Beyond Covenants Not to Compete: Equilibrium in High-Tech Startup Labor Markets.

Author:Aran, Yifat

Introduction I. Silicon Valley's Birth and the Current Policy Debate A. How It All Started B. The Policy Debate Inspired by Silicon Valley's Success II. Noncompete Enforcement: A Battlefield for Economists A. The Conventional Economic Analysis of Noncompetes B. The New Wisdom Regarding Noncompetes C. The Quest for Empirical Support III. Equity Compensation as the Missing Link A. The Origins of Broad-Based Employee Stock Options B. Startup Employee Stock Options and Employee Mobility IV. Equilibrium in Tech Startup Labor Markets A. The Selective Effect of Stock Options on Employee Mobility B. Incentive to Invest in Human Capital and Innovation C. Allowing Talent to Move to Its Highest-Value Use D. A Solution to the Collective Action Problem V. A Cautionary Note on Liquidity A. The Change in Economic Conditions Affecting Silicon Valley B. The Change in Regulatory Conditions Affecting Silicon Valley C. Talent Mobility in an Age of Limited Liquidity Conclusion Introduction

The legal literature and popular press feature considerable debate over "noncompetes": contracts limiting employees' ability to work for competitors after their employment ends. (1) These agreements were once considered an essential means of protecting trade secrets and encouraging companies to invest in human capital as well as research and development (R&D). (2) They are now increasingly regarded as a threat to innovation and economic growth. (3) While most of the research in this field focuses on the importance of mobility of skilled employees among firms as a catalyst for knowledge transfer and entrepreneurial spawning (4)--with Silicon Valley being the most prominent example (5)--this Note seeks to illuminate the role of broad-based employee stock options (6) in moderating this mobility.

Although the use of noncompetes as sticks to induce workplace loyalty is largely prohibited in California, employee stock options are considered a legitimate carrot for achieving the same goal. (7) The retention function of private firms' employee stock options is common knowledge among practitioners. (8) This function, however, is often underappreciated in the literature on employee mobility and innovation. (9) For an employee holding an equity stake in a startup, the decision to leave the company might involve substantial financial consequences. (10) This Note therefore takes a classical economic "rational person" approach to decisionmaking. By doing so, it intends not to discount the importance of other factors guiding employment choices such as the quality of relationships with colleagues, professional development, or personal satisfaction--but rather to illustrate the role employee stock options play in the specific context of startup employee retention.

Building on a previous observation by Richard Booth, I argue that the combination of a strong public policy against enforcing noncompetes and a favorable approach toward broad-based employee stock options is what explains Silicon Valley's efficiency in matching talent with ventures. (11) Due to the prevalence of employee stock options among Silicon Valley's technology firms, (12) it is inaccurate to characterize the region as a labor market with high mobility across the board. Stock options, however, induce retention in a different manner than noncompetes. Whereas noncompetes suppress employee mobility regardless of company success, stock options provide a strong retention tool in the hands of successful startups only. The asymmetric payoff structure of stock options binds employees to the startup when the startup prospers but pushes them away when the startup stumbles. Thus, stock options inherently contain an efficient-breach mechanism that channels employees of less successful firms toward more promising ones, preventing inefficient retention. Moreover, stock options link the strength of the retention incentive to a startup's prospects and an employee's relative importance within the company. (13) Consequently, they provide a narrowly tailored means for talent market regulation, steering talent to where it is most valuable.

This Note further suggests that historically, successful startups either needed to go public to raise money and provide their investors and founders with liquidity or were pushed to go public by the federal securities regime. (14) This pressure intensified when employees began to exercise their options in large numbers. (15) An initial public offering (IPO) allowed the vested employees to cash out and thus released the company's grip on its entrepreneurial talent. (16) While most employees continued working for their firms after they went public, many entrepreneurial employees chose to found or join a new startup. (17) Padded with cash, these employees were better equipped to bear the risks associated with such entrepreneurial endeavors. Thus, stock options had a built-in release valve that calibrated the limitations on employee mobility to the company's life cycle and allowed employees of mature companies to depart. In a cycle typical of Silicon Valley for many years, startups that had peaked would lose their talent to younger ones that were just taking off. (18) Hence, IPOs played a central role not only in the career paths of individual employees but also in the regeneration of the local industry cluster.

