On Stock Based Compensation

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On Stock Based Compensation

We recently had a discussion of SBC as a side issue on another thread, but I thought it’s such an important issue, and otherwise bright guys get so tied up and moralistic about it, that I thought it deserves its own thread.

First, in discussing his worries about Sentinel, one of our valued posters wrote:

First, dilution: S’s weighted average share count was up 7% in the last 4 quarters. That’s quite a lot. More than most companies we follow I believe.

I suggested a different way of thinking about that. Sentinel had 7% more shares than a year ago but revenue was up 106%. That means revenue per share was up 92.5%. Did he consider having 92% more REVENUE PER SHARE of stock a damaging dilution? Did he have any other companies who had revenue per share up 92% last quarter ???

Then he went on to discuss his worries about GAAP operating margin (so he included expensed SBC according to the way GAAP requires).

I responded: Well, actually, SBC causes dilution but doesn’t cost the companies a penny. Expensing SBC has nothing to do with reality.

GAAP counting it as an expense AND a dilution is just the way the bunch of obsessive CPAs who created GAAP decided to punish the tech companies who used SBC for being bad boys.

Look, if a company creates and gives away a share of stock , it dilutes the stockholders by a share, but it doesn’t cost the company anything. And if they give away a thousand shares it doesn’t cost the company any more than one share, which again, is zero dollars.

If the adjusted earnings are $5 million but the company gives away 100,000 shares worth $20 million , guess what? The company doesn’t actually lose $15 million. In actual dollars that you can hold in your hand, it makes the same $5 million they had before GAAP started messing with them. That’s the profit they have before capex, etc. Those 100,000 shares didn’t cost the company anything. They just diluted us.

And that’s the reason that every one of our CFO’s says “when I give results everything after revenue will be in adjusted figures,” and why they say they use adjusted internally to evaluate how the company is doing, and why both company and analyst estimates are in adjusted numbers, etc.”

Then another bright guy, talking about Bill, wrote:

“This is a whopping 31% increase in share count over just the last two years! This kind of dilution is very excessive and going to make future returns difficult if they continue at this pace. I expect much of this was driven by the Divvy and Invoice2Go acquisitions.”

I couldn’t believe it and pointed out that two years ago Bill had $46 million revenue in the quarter. This last quarter they had $230 million. That’s FIVE TIMES as much revenue as they had two years ago !!! 500% as much revenue !!! And he was complaining about 31% dilution in that time???

It seemed so ridiculous to me that I accused him of kidding. Bill had two crucial acquisitions that changed the entire nature of the company, and if they paid 31% dilution to have 500% as much revenue it was well worth it. They had almost four times as much REVENUE PER SHARE as two years ago! Wow! what a catastrophe!

Do you have any other companies with four times as much revenue per share as two years ago?

The only possibility would be Sentinel which has grown revenue from $25 million to $115 million in that quarter in the last two years. That’s 460% as much revenue as two years ago !!! And assuming 7% dilution each year, the REVENUE PER SHARE of our stock is now 402% of what it was two years ago, so four times as much revenue per share! Wow! What a lot of dilution !!!

To summarize. Yes, the SBC dilutes our shares but a few per cent dilution in a company growing by leaps and bounds turns out to be insignificant (Sentinel and Bill were good examples of that), and the SBC is good for our investment as it binds the company employees interest in the stock price growing to our interest in the stock price growing (instead of having them just take their salaries and go home). SBC dilutes us, but SBC doesn’t cost the company anything, nothing, not a penny, even if the company gives away $10 million dollars of stock.

I hope that this helps, and sorry if I get vehement about this, but the idea of saying the SBC is an expense to the company is so obviously and clearly unrelated to reality that I get emotional confronting it.

Best

Saul

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Completely agree, but aren’t there some rules of thumb about what level of SBC is acceptable?

Example: BILL’s SBC was $119.4m this quarter. The dilution is higher than most companies, but to your point, who cares about 1% dilution – even in a single quarter ($0.12b for a $12b company) if they’re growing revenue at 60%+? If we’re not worried about dilution, why should we care?

The 119.4m SBC was 46% of revenue this quarter.
…a year ago (Q2 2022): 49.7m or 32% of revenue
…last quarter (Q1 2023): 72.6m or 32% of revenue
So whether or not we think 46% is a lot, it’s up from 32%. It went up 46.8m sequentially.

Then they say their FCF was 47.7m this quarter (up 35.7m sequentially!) Why do we care about FCF? Because ostensibly it means that the business ran profitably, right? Isn’t that why we care about FCF? But if SBC increases more than FCF, is that a sustainable way to be profitable?

