Musings on stock-based compensation

I was just looking into a very rapidly growing company which gives a real lot of SBC. Some posters where I was reading were quite unhappy with this. I was thinking to myself that perhaps all this stock-based compensation is really a good sign. Clearly, if the people working at the company are willing to accept stock in place of larger cash salaries that they would get at a stalwart, they must be convinced that the value of the stock they receive is going to keep going up (in spite of the dilution that the SBC inevitably causes). Otherwise they’d say “no thanks”, or go to work elsewhere.

Wow!, As I wrote that, it came to me that this ties in to the study that someone quoted here a month or so ago, which I think showed that high levels of SBC correlates with stocks that turned out to be the most successful investments. Interested in thoughts from others on this.

Saul

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I like the incentives attached to SBC compensation, and believe that the best companies where the stock compounds is able to attract as well as retain the best talent.

But I think it’s a fallacy of division to assume that because some of the best stocks had high SBC, that SBC is a metric we should actually be looking for. You don’t hear about the high SBC companies that fail to provide an adequate return.

Instead, high SBC should just be a characteristic to take note of - if the dilution outweighs the growth rate/runway of the company, then you avoid the stock, if not, then you buy the stock. The fundamental analysis that you describe in your knowledge base is still a far more important characteristic to screen against rather than high SBC

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I think I am unusual in this but do have good company (including, I think, Buffett).

I do not think company insiders should be rewarded using the company owners’ cash. If a director or employee is really doing work above and beyond what his generous salary expected (he probably is not) he could receive a bonus. If the employee chose, he could then invest the money in the same shares the owners of the company buy and in the same market.

It is often said that options 'align the interests of etc. etc. This is self-serving tosh. The owners get diluted, quite often significantly. Quite often the owners do not even know they have been significantly diluted, thus it appears underhand.

I think the practise should be abandoned. Let them buy shares in the open market like everyone else. That’s what I call ‘aligning the interests of shareholders and management’! All for one and one for all. No special backroom deals here.

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The fundamental analysis that you describe in your knowledge base is still a far more important characteristic to screen against rather than high SBC

Hi Aphalite, It never really even occurred to me to actually screen for companies with a lot of SBC. I wouldn’t dream of doing that. I was just playing with the idea that if you have already found a company you think has great prospects but also pays a lot of SBC, maybe management thinks they have great prospects too, and that’s why they are willing to accept SBC in place of cash (to some degree).
Saul

Clearly, if the people working at the company are willing to accept stock in place of larger cash salaries that they would get at a stalwart, they must be convinced that the value of the stock they receive is going to keep going up (in spite of the dilution that the SBC inevitably causes).

I’ll offer a caveat. If I’m an executive facing:

  1. something like 50% or 100% more total compensation than last year, even if it is on paper

or

  1. a 5-10% raise over last year

…then I am very likely to accept SBC and take my chances with share price and dilution.

This to say, even without looking at the numbers, I seriously doubt executives are willing to accept SBC if they’re being paid something similar to what they’d get in cash. My guess is, accepting SBC is a way to get paid more.

  • Bear

I think you are right. In negotiating salary and SBC you want to strike a good balance but you will not accept lower salary for a bit more SBC. The salary is the main compensation base and it needs to be good. What happens is if the IPO or the stock takes off then you earn many times your salary but that is often not expected. It also depends on if it is an early stage start-up or a more established but growing company. You would negotiate salary and SBC differently. I have been to start-ups that gave me a very large SBC but it turned out to be worth nothing. Thankfully I did not back off that much on salary.
SBC is definitely a motivating agent especially in a start-up. For the larger companies the motivation tends to be diluted as well since much of the thing is not resting on your shoulders alone.
Here in the Valley SBC is a norm. Every tech companies around here give SBC and it is expected from workers.
I can understand that for investors that may look like dilution of their share but if you need the people to work and have them happy to make the results that will eventually reward the investors. On the other hand, when things do work out or the business never grow so much to give these rewards then the investors should be wary. There are many tech companies that do not treat the investor properly. We (investors) should shy away from those even if they may be an ok place to work.

tj

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Having read the whole thread, no offense, but I find the opinions expressed a bit simplistic. Stock options can be a good thing and they can be abused so it behoves the investor to find out how they are being used on a case by case basis.

