In the case of the company I was analyzing, equity grants expense made a HUGE difference in cash flow. It felt to me that if all the software companies and software company investors are agreeing to ignore the cost of equity grants, they are participating in a mass delusion, one that makes their businesses look much better when compared to other sectors. But I’m new to analyzing software companies, so it’s probably me.
Most US firms use GAAP accounting, but some use IFRS. The equity grant under IFRS used based around “IFRS 2 Share-based Payments” which you can look up. The company has to measure the fair value of the equity instruments granted at the grant date (if there is no market price, the so called “fair value” is estimated based on an arm’s length transaction with someone knowledgeable and wanting to trade). For GAAP, stock based compensation is shown as a non-cash expense on the income statement:
It is not shown on the cash flow statement, but I don’t think it should be in any case, because that is the whole point of stock based compensation - it allows the company to pay employees without changing the cash holdings. You are absolutely correct, though, that it is true economic loss to the owners, and so it should be expensed, which it is, in the earnings.
(As a mental experiment, if you wanted to compensate for the share dilution by buying back the same amount of stock (so shares outstanding remained unchanged) then you would be using up cash, which just demonstrates that there is a theoretical cash loss if the company was to not dilute its shares whilst paying the employees with stock - and this would show up on the cash flow statement. Many companies in fact do this, buying back stock at a similar intensity to the equity grants, and consequently use up their cash).
For software firms that are expanding super-rapidly, wanting to not use up cash, thus paying their upper management ludicrously via stock instead of cash, I don’t have much to say, except the following: The occasional successes (when the company succeeded, employees become ludicrously rich, and the shareholders also do well) seem to “make up for” (by which I mean “avoid shareholders complaints”) the many times the company flops (the employees still received huge compensation largely cashed out along the way, and the shareholders blame their own investing judgement rather than the ludicrous pay). The result is that not enough people complain about the massive employer compensation culture. The combination of these two paths - some companies winning, most failing - allow Wall St bankers to win each time, whilst the company shareholders tolerate the ludicrous compensation, in the off-chance that the company will be exceedingly victorious, but omitting that they usually will fail at some point (much further down the track), and shouldn’t have been paid so much along the way.
Having said that, software (which you brought up) is a truly great industry. I’m not discouraging investing in software firms, but just that the payment culture (especially in banking) more broadly is ludicrous, so software firms follow the similar Wall Street and City of London present cultural norms. Company X observes Y paying their managers more, so they ask their board for their pay to be raised, who are paid to agree. Iterate the previous sentence for a new X and Y value, repeatedly, and calculate the result after many years.
One of the very first things I do when investigating a company is to look at the change in shares outstanding since the IPO, or at least in recent years. If it the shares outstanding are going up, then the calculation of intrinsic value (IV) becomes much more difficult for me, and I usually skip the investment. I thus lose a lot of extremely good investments in this way because often expanding companies do genuinely require (and make excellent use of) massive, and even rather long-term repeated, cash access by continuing to issue shares whilst chasing a major long-term opportunity. Amazon used this method to bring in incredible amounts of cash for a long, long time, whilst not making money, and then in the end making a lot of money - but it is far harder to identify those that will make sensible investments, and those that are just spending the cash with a good story.
Sometimes, you only need a good story though, which brings up the next paragraph.
In addition to share dilution to pay staff, the share dilution is also often used by software companies to simply raise cash for operations. This has worked extremely well in the past - where the company trades far above intrinsic value. Allow me to explain, and hang in there because this is weird (and it is rare to meet an investor that understands it, in fact I have yet to meet or read about any such investor). You can form a company that has a good story, with the help of a reputable banker, issues shares above intrinsic value to raise cash, whilst having no operations of importance (other than broadcasting the story). You can do this indefinitely, and actually increase the intrinsic value indefinitely by doing so, provided the quote remains above intrinsic value as the cash is brought in by using shares above IV. Such a company could have no operations at all, but just trade consistently at, say 2 x cash, and it can continue to issue shares at 2 x cash if the market is confident enough about its prospects. To repeat, the intrinsic value (not only the quote) will rise indefinitely, even without any operations. It only needs a good story to make investors believe that the quote should be 2 x cash, and then keep in issuing shares as aggressively as it can get away with. This is hard to believe, but you can simulate the concept with a spreadsheet fairly easily. Keep the income near zero, (or some small loss to pay for hyped marketing and a charismatic CEO), have a good IPO for at least $1 billion in initial cash, and then keeping issuing shares to bring in more cash and set the price at some multiple of the cash holdings. Eventually it will pass $10 trillion in market cap (and have cash holdings of $5 trillion), and still have no operations.