Again, I’m not super worried about it from a dilution standpoint. But what if it doubles again? How much is too much? Take it to the extreme. I think even you @SaulR80683 would see it as a problem if they did something silly like $3b of SBC next quarter. Sure, that’s not going to happen, but at what point between 119m and 3b do you draw the line and say, this is a problem? (for a company with 260m revenue in the quarter)

Bear

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I like SBC and usually the ‘dilution’ is minimal and compensated by not having to pay salaries, kind of like mini secondaries. But SBC, like everything else, can be abused. Don’t write off SBC as good or bad, check that it makes sense for your investment.

One rule of thumb might be that EPS is growing faster than dilution.

Denny Schlesinger

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I respectfully but strongly disagree with Saul on this topic.

If paying your executives with Stock Based Compensation (SBC) is not an expense, then presumably, paying your suppliers with stock would not be an expense. Should a car company be able to pay its suppliers with stock, then not expense those purchases and therefore declare itself wildly profitable because it was smart enough to pay for its supplies using stock? The purpose of GAAP is to determine profit, not to do cash accounting, so I don’t think it makes much sense to say stock costs the company no cash. If a company takes loans from a bank to pay its employees, that costs the company no cash either. Ah, you say, but they have to pay the loans back. So suppose they pay the loans back by giving stock to the banks? Then it costs them no cash, and it is not an expense?!?!?

If paying your executives is not an expense, then can you just give me some stock? No? Because I’m not doing anything for you? So you are giving your executives stock in exchange for them doing something for you? Why won’t they do it just for cash? Oh, they WOULD, but only if you gave them more cash? So you are saving cash by paying them in stock? And you won’t give me any stock because I am not doing anything for you? But it is not an expense?

Often simultaneous to giving execs SBC, a company will be repurchasing shares, literally buying them back on the open market FOR CASH. I’m pretty sure AAPL is doing this right now as you read this. So giving the execs stock costs the company nothing. But then the company goes and spends billions of dollars to buy back the shares they gave away that cost them nothing to give away. That seems like a puzzle, if the company is buying shares back for cash and then handing shares to the executives, how is that consistent with “costs the company nothing?”

I have been paid in stock based compensation during the decades I worked at Qualcomm. I am much richer having been paid with stock, and Qualcomm has since spent many billions of dollars buying back shares, presumably some of those shares being the ones they gave me that I was able to exchange for (wait for it) cash by selling them on the open market. And which Qualcomm thought were worth retrieving in the only legal way they could, by buying them back for cash on the open market. You might argue “well those shares cost the company nothing when they gave them to you.” But if Qualcomm had taken a loan from a bank to pay me, that would have cost them nothing, too. Should they be able to pay execs from loans OF SBC without expensing it?

None of this is to say that paying people or suppliers or banks with SBCs is wrong or immoral or somehow questionable. It is a financial strategy which can make sense for a company which is growing quickly with a stock price that is high. Just like getting a loan at a low interest rate makes sense for companies, or paying somebody with IOU’s makes sense sometimes. But thinking that of all these various ways to pay for things, SBC in particular is not an expense, not a charge against whether you are operating at the moment in a profitable fashion is, well, a wierd exception that doesn’t seem to fit anything else we know or believe about what it means to pay for something.

Saul’s position on this is held by many intelligent silicon valley execs. My position on this is held by many intelligent execs including, for example, Warren Buffett who can no more fathom how people can pretend that paying people in shares is any different than paying them in barter or cash as far as figuring out how much you are paying to get the work done, which is the purpose of GAAP accounting. If you think it is significant that you don’t have to spend cash when you pay with stock, then what you really want to look at is cash flow statements, which do NOT tell you whether you are profitable or not.

I managed to have great respect for the C-suite at Qualcomm while I was there despite our disagreement on whether or not expensing stock option grants made sense or not. I hope I haven’t broken any rules of this board by disagreeing on this issue. No matter where you come down on this issue, I hope the readers and writers on this board will benefit from having a better understanding of why the people who think SBC is obviously an expense will be helpful in your investing pursuits.

Cheers,
R:)

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I have mixed feelings on this topic and lately Brad Gerstner - Altimeter Founder (highly regarded in Silicon valley and early investor in Snowflake) went public and it appears the sentiment is changing…
This is what Brad had to say on the topic on twitter
“Altimeter hugely supports SBC as an important ingredient for start up success - but it is NEVER a free lunch. By the time a company is public it should 100% be treated as a cash expense. You do NOT have a profitable business if “cash flows” less SBC is negative.
And yes, this includes $SNOW. When building a high growth subscription biz - lack of current year profits (ocf-sbc) may be ok so long as u gain massive leverage against total costs over time (see cable cos). But that must be proven. I believe $SNOW mgmt has a plan.”
I think that is a balanced view which is helpful.

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Most of the discussion on this SBC topic has been focused on whether SBC is an expense to the company or not.

I prefer to look at it from the shareholder point of view. After all, as a shareholder, I want the value of my shares to keep rising, irrespective of what the company does with their growth, their margins, their SBC, their use of cash etc.