Aligning interests is relative. If the stock is sold as soon as it is received there is little future alignment, only short term alignment like with bonuses. On the other hand, since getting the stock causes a tax liability it makes sense to sell enough stock to raise cash to pay the income tax.

I don’t pay much attention to stock options but I do check share count on the quarterly reports to make sure I’m not getting excessively diluted.

Denny Schlesinger

An alternative to stock options is to sell treasury shares to workers at a predetermined discount (and other limitations). IBM had such a system when I worked there on the early 1960s. I never bought any.

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Denny,

Exactly what I wanted to say. It’s not as simple as it’s all great or let’s dump all SBC.

Just to ad to the other side of the coin - I want the management team to be rewarded based on stock performance and giving them a straight cash bonus from the revenue is not efficient (taxes) while stock from buybacks is not the way to go for young companies that are just starting to break even.

Now there are managers that I would not worry about - Bezos, Page or Musk can carry their businesses on their passion alone. But executives for hire, however competent they might be - I want their financial interests aligned with mine as much as possible.

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I do not think company insiders should be rewarded using the company owners’ cash.

Here’s the deal:

• If you want your employees to act like like workers, you pay them a working salary.

• If you want your employees to act like they own the business, you make them co-owners of the business.

It really is that simple. When the people who can make a difference in the success of the company have a stake in the success of the company, they make decisions that improve the success of the company. If they don’t, they tend make decisions that help their department, or worse, their careers.

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If you want your employees to act like they own the business, you make them co-owners of the business.

Why should we have to make them be owners? Why can’t they buy the stock themselves with their own salary? I know a lot of companies offer an employee stock purchase plan and even offer shares at a discount. I wouldn’t have a problem with that. Forcing shareholders who purchased shares on the open market to sacrifice a part of their ownership is just wrong. An employee gets a salary. They see it as safe and secure. Many of them that is what they want. An investor gets capital gains and dividends. We take the risk of purchasing shares with our own money taking a risk for the possibility of greater rewards. Why should we be forced to sacrifice a percent of our ownership to give to those who didn’t take on the risk of buying shares? If a founder wants to give away a part of HIS shares by all means let him but don’t start giving away someone else’s shares.

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Here’s the deal:

• If you want your employees to act like like workers, you pay them a working salary.

• If you want your employees to act like they own the business, you make them co-owners of the business.

It really is that simple. When the people who can make a difference in the success of the company have a stake in the success of the company, they make decisions that improve the success of the company. If they don’t, they tend make decisions that help their department, or worse, their careers.

It sounds logical enough but I wonder if any serious study has done to verify the effect. After all, Options don’t make you owners as much as potential owners until you can exercise them. I have seen quite a few people early just want to jump from one place to the next chasing the potential to make big money on options. Having worked at a failed .com back in the day, I would notice the number of options sky rocket when things got shaky as well as many just jumping ship when they would see their options were not likely to be exercised anytime soon.

The attitude just seemed it would be easier to start anew with fresh options that try to climb out of the hole. It didn’t really produce much loyalty like you get out of owners when there is a possible delay or setback with options already given.

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Options are cheap, cash is precious. You want talent, cash burn is an issue, your only currency are stock options. No lose for management. Things don’t work out they cost you $0. Things do work out, nobody cares about the dilution.

Stock options are another form of economic stimulus. Creating perceived wealth out of potential. Causes talented and expensive people to work for less money than they otherwise would be able to demand and that you could not afford.

It is another competitive advantage of a fast growing public company with a story to tell.

Tinker

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Smorgasbord1: I am sceptical about your final para. I regret that loyalty to companies died long ago (hence the vast riches of head-hunters, second only to hedge-fund managers). Share options are just money; probably useless in retaining staff except in terms of the general remuneration arms race. An enticement to be sure but a badly-designed one, susceptible to a misplaced company generosity which is sometimes seriously disadvantageous to the owners of the company.