But a combination of economic and legal conditions in the current environment allows successful companies to delay going public, weakening the built-in release valve previously embedded in stock options. Today, companies are able to raise growing sums of money on private markets, (19) and regulatory changes including the Jumpstart Our Business Startups (JOBS) Act of 2012 have made it even easier for them to grow in size and valuation while staying private. (20) Thus, the lock-in effect of stock options might significantly impede the departure of much-needed entrepreneurial talent from the most successful private firms. The lock-in problem not only is unfortunate for the individual employees involved but also poses a threat to the efficiency of the regional economy. Companies' new ability to delay holding liquidity events might cause inefficient retention in large private companies and could hinder the creation of successful new startups. (21) This Note seeks to draw attention to the role stock options play in the allocation of talent in the startup labor market--specifically in the rise of Silicon Valley--and voices concern about the erosion of this important incentive.

This Note proceeds as follows. Part I highlights the serendipitous circumstances that gave birth to the now-common model of venture capital-backed startups and, consequently, to Silicon Valley. It then turns to the policy discussion surrounding noncompete enforcement stimulated by Silicon Valley's economic success.

Part II introduces the academic debate on noncompete enforcement. It first describes the conventional economic analysis of noncompete enforcement and then describes the new wisdom regarding the relationship between this retention tool and the suppression of innovation and economic growth. Finally, it examines the empirical evidence economists have begun to collect regarding the effects of noncompetes on economic growth, employee mobility, innovation, and entrepreneurship.

Part III sheds light on the missing link in the discussion regarding employee mobility and Silicon Valley's success--employee stock options. It starts with a brief historical review of the use of broad-based employee stock ownership in Silicon Valley. It then continues with a short technical overview of the gradual vesting schedule, the potentially heavy tax implications of exercising stock options, and how these system design features can suppress employee mobility.

Part IV, the heart of this Note, discusses the efficiency attributes of a startup labor market characterized by a noncompete ban and a favorable approach toward employee stock options. Stock options protect the company's initial investment in R&D and employee training--much like noncompete agreements do. However, unlike noncompetes, stock options have the selective effect of encouraging employee retention only when the match between the employee and the startup is efficient from the standpoint of the regional economy, and only for a limited duration (throughout the vesting schedule and as long as the company remains private).

Finally, Part V concludes with a cautionary message. It turns the spotlight on unintended side effects of recent changes in the economic and regulatory environment that allow startups to grow in size and valuation without going public. Companies' current tendency to delay liquidity events, such as IPOs or acquisitions, affects employee mobility due to the lock-in effect of stock options. Therefore, lack of liquidity for employees might impair the efficient allocation of talent that has characterized Silicon Valley for many years and hinder the distinctive attributes of this regional economy.

  1. Silicon Valley's Birth and the Current Policy Debate

    One could start telling the story of Silicon Valley at different points in time: At the dawn of the twentieth century when radio fans began to gather around the San Francisco Bay Area; (22) in 1937 when Stanford University School of Engineering graduate students William Hewlett and David Packard started a small electronics company in a Palo Alto garage; (23) a decade later when Stanford Dean of Engineering Frederick Terman managed to open a university-based technology incubator; (24) or in 1955 when William Shockley, one of the fathers of the transistor, left Bell Labs to start his own semiconductor business in Mountain View. (25) As with any attempt at periodization, the choice is somewhat arbitrary. However, for the purposes of this Note, the story starts when a group of employees chose to depart and compete with their former employer.

    1. How It All Started

      In 1957, a group of young...

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