So let’s try to boil this down using smaller numbers

Company A has 1 owner who holds all the shares of the company 100 shares
The value of the business (market price) is $100
Value of each share is $1

Company A hires a new employee and pays them in stock.
The employee is paid 25 shares

Now Company A has total share count of 125
Owner holds 100 shares
Employee holds 25 shares
Market value of the company = $100
Each share is now worth $100/125 shares = $0.8

Irrespective of whether the company’s revenues grow, the market value of the company has to increase in order for the value per share to increase.
Revenue growth by itself is not enough.

Market value will increase if:

  1. Margins increase
  2. Market share and opportunity increases
  3. Cashflows increase
  4. Balance sheet health improves (higher cash and lower debt)

In 2022, many hyper growth companies struggled to achieve 1, 2, 3, or 4 or any combination of these.
In 2023, the jury is still out about what will happen.

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I’m not very knowledgeable on this, so maybe this is wrong - but this is how I look at it.

In order to grow, early stage companies need to raise cash to invest in growing the business. They raise cash by selling new shares to the market via secondary offerings. They also raise cash by taking loans or selling bonds. Those things don’t dilute the value of the company as long as they are done at reasonable rates, and as long as the company really uses the money for growth. IMHO, SBC is exactly the same thing as a secondary offering. Instead of selling the shares on the open market, they are “selling” them to employees in exchange for the employees accepting a lower salary than they might otherwise demand.

And the employees are taking the risk that the stock is going to be worth more in the future than it is at the time they receive the options for the stock. (In the last few years, it’s not looking like such a great deal for the employees.)

Said a different way, if the company did not use SBC, they would instead just need to raise cash (to pay the employees) through a secondary offering.

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I have a somewhat different view of SBC. Rather than getting stuck on the math of it, I’ve come to accept it’s simply part of the gig with tech firms. The mental adjustment I’ve made is giving software less of an advantage over other business models for being “asset light”. SaaS’s assets are employees, and it costs stock to buy the best of them. In a way, I view it as Cap Ex for winning and/or retaining the right employee capital.

Besides, if most of the other metrics line up the way they are supposed to, we seem to have a lot less consternation over SBC. That’s makes it more of a tiebreaker metric for me than something I want to use to drive my investment decisions.

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Hi RalphCramden,

Perhaps you can look at it this way:

You, Alice and Trixie order a pizza for $6 that is cut into 6 slices ($1 = 1 slice), and you get to eat 2 of those slices. They belong to you and you paid your $2 share. Everyone gets 2 slices.

But none of you feel like going out into the rain to pick up the pizza and bring it home. So you ask Ed to go and get the pizza (it’s 1955 so there is no delivery).

Ed’s goofy, but he’s not stupid. So he says, “I’ll do it if you give me a couple of slices for the service”.

You, Alice and Trixie agree to give Ed 2 slices. But you instruct the pizzeria to cut the pie into 8 slices instead of 6 slices so that everybody still gets to eat 2 slices.

So Ed takes the $6 to the pizzeria, pays for the pizza and brings it back to your apartment where you all enjoy the pizza. It didn’t quite satisfy everyone like it usually does, because the slices were a little smaller than usual.

Thereafter, Alice documents what was spent on the pizza (she’s a stickler for keeping a tight budget) and writes $6 into her notebook.

You (the FASB) disagree, demanding that she writes down $8 ($1 = 1 slice), although she still has $14 left from the $20 she had before buying the pizza.

So did Ed get paid $2, in portions of everybody else’s pizza or both?

As this is the Honeymooners and you’re RalphCramden, there is one final twist to the story. You are so adamant about the pizza costing $8 that you take $2 from Alice’s money box and give it to Ed just so the cost of the pizza could be properly accounted for.

DJ :wink:

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But looks like you missed the best part where Ed vomits out the pizza when he gets the 2$. Now all is right with the world and everyone has the anticipated amount of pizza while Ed gets the cash. It is a tad disgusting but it is necessary to make your example work :slight_smile:

At the end of the day, we first pay for that compensation via dilution and then when dilution is reversed, we end up paying with cash instead. Either way, it is a real expense.

But perhaps more important than individual interpretations of the facts are the prevailing perceptions and expectations of market participants. If so many tech companies are starting to pay attention to SBC and to make promises related to accounting for SBC and reducing SBC, and even make the subject a focus during calls, then it matters.

Now does that change how I should invest? I agree with @stocknovice as I think it is just a secondary item to monitor, not a reason to invest/not invest.

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Isn’t the argument that SBC is commonly used in early stage companies but then reduces on a percentage basis as they mature? Therefore we should ignore SBC when evaluating the viability of young companies. If SBC continues to be a significant % of revenue as the company ages, then it would be a concern.

It would be useful to track SBC as as % of revenue for several successful companies to have a guideline.

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All points of view on this subject seem to have been well represented and it’s time to bring this thread to a close.
Saul

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