They talk about stock-based compensation of the company and it do influence the balance sheet.
When stock price rising it is fine, but when stocks price falling,they have to reprice options, grant more shares, or pay more cash.
They mentions:
Crowdstrike
Snowflake
Shopify
Zscaler
Lyft
Crowdstrike
Paid $310 million in stock-based compensation in fiscal 2022.
Generated $442 million free cash flow in fiscal 2022.
Snowflake
Paid $605 million in stock-based compensation in fiscal 2022.
Generated $149 million free cash flow in fiscal 2022.
Zscaler
Paid $328 million in stock-based compensation in fiscal 2022.
Generated $196 million free cash flow in fiscal 2022.
That article’s treatment of SBC is too harsh (suggesting that most or all of the SBC should be subtracted from FCF). The assumption is that somehow the companies will pony up cash and pay more cash wages to their employees to compensate for a fall in value of their stock options/restricted stock.
That is not what happened historically in downturns if you look at how SaaS behaved in downturns like 2016, 2018 or 2020. Like other companies, they also tightened their belt and conserved cash. Nowhere did they try to make their employees whole by issuing more shares or pay them higher wages during downturns.
That’s not how it works in real life.
Companies will do that only if forced to do so, say, to stem an employee exodus - but with the stock prices of the entire tech sector hit and other companies also trying to conserve cash, where can those employees jump ship to? Nowhere.
I just want to clarify: I’m not saying that SBC does not matter. It clearly does, but the impact is greatest in certain companies, namely,
Companies with high SBC/revenue (those are the ones relying on their expensive stock price, rather than cash, to pay employees; and now with the slump, they can’t do that anymore).
Companies which don’t generate much FCF or have the most negative operating margins. They are caught in this “death spiral” where their stock prices are hit the hardest in the current market (with their employees taking the most “pay cut” from those devalued options). At the same time, they don’t have the resources to pay their employees more. Any attempt to pay out more cash wages results in their non-GAAP operating losses deepening, which then results in their stock price falling even more.
I am glad that CRWD and DDOG are behaving in a responsible way where their SBC/Revenue is less than 20% which is in line with companies like ServiceNow. their stock dilution is also running below 2% a year (again in line with Servicenow). This is the well-trodden path to SaaS greatness, which CRWD and DDOG are embarking on.
Now, I can’t say the same for companies like Sentinelone, Snowflake or Zscaler where their SBC/Revenue are running at above 40%.
By the way, Sentinelone has a non-GAAP OPM of MINUS 72%; and if you subtract their SBC of 43%; their GAAP margin is actually a mind boggling MINUS 115%.
For these companies, it can be fairly argued that there were using their expensive stock prices to prop up their non-GAAP operating margins (since SBC doesn’t go into non-GAAP margin calculations).
If you think that’s bad, try looking into the tier 2 SaaS names that were not discussed much on this board - you will be shocked by how much they are using SBC to pad their margins.
The reality is there were a lot of value-destroying behavior among many SaaS companies which were camouflaged by low interest rates and inflated valuation in 2020/2021.
Taking SentinelOne as an example, how does it really effect them financially? My experience having been a tech employee thru a few of these is the following:
All companies end up re-pricing their existing stock option grants. Nobody is offering cash instead to employees as the article states (perhaps Shopify, but don’t expect this to get traction). So if you are an engineer holding say 1000 options that were granted when you started employment at the company in Nov 2021, your grant was perhaps priced at $62 lets say.
I don’t believe the company expends any cash until the option is exercised?
So, that engineer’s options are deeply under water and worthless, compared to what he can attract on the open market. Perhaps NET wants him to join and he can get new options at 10% off today’s NET price. So SentinelOne is forced to “reprice” their employee options. Essentially, the employee gives up the existing options and the right to exercise those for having them replaced with new options at closer to market price today, but with the caveat that goes with all new options, which is you can’t exercise them for normally a year from grant date.
Financially, what just occurred by repricing these options? It seems like nothing has financially happened. But perhaps I’m wrong here? It keeps the tech guys all working as potential owners of the company. Companies whose stock price gets crushed do this all the time to keep their employees “in the game” and from being poached away. So yes, while a company like SNOW currently has huge SBC payouts, will they have almost no payouts in the coming quarters since nobody will be exercising those underwater options? Again, I’m not sure how the accounting goes on this for cash flow. But it seems like the actual repricing of options is what will happen, and that by itself is a non-event in terms of cash flows, until some time in the future when they are exercised.
"Financially, what just occurred by repricing these options? It seems like nothing has financially happened. But perhaps I’m wrong here? It keeps the tech guys all working as potential owners of the company. "
If nothing financially has happened when you reprice options, we are essentially saying stock options are “free money” and has no consequences to existing shareholders. That can’t be right.
What happens when you reprice options is more dilution at a given stock price.
Suppose at the height of the mania last year, S’s stock price is at $80 and its options have an average strike of $120. that’s out of the money and not counted towards shares outstanding.
Now S has to reprice its options to $40 for example. So now, once the stock price goes above $40, options are in-the-money and would be included in shares outstanding; and shareholders like you and me now own a smaller piece of the company.
and it also causes a larger “EV” relative to the same revenue and make the valuation higher (and all else being equal, will cause the stock price to fall).
If nothing financially has happened when you reprice options, we are essentially saying stock options are “free money” and has no consequences to existing shareholders. That can’t be right.
What happens when you reprice options is more dilution at a given stock price.
Suppose at the height of the mania last year, S’s stock price is at $80 and its options have an average strike of $120. that’s out of the money and not counted towards shares outstanding.
