Give Me Equity or Give Me Death - the Role of Competition and Compensation in Building Silicon Valley

Abstract

In this essay, I argue that the preeminence of Silicon Valley as an incubator of technology companies is attributable to equity compensation. Ronald Gilson, relying on the work of AnnaLee Saxenian and others who have noted the tendency of Silicon Valley employees to job hop, has suggested that California law prohibiting the enforcement of non-compete agreements was a major factor in the rise of Silicon Valley (and the demise of Route 128). I extend this line of thought by suggesting that California employers may have relied on equity compensation as a substitute way to bind employees. I argue further that equity compensation (in its many forms) is a superior way to assure the loyalty of employees. First, equity compensation induces employees to focus on how their efforts will contribute to the success of the business. Second, equity compensation saves cash for the startup firm and permits firms to compete for talent without offering more cash. Third, equity compensation forces the company to seek and plan for liquidity. Fourth, equity compensation induces employees to consider the prospects of the employer firm and thus induces employer firms to consider the ideas of employees. In addition, equity compensation may induce employees to exit unpromising ventures sooner rather than later thus allocating resources more efficiently. Fifth, equity compensation induces firms to maintain an efficient size. If a firm grows too large, too diversified, or too unfocused, equity compensation will become less attractive for employees. Thus, equity compensation will tend to induce spin-offs and other divisive transactions. Finally, equity compensation may be an efficient substitute for more intrusive forms of dispute resolution such as fiduciary duty. Employees will be less tempted to cut and run if they must give up bird-in-hand equity. Moreover, equity compensation is more fine-tuned than non-compete agreements. Whereas most non-compete agreements have a specified duration, equity compensation will effectively bind an employee only as long as necessary to assure the success of the venture.

Keywords: Silicon Valley, Route 128, industrial district, covenant not to compete, tacit knowledge, know-how, trade secret, collective action, market failure, stock option, equity compensation, venture capital, liquidity, diversification, spin-off, east coast deal, west coast deal, closely held corporation

JEL Classification: D2, E2, G3, J6, K2, L2, M5, N3, O3, P5, R1