As an owner I do not delight in being diluted in this way. However, I do agree employees should be encouraged, or even required as a condition of employment, to align their interests with owners in some way. Food for thought. Obviously the outcome for them would lie several years hence and depend on company success defined by return on invested capital during the period of their employment.

I regret that loyalty to companies died long ago

Well, it’s been mutual on both sides. Does anyone get a gold watch or a full pension from a private company anymore?

Share options are just money; probably useless in retaining staff except in terms of the general remuneration arms race.

Actually, they are a key element in retaining staff. Typically, employees vest in shares over at least a 4 year period, often late-loaded into the final year. If the employee leaves early, he leaves the shares behind. And if the company has done well, those shares are worth money. So, unlike a salary where you earn as you go, with shares your earnings are often delayed, and only if you stick around.

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Why should we be forced to sacrifice a percent of our ownership to give to those who didn’t take on the risk of buying shares?

The employees take the risk of putting part their livelihood at risk against the company doing well or not. And, unlike you, the passive investor, they don’t get to sell on a whim only to buy back later. They’re in it for a long haul, typically 4 years.

Forcing shareholders who purchased shares on the open market to sacrifice a part of their ownership is just wrong.

Companies like Alphabet, Amazon, Apple, Facebook, and Netflix disagree with you. And their stockholders are richer for it.

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Smorgasbord,

I was probably a bit blunt in my last post. Obviously I don’t like stock based compensation though as an investor I have learned to tolerate a little bit. I feel it is a double edged sword which will cut you both ways if your not careful. In moderation I could see how it may be alright at times. It is just some companies abuse it. I also don’t like how companies seem to hide it as Ambarella seemed to do in their report today. I posted about that up board so I will not get into that here.

When I am selecting stocks I have made SBC actually one of the first checks I do. If it is too high I throw the company out because it is dangerous investing long term when your shares are being diluted away at a rapid rate. My personal limit is 10% of revenue. If SBC exceeds 10% of revenue I go elsewhere. It is also something I monitor quarter to quarter closely. If it starts to get out of control I mark it as a yellow/red flag depending on how bad it has become. There are plenty of other companies out there to pick where I feel more comfortable.

I just found this tonight and found it an interesting read on this very subject. This article may have been posted before though I haven’t seen it so here it is. Sorry if it has already been posted…

http://www.fool.com/investing/2016/06/16/stock-based-compens…

Best,
Soth

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My personal limit is 10% of revenue. If SBC exceeds 10% of revenue I go elsewhere.

Hi Soth, I find that a curious limit, even feeling about it as you do. You are not considering company growth in that limitation at all. For example, if a company was growing revenue at 5% and diluting stock by 10%, I’d agree with you totally. On the other hand, if the company is in hyper-growth mode and growing revenue at 50% per year compounded, and diluting stock by 10%, they are producing a lot of growth of capital for me, and more power to them. But that’s just the way I see it.
Best,
Saul

PS. - Growth like that is not impossible by the way: Shopify, for instance is compounding revenue growth over 90%, Arista by 60+% and 43%. LGIH by about 60% for three years, HUBS by 50%, etc.

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Hi Saul,

You make a good point and I guess my quick answer is I usually consider it on a case by case basis. Though if a company doesn’t meet this quick check I almost always throw it out regardless of growth rate. Does it matter how much they grow if my ownership is diluted down to nothing? I only use 10% because it is an even number relatively easy to calculate on the fly. It is also an amount that is relatively easy for many companies to beat and seems to weed out the worst of the offenders. It is something that I only started doing within the last year so I am still in test mode and open to alternatives if someone has a better idea.

