GAAP vs non-GAAP

Stock-based compensation, in my perspective, is a way of taking money from shareholders to compensate company executives, without affecting the company’s bottom line. It is also a very very good way to pay employees at small up-and-coming businesses, when they are growing rapidly but aren’t generating a profit yet so cash-flow is an issue.

The problem is, where do you stop stock-based compensation? Is there a percentage of revenue that is considered acceptable? Is the growth of the company a big factor here, where LinkedIn can get away with an enormous amount of stock-based compensation, while other companies can’t?

From personal experience, one of my jobs is at Costco. The CEO, Craig Jelinek, likes to advertise to people and employees that his salary is $500k a year, that’s it. In reality, he makes about $6.5 million, due to stock-based compensation. Granted that isn’t a lot for a company this size, though he does get to exercise quite a few options as well. Part of the problem though, is that there is this big gap between executive officers, and regular employees. There is an Employee Stock Purchasing Plan, though it doesn’t offer any real reason to participate in it - no lookback period, no discount on the stock price, nothing. If you want to get employees motivated in their company and working harder, it works pretty well if they have a vested interest in the company succeeding - and that’s where stock-based compensation and other incentives come in. So why is it that executive officers get all kinds of extra stock-based compensation and free options, especially when they’re on a Cap Ex spending rampage without having a clue about what the business should do to continue growing in the next 5 years?

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I think the most important thing is that when you read the reports it doesn’t matter whether you start with GAAP and look at the adjustments or look at non-GAAP and see how it reconciles back to GAAP.

Yup, that’s the point. You want the management be rewarded bonuses based on stock performance. If you give them cash, it will lower the EPS (lower earnings). If you give them stock, it will lower the EPS as well (more shares). There is one difference though - in the second case you pay much less taxes.

I think the bigger question is whether or not it is an expense.

Exactly.

If a company issues stock or options to pay for consulting, the consulting is still considered an expense. It doesn’t suddenly disappear from the income statement. The expense for consulting is recorded at fair market value. Same goes for issuing stock or options to pay for other goods or services (or assets).

If a consultant and an employee both work together to create a product, and they both are compensated with options, why would one be an expense and the other not?

Ears

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Recording stock options as expenses is a big conceptual accounting mistake because it is not the company funding the expense but the shareholders who have their own separate accounting where it should properly be recorded.

Let’s suppose three of us get together to found a lemonade stand. Partner one buys the lemons. Partner two makes the lemonade. Partner three serves customers. The business grows and they decide they need someone to manage the accounts. Instead of hiring a manager they elect to take on another partner. The new fellow will get ten shares from each of the original partners. The business accounts are not affected at all but each partner paid for the new managing partner.

The shareholders are entirely separate entities from the company and their accounting systems should not be commingled. The reason many businessmen hate stock options is because it is avery successful maneuver.

June 11, 2002
Options Math

http://softwaretimes.com/files/options%20math.html

Denny Schlesinger

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I like thinking of stock-based compensation in the way Denny described. If you are looking at the company from the perspective of a potential buyer of the stock, then you must understand if stock options are part of the deal. If they are, you absolutely need to adjust your expectations lower to reflect this, because as Denny said - stock based comp is paid by the shareholders.

SBC cannot be ignored, and it is a very real cost, but it is only a real cost to shareholders. If Company A has operating income of $100m, and 100m shares outstanding, and zero SBC, then Company A becomes a less attractive investment - from the view of a stockholder - if operating income is spread over 105m shares.

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Ears,

Very good to hear from you. You understand accounting as good as anyone I believe, yet I’m not sure this is an accounting issue. I may be thinking about this too much and am somewhat surprised others haven’t chimed in.

So far, I’m in Saul’s camp. It is as simple as this. I don’t see why the numerator (profit) needs to be reduced in kind with the increase to the denominator (# of shares). That just doesn’t make any sense to me.

I am not trying to persuade anyone and am not just following Saul blindly.

