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ChangeThe views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Key points
We believe:
- Investors should consider treating stock-based compensation (SBC) as a cash expense when assessing business models and valuing firms.
- Companies may be able to mitigate exposure to some exogenous risks by limiting the extent of SBC in their compensation mix.
- Boards may be able to better evaluate management teams by using financial metrics that treat SBC as a cash expense.
Stock-based compensation is an increasingly common tool used to pay employees, especially in the tech sector. SBC works particularly well when companies are growing, and equity markets are consistently moving higher. However, when growth slows and/or equity markets begin to decline, companies that lean heavily into SBC run the risk of a self-reinforcing cycle with severely negative consequences. This risk may not be fully appreciated by investors, companies, or boards who may be conditioned to a positive market environment.
This piece focuses on a specific area within the technology sector — large-cap software-as-a-service (SaaS) companies — where compensation schemes tend to lean heavily on SBC. Importantly, many other similar examples exist across the technology sector.
How it works — Traditional accounting for SBC
Simplistically, when an employee is paid in stock, two accounting entries are made and meant to offset one another.
First, SBC is excluded from traditional calculations of non-GAAP earnings and operating/free cash flow. For instance, if a firm pays US$200 million in total compensation, ½ cash, ½ stock, then non-GAAP earnings and operating and free cash flow would be US$100 million higher than if employees were paid exclusively in cash.
Second, SBC is added to the number of diluted shares outstanding. If a firm pays out US$100 million worth of stock and its stock price is US$20, share count would increase by five million shares.
In our view, investors generally believe this offsetting mechanism makes it okay to exclude SBC from their earnings/cash-flow calculation for valuation purposes. Likewise, many companies believe it is okay to exclude SBC from key performance evaluation metrics. We disagree with both practices.
Facts: SBC at large-cap SaaS companies
To assess whether stock-based compensation is being overused, we looked at five financial metrics:
- SBC % of operating cash flow (OCF) (i.e., how much of a firm’s OCF is the result of paying employees in stock rather than cash?)
- Change in OCF margin due to SBC (i.e., how much would a firm’s OCF margin decline if employees were paid in all cash versus their current cash/stock mix?)
- Growth in SBC versus growth in revenue for the last five years (i.e., is stock compensation growing faster or slower than revenues?)
- Percentage of OCF devoted to share repurchase over last five years versus change in shares outstanding over that time period (i.e., how much does a firm have to spend to offset dilution from SBC?)
Figure 1
This data shows that large-cap SaaS companies’ SBC is high relative to the broad market. More specifically, SBC represents a meaningful portion of current cash flow (39% versus 4%) and flatters reported FCF (free cash flow) margins to a significant degree (12% versus 1%). In addition, SBC is growing faster than revenue even as these large companies mature (1.1x versus 0.9x). Finally, companies are having to spend a sizable portion of their cash flow to offset dilution resulting from SBC, and share counts are still rising (30% of OCF and 7% growth in shares outstanding versus 22% of OCF and 2% reduction in shares outstanding).
Many investors contend that SaaS companies are some of “the best businesses” in the world due to their attractive unit economics, strong cash generation, and recurring revenue models. In our view, the data above should cast some doubt on this characterization. We contend that unit economics and free cash-flow margins are not nearly as compelling if SBC is treated as a cash expense. We think these are relatively mature businesses that should be de-emphasizing SBC at this stage in their growth cycle; yet we see the opposite. Likewise, valuation rises significantly if SBC is treated as a cash expense (i.e., stocks look a lot more expensive).
Positive case — When SBC works well
Proponents of stock-based compensation cite certain virtues: It aligns employee interests with overall company performance, provides upside optionality to risk-seeking workers, and allows fast-growing companies to preserve cash for reinvestment. In startups, a heavy lean toward SBC is logical as a form of risk sharing between employees and investors. In more mature firms, the system works particularly well when companies are growing, and equity markets are robust.
- Employees benefit from the shares issued to them being worth as much or more than they initially expected.
- Employers benefit from happy employees, a powerful tool for talent retention/attraction and less need for cash outlays. Also, the better the stock performs, the higher the valuation multiple, and the fewer shares/less dilution required to pay employees the same dollar amount.
- Investors see the system works well and are willing to value the companies on non-GAAP earnings or free cash flow — metrics that are flattered by greater use of stock compensation.
- Executives and boards respond to these dynamics by structuring their own compensation plans around financial metrics that exclude stock-based compensation.
- A positive feedback loop is created as each of these dynamics reinforces the others.
Negative case — Risks associated with SBC
However, in a less robust economic/market environment, the positive feedback loop outlined above flips on its head:
- Employees earn less than initially expected as share prices decline.*
- Employers are faced with three choices, each with negative consequences — increase cash compensation (margins decline), issue additional shares (dilution increases), or do nothing (risk higher employee turnover).
- Investors realize that stock-based compensation carries these risks and start to account for SBC in revised valuation metrics which results in lower stock prices. This then requires greater issuance/dilution to achieve the same level of employee compensation.
- Self-reinforcing cycle is created as each of these dynamics reinforces the others and compounds the associated risks.
*For example: A software engineer who makes US$200k in cash compensation (salary) and US$300k in stock for a firm whose share price declined by 50% would have experienced a 30% decline in total compensation.
Common rebuttals and our perspectives
In highlighting these risks to management teams and investors, we hear three common rebuttals:
- Double-counting: “While stock-based compensation is excluded from non-GAAP earnings and free cash flow, it is factored into calculations of fully diluted shares outstanding.” For the reasons outlined above, we disagree that factoring in theoretical dilution successfully captures the risks associated with a prolonged stagnant or bear market. However, we agree that if one is going to treat stock and cash compensation equivalently, the corresponding adjustment must also be made in the share count (i.e., we agree — double-counting is too penal and should be avoided).
- Everyone will be in the same boat: “Employers will not need to respond to lower stock prices with more cash/stock because all firms will be in the same position. Further, large, established firms will be relatively advantaged versus startups because of a higher mix of cash in their total compensation.” In recent months, some of the largest technology companies have committed to meaningfully higher compensation programs suggesting this logic fails in practice. Moreover, technology talent is in high demand across many industries so employees are likely to have optionality with firms that are not suffering from the same negative feedback loop that may exist in the tech sector.
- Employees do not plan for bull markets: “Employees may have over-earned due to rapidly rising stock prices in the past but no one expects/counts on that pace of appreciation to continue.” First, the risk we are highlighting is that shares are worth meaningfully less than expected (not that they will no longer deliver positive surprise). Second, it is natural for employees to become accustomed to a certain level of income (i.e., eventually the upside surprise becomes expected) and construct their lives accordingly. Anything less is likely to cause dissonance with their employer.
Bottom line on stock-based compensation in the tech sector
Companies that lean heavily into SBC face a significant risk of a negative self-reinforcing cycle if economic/market dynamics turn negative. Therefore, we believe investors should treat SBC as a cash expense when assessing business models and valuing firms and engage with management teams on this topic. Critically, companies that lean heavily into SBC may not be as great or cheap as meets the eye. In addition, we think companies should limit the extent of SBC in their compensation mix as they mature to mitigate exposure to exogenous risks. In our view, the benefits of SBC can be achieved with moderate share issuance and/or ownership requirements funded through cash compensation.
Finally, we believe boards should evaluate and compensate management teams based on financial metrics that treat SBC as a cash expense because it is a more accurate measure of economic value creation over the long term.
In our view, these factors are crucial for tech investors to consider, particularly given today’s rapidly evolving market environment.
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