Equity Illusions


Equity compensation grants for rank-and-file employees are common among venture-backed start-ups and are considered an ingrained part of their business culture. However, extremely little is known about start-up employee equity holders. This article takes a first step toward filling this gap. More than 1,000 U.S. employees with a college-level STEM degree participated in a survey experiment. Through the combination of natural language processing and machine learning techniques with conventional regression modeling, we examine employees’ financial literacy regarding equity-based compensation and their willingness to forego cash compensation for start-up equity. The findings indicate that employees commonly respond to economically irrelevant signals and misinterpret other important financial signals. Thus, respondents demonstrated a greater demand for equity grants when the number of shares offered was relatively large, even though the ownership percentage was fixed. This tendency is associated with low level of financial literacy regarding equity-based compensation as measured by a three-item test developed in this study. The findings suggest that employees harbor a range of “market illusions” regarding start-up equity that can lead to inefficiencies in the labor market and that sophisticated employers can legally exploit. The study’s results raise serious questions about the protection of employees in their investor capacity in a market in which highly sophisticated repeat players—namely, venture capital and other private equity investors—interact with unorganized and uninformed retail investors.

Forthcoming in Journal of Law, Economics, & Organization