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We believe:
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.
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.
To assess whether stock-based compensation is being overused, we looked at five financial metrics:
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).
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.
However, in a less robust economic/market environment, the positive feedback loop outlined above flips on its head:
*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.
In highlighting these risks to management teams and investors, we hear three common rebuttals:
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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