at preventing the imminent expiration of its employees’ RSUs. The company used the funds to activate the RSUs, cover withholding taxes, and offer both current and former employees the chance to sell their shares at the new valuation. Just over two years before, in December 2020, Airbnb faced a similar time crunch, launching its IPO just in time to secure its workers’ valuable RSU grants. Conversely, in February 2022, Foursquare, the once-trending geolocation firm, ran the clock, resulting in over 100 former employees’ RSUs disappearing without a trace. Thus, the fate of employees’ sizable fortunes, sometimes amounting to millions of dollars, remains precariously poised, reliant on the goodwill of founders and investors.

The chapter underscores the dynamic interaction between inventive startup lawyers, who are constantly developing and refining equity compensation schemes, and the evolving regulatory landscape led by the Securities and Exchange Commission. This interplay is a complex balance of adaptation and compliance, where legal innovation navigates within the boundaries of regulatory constraints. It explores how deregulation of equity compensation has allowed startups to stay private longer, thus postponing the liquidity events that are essential for the vesting of double-trigger RSUs. Thus, the extended phase before going public presents significant challenges to an equity compensation system that was initially designed with shorter timelines to public markets in mind, inadvertently shifting IPO timing risks from the company to its employees.

Furthermore, the chapter provides a detailed examination of the Israeli framework for employee equity compensation, specifically Section 102 of the Israeli Income Tax Ordinance. This section serves as contrast to the American equity compensation model under Section 409A. The Israeli model employs an escrow system, deferring taxes until a liquidity event occurs, and offers more flexibility in setting exercise prices and expiration dates for equity compensation schemes.

In summary, the chapter provides a historical perspective on the interplay between securities regulations and equity compensation designs, revealing a reciprocal influence between compensation practices and the liquidity horizon of private venture capital-backed companies. It calls for a closer examination of the relationship between the timing of tech IPOs and equity compensation considerations, shedding light on the role of human capital management in tech companies’ transition from private to public capital markets.

The chapter also suggests paths forward. It advocates for a tax reform that could safeguard the interests of both companies and employees in the tech sector. As such, it is informative for policymakers, legal practitioners, and corporate executives, offering insights into an understudied factor that often determines the transition of startups into public capital markets.

Yifat Aran is an Assistant Professor of Law at the University of Haifa School of Law.

The author's chapter can be accessed here.