The Cost of Stock-Based Compensation

Stock-based compensation (SBC) is a common way for companies to pay their staff. This is especially true for technology companies and startups without much cash, It is still common in many technology companies such as Amazon and Adobe Systems.

During earnings season, investors are presented with a great deal of reports, press releases, glossy presentations, and conference calls. All of these come with commentary that directs how management want their results to be interpreted. These "suggestions" generally come in the form of "underlying results", or for global companies, "non-GAAP results". (GAAP being Generally Accepted Accounting Principles, the accounting standards companies must adhere to).

That's right folks, buckle in, we have an accounting lesson today!

Stock-Based Compensation

Stock-based compensation has a couple of main benefits including:

A company can pay their staff bonuses without worrying about the impact on cash flow.
This is particularly important for early stage and loss-making companies that might be relying on external funding like equity or debt to fund operations.

Aligns employees to the success of the company.
By giving employees shares, they will have a vested interest in seeing the share price appreciate, motivates good employee performance and longevity in tenure.

The main drawback is that stock-based compensation dilutes existing shareholders. What this means is that when new shares are issued, existing shareholders now own a smaller part of the pie and will receive a lower proportion of the company's earnings and future dividends.

This is perfectly summed up in the following Twitter meme below

So far, so good. If the above holds true, and I believe it does, there isn't a huge issue with stock-based compensation if it is understood.

Problems with Stock-based Compensation

Problems can arise when management want to adjust their earnings for stock-based compensation. They will likely argue that because the compensation is non-cash, they get a clearer picture of the financial situation by ignoring it and asking investors to do the same.

This can't be further from the truth.

While it is true that stock-based compensation is not paid out of the company's bank account, it is a real cost to shareholders as they now will receive a smaller share in the company's profits. In accounting speak, it also represents a material economic transaction, which means it should then be included in the financial statements.

Consider every time an employee is paid in stock (or stock options), the company is essentially running a micro equity raise. During an equity raise, a company will issue shares in exchange for cash. When a company pays an employee in stock, they issue stock, and in return the company gets to keep the cash owed to the employee. It is cutting out the middleman. Although, what if the company paid the employee in cash, then immediately issued shares to the employee for the same amount. Without question, the accounting treatment would be to expense the remuneration on the income statement and there would no need to adjust for this with "non-GAAP" earnings.

Example of Stock-based Compensation

Let's say you have 2 identical companies. Company A only pays its employees in cash. Company B only pays its employees with SBC (this doesn't happen, but for simplicity let's say it does). Both companies earnt $200m in statutory net income, have 100 million shares on issue, with EPS of $2.00, and a share price of $25.

Company B issues $45m of stock-based compensation in the form of options that can be exercised at the current share price. This would mean the company will issue 1.8 million shares.

If you owned 10% of both companies at the start of the year, you would only own 9.82% of company B at the end of the year. This would reduce you share of (statutory) net income, from $20m by $353,635. Sure, that's small potatoes (only 0.18%) compared to what you did receive, but that's just one year. You now earn 0.18% less every year (assuming no more stock is issued). If you assume you will receive this profit into perpetuity, at an 8% discount rate. This earnings stream (simplistically calculating it like a perpetuity), this earnings stream foregone because of stock-based compensation has now cost you a present value of $4.4 million!

It doesn't seem so minor now does it. Now let's say that the company issues another 1.8m shares next year and all other items remain the same. That's another cash flow stream with a present value of $4.4m foregone and your shareholding would continue to reduce.

To be fair, it's not like you are getting nothing in return for giving up some of your shareholding. Like I mentioned earlier, what you are getting is higher cash flow now that can hopefully be invested in other areas of the business that can earn a higher return on investment.

Summing up

My view is not to say stock-based compensation is bad, far from it. Certainly, it can be a very good incentive for employees and can help fund operations for companies that don't have the cash needed to get to scale. Silicon Valley lives and breathes this business model. I have demonstrated that stock-based compensation is a real cost. If not on the income statement, at least to existing shareholders.

I'll finish with a word from Warren Buffett, who famously said in his 1992 letter to shareholders:

"It seems to me that the realities of stock options can be summarized quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?".

Written by Luke Durbin
Portfolio Manager
Oracle Investment Management

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