Going through a few of the stocks you mentioned I actually have been considering Shopify and it actually meets my quick little test according to the most recent earnings release. They have SBC of 8.3 million for the 6 months and their revenue is $159 million for that same 6 month period. I noticed it is a metric that has grown quickly over the previous year so it is something I would note and watch going forward. Sadly I have been watching SHOP and have not bought yet. I haven’t found the time to dive in and do proper research so I have passed for now. It seems to be a great stock for those invested and I am happy it has performed well for those here who have invested. I still have to stick to my rule that I don’t buy a stock until I have researched it fully. Those numbers look awfully enticing. I may have to dive in this weekend. :slight_smile:
https://s2.q4cdn.com/024715446/files/doc_financials/2016/Q2/…

I have actaully been an investor of LGI Homes which I discovered after it was mentioned here on the boards. I am very grateful for it BTW as it has been a great stock for my portfolio along with many others it sounds. Though unless I am missing something I don’t really see any mention of SBC in their last earnings release. Maybe it is in the sec filings as I haven’t checked there yet. I am not all that worried as the 6 month diluted share count seems to have actually dropped.

Arista (ANET) is a company I am not at all familiar with though quickly looking at their latest release they are also within my 10% check and it looks like their SBC growth is leveling off a bit. Their 6 month revenue is $510 million and SBC for the same 6 months is 27.5 million. As a company grows and gets larger it seems many companies have a tendency to also become less dependent on SBC at least as a percent of revenue. The main reason I passed on ANET is because I often avoid networking hardware companies. It is just an industry I always had a hard time getting excited about and personally don’t like to research.
https://finance.yahoo.com/m/5606a66d-b40e-388b-9209-39f27918…

Fleetmatics (FLTX) is a company I owned personally though it barely exceeded my SBC limits. I decided to invest anyway knowing it was barely over 10% of revenue with the idea that I would watch it closely. They have Q1 revenue of $78.9 million and SBC of $8.2 million. I got lucky on this one when it was announced they would be acquired by Verizon for a quick 2 month gain. I wish this happened more often. :slight_smile:
https://finance.yahoo.com/news/fleetmatics-reports-strong-fi…

I guess you can say I don’t find my 10% bar all that hard to clear and keeping this as a regular metric I check just makes me feel more comfortable as an investor.

Here are some of the companies this quick check will keep me from buying…
Workday(WDAY) -
6 month Revenue: 723 million
6 month SBC: 166 million
You might notice SBC accounts for almost all the the difference between GAAP and non-GAAP earnings. I find these gaps to be a yellow flag and something I like to look into further.
https://finance.yahoo.com/news/workday-announces-fiscal-2017…

Twitter(TWTR) -
Quarterly Revenue: $602 million
Quarterly SBC: $167 million
Once again SBC accounts for almost all the difference between GAAP and non-GAAP
https://finance.yahoo.com/news/twitter-posts-second-quarter-…

Linkedin(LNKD) -
Quarterly Revenue: $711 million
Quarterly SBC: $145 million
Yet once again SBC is the biggest difference between GAAP and non-GAAP earnings.
https://finance.yahoo.com/news/linkedin-announces-second-qua…

Don’t get me wrong I am not at all saying these are terrible companies and they may go on to be great investments for shareholders as well. I am just saying excessive SBC is a headwind I would rather not deal with in my investments. I think all three of these companies are wonderful businesses and have done a lot to make society better in their own way. Though as a potential shareholder I realize there is a big difference between a good company and a good investment. When researching companies I feel it is important to not only research the company but also research the ownership structure linking the shareholders to the company. Does the management have shareholder friendly practices that will optimize the chance of me getting a successful return on my investment?
Every time I think of SBC my thought goes to the movie “The Social Network” and how in the movie the original CFO of facebook was diluted almost entirely out of his ownership in the company by the other execs. It is a good movie if you haven’t seen it.

Best,
Soth

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Thanks Soth, Nice discussion. Appreciate your contribution to the board. I was in LNKD for a short time, but exited. I can’t remember ever being in Twitter or Workday.

Best

Saul

Companies like Alphabet, Amazon, Apple, Facebook, and Netflix disagree with you. And their stockholders are richer for it.

I am sure you can find far more companies that stockholders are not richer for it yet they still disagree with me or other shareholders.

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