Where is Monkey? Sorry Monkey but here goes.

If the number of bananas in the rainforest is set, one could divide the number of bananas by the number of monkeys, to get bananas per monkey. But us monkeys tend to procreate increasing the number of monkeys (denominator).

For those who believe in GAAP, should we reduce the number of bananas by the same amount we increase monkeys when calculating the new bananas per monkey?

This is not tongue in cheek.
And again. Sorry monkey.

Thanks,
AJ

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GAAP vs non-GAAP is, of course, not only about stock based compensation, but it is one of the more frequent factors, especially in rapidly growing tech companies. I think the key issue here is that giving stock options is an important thing to know about the company, especially since it has sometimes been done to excess at the peril of stockholder value, but it is not a fact about how the business itself is doing. In this, I think Saul is exactly on the mark. Additional shares are an important factor in the stockholder’s accounting, but not the company’s.

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yet I’m not sure this is an accounting issue

It’s an economic issue. If fully diluted EPS is a useful way to understand the impact of share options, then whenever a company issues stock to pay for goods or services we should exclude that expenditure from the bottom line. So rent, consulting, raw materials, a building – anything – paid with shares should be excluded from the income equation if we are to be consistent with our analysis.

Ears

Ears,

I guess based on today’s discussion, I disagree.

Maybe this is something everyone on the board has already reconciled for themselves. I had not.

If a company issues stock irrespective of its use, I only see it as dilution and not affecting the income.

I don’t know if there is any more to this issue. Again, if it was something that everyone takes for granted already and has their mind made up on, sorry for the waste of bandwidth.

AJ

" important factor in stockholders accounting, but not the company’s. "

Good point, easy to understand, and true.

Denny really hit it on the nose here:
The shareholders are entirely separate entities from the company and their accounting systems should not be commingled.

Thanks Denny, That was just what I was trying to explain here:
You have a right to be angry that the company gave away 5% of what you would have had. But the abstract COMPANY doesn’t know or care who its shareholders are, or how many they are, or how they are divided up. The COMPANY just knows that IT made a million dollars, and that money is in the bank, and on its balance sheet as Cash..

And as Tamhas said a little further on:
I think Saul is exactly on the mark. Additional shares are an important factor in the stockholder’s accounting, but not the company’s.

And as bobolaw said: it is only a real cost to shareholders.

And this below is also wrong. Another error of GAAP accounting, GAAP nonsense: If a company issues stock or options to pay for consulting, the consulting is still considered an expense. It doesn’t suddenly disappear from the income statement. The expense for consulting is recorded at fair market value.
But it’s NOT an expense for the abstract COMPANY at all! It doesn’t cost the company a penny. It only dilutes the stockholders. The company gets it for free.
Any one has a right to be angry at the board for diluting their ownership in the company. But how many shares there are, and your percentage ownership in the company doesn’t matter a hoot to the company. It doesn’t cost the company a penny.

Thanks you all for a great discussion. This is the best discussion of stock-based compensation I have ever read, and really helped me to clarify it in my own mind! Thanks very much.

Saul

For Knowledgebase for this board,
please go to Post #17774, 17775 and 17776.
We had to post it in three parts this time.

A link to the Knowledgebase is also at the top of the Announcements column
on the right side of every page on this board

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Because I’m relatively new to the game within the past four years or so, I’m often discouraged from writing either because it may be completely stupid or it is something that everyone already takes for granted.

Thanks you all for a great discussion. This is the best discussion of stock-based compensation I have ever read, and really helped me to clarify it in my own mind! Thanks very much.

I sure am glad I started asking about stock based compensation after Saul started this discussion.

Thanks to all who chimed in on this discussion.

It truly is the difference between accounting and common sense I think. And sorry to all of the accountants out there who take GAAP as gospel. I’m sure you have your reasons as well. They just don’t make sense to me as an engineer and not an accountant.

Regards,
A.J.

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