Now S has to reprice its options to $40 for example. So now, once the stock price goes above $40, options are in-the-money and would be included in shares outstanding; and shareholders like you and me now own a smaller piece of the company.
and it also causes a larger “EV” relative to the same revenue and make the valuation higher (and all else being equal, will cause the stock price to fall).
The scenario above though isn’t realistic. Stock option grants are never $120 when the stock all time high is $78.53. The grants are typically priced close to the “current price” so when they were granted at say $80, and they are now taken off the market and re-granted at $40, they represent the exact same thing that they always represented - that is POTENTIAL dilution. Potential, meaning that they will dilute if the stock price gains from the grant price. Which is a lot better than the stock not appreciating and the options are therefore never exercised.
I don’t see the case where the dilution today is different than the dilution was before, which is the argument the Barron’s article makes. I had my stock options repriced during the dot-com meltdown several times. There was no “loss of employees” because of SBC. We had options repriced from $40 to $3. We went thru 3 years of literally nobody exercising options and thus the company had $0 SBC costs on it’s cash flows. When the business started to recover, the stock price started to recover and the SBC flows began again.
And to be clear, SBC is dilutive - always. But I am stating that it’s not more dilutive or less dilutive in the scenario Barron’s outlines. Repricing stock options will have to happen to keep employee’s from all changing jobs. But the actual repricing itself is not more or less dilutive, at least that I can see.
“But the actual repricing itself is not more or less dilutive, at least that I can see.”
But it does. in your example, when your options are repriced from $40 to $3, all those options become in the money when the stock price is at, say, $5.
Before repricing, those $40 options are not worthless, but they can’t be exercised. with the repricing, it does. This is why it’s more dilutive.
It may help to retain employees but it comes at a cost to existing shareholders.
we are essentially saying stock options are “free money” and has no consequences to existing shareholders.
The key issue with options is that they potentially (they have to be worth exercising) impact the shareholders, but they don’t financially impact the company other than the relatively trivial amount of money they get when the options are exercised.
GAAP requirements that one expense the options add to the confusion.
The key issue with options is that they potentially (they have to be worth exercising) impact the shareholders, but they don’t financially impact the company other than the relatively trivial amount of money they get when the options are exercised. GAAP requirements that one expense the options add to the confusion.
Thanks tamhas, I was wondering when someone would point out the obvious. Stock options (if exercised) dilute the shares, and thus reduce earnings per share, but giving out stock options doesn’t cost the company anything, not a penny, and GAAP’s insistence that they be expensed as an imaginary non-cash expense, is just those obsessively righteous accountants saying “We’ll punish those naughty boys who give stock options by making believe it’s an expense as well as a dilution”, which is why no-one pays attention to GAAP results except the SEC, and everyone else uses adjusted results, including the CFO’s in the conference calls, the CEO’s in analyzing the business progress, and the analysts.
JMHO
Saul
But it does. in your example, when your options are repriced from $40 to $3, all those options become in the money when the stock price is at, say, $5.
Before repricing, those $40 options are not worthless, but they can’t be exercised. with the repricing, it does. This is why it’s more dilutive.
It may help to retain employees but it comes at a cost to existing shareholders.
My point is that when the $40 options were granted and the stock was say at $44 (10% discount), the options cost the company (assuming no change in stock price) only 10%.
So if the stock then drops to $5, those options are worthless. The company is then forced to re-issue those options at the same 10% discount rate, so now at $4.50 strike price.
So yes, there was a VERY brief period of time where those options were under water and had no effect on the company’s financials. And for that period of time, they were vulnerable to losing their key tech talent.
But in the end, re-pricing those options has ZERO net effect on the company compared to when they were actually issued. Sure, they dilute stockholders, but there is no change to that. They diluted the stockholders the same either way, simply by the # of shares in the option program. Barron’s tries to make the case that repricing the options is some sort of catastrophic event, and it has no effect compared to the original issuance. In fact, in a falling market, it makes the SBC program cheaper to fulfill for the issuing companies.
the options cost the company (assuming no change in stock price) only 10%.
Issuing the options costs the company nothing … unless you are going to count the opportunity cost that they could have sold those shares in a secondary option. In fact, if the option is ever exercised, the company gains money.
My experience around options that were repriced is that the employees of the company are given a choice something like this. Before going into it keep in mind this important point - it is not a one for one exchange, as you will see.
Let’s say you have an option to buy 1000 shares with a strike price of $78/share vesting over four years at 25%/year. So every year you stay with the company you have the right but not the obligation to buy 250 shares at $78/share. The option typically expires in ten years or when you leave the company whichever comes first.
Now let’s say the stock price goes way down to $20/share leaving all your options underwater.
At least in my case all employees were offered to have their options repriced at the new $20 price by turning in their current options at a ratio of 3 to 1. (I can’t remember the exact numbers it was so long ago.) This is an important point - if you choose to accept the repricing offer the amount of shares dropped significantly to the original option agreement. It is based on a percentage usually derived from a model knowns as Black- Scholes. I’ll put a link to an explainer below.
All of the option pricing/repricing for a public company is transparent to shareholders - it is fully disclosed in the company’s filings with the SEC.
The bottom line is there is no free lunch for the employee - it is no fun to have your options repriced.
As for shareholders I am not sure how this would negatively impact them unless the company started paying out cash to retain the employees. There will be less dilution as a result of repricing not more dilution as the shares in the employee option pool will be dramatically reduced.
I’ve read through this thread, and thought I would add an additional perspective as a fairly senior engineer who has worked across multiple enterprise SAAS companies.
I’ve never been offered options. I know very few employees who are. RSU’s are the way that the majority of stock grants to employees in larger companies occur. These vest on a schedule, resulting in dilution regardless of volatility of the companies stock price.