On multiple occasions I’ve exposed the wonders and horrors of employee stock options - they can make you rich over night, but may force you to shake out the couch cushions to own them.
What’s less talked about is the impact of granting stock on the issuing companies.
Stock based comp is a non cash expense that shows up on a company’s profit and loss statement. A non cash expense means you record a charge on the P&L, but no cash actually leaves the building. It’s kind of like a theoretical hit you have to take when you report your financials. As a result, it increases your operating expenses and decreases your net income. And if you trace it all the way through, it makes your earnings and earnings per share go down.
Mechanically, stock based comp gets expensed on the P&L as employee stock options vest (typically over a four year period). As they come to fruition, accountants assess the value of equity that employee hold and record the non cash expense.
Riveting stuff, I know.
As a bit of background, here’s how I ended up going down this rabbit hole… While sitting on my in-laws couch, enjoying a fat bowl of cookies and cream with editor in chief Walter (from a premium local establishment, of course, not any of that Turkey Hill shit), I was draw to Expensify’s efficiency - they are producing more than $170,000,000 with less than 140 employees.
Buuuuuut…. the plot thickens! Then I realized they were actually losing money and operating at a loss.
What?! How much are they paying these people? How many Super Bowl commercials did they buy? Also, good for you, 2 ChAINz!
The real answer lies in the massive amount of stock based comp they’ve been strapped with. From a free cash flow perspective, Expensify is printing crispy hundreds. But when they factor in the non cash SBC expense, it drags their operating profits into the abyss.
Source: Expensify’s FY22 10K
As you can see, Expensify spent $63M on COGS + $122M on OPEX = $185M in total spend. But $52M (28%) of that is SBC. So they are technically losing $27M a year on paper, or 33 cents per share.
I reckon they’d look like a beacon of profitability if it weren’t for SBC.
(Note: But they’d also pay more in taxes…)
So why do we jump through these quasi-real hoops?
Charge it to the game
Well, basically, the accounting police (Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS)) acknowledges that one of the most powerful levers a company can pull to incent their employees is to offer them a piece of the company.
And they’ve got a point - the company’s cash payroll expense would be a TON higher if it weren’t for stock based comp. I know I would be negotiating a lot differently if it were not for stock. Cut the check, my G!
And it seems to work. According to Next Big Teng :
SBC can offer meaningful human capital benefits when used effectively, such as:
Retention: When paired with a vesting schedule or used as a performance reward, SBC can help to retain existing employees. A 2017 Study from the University of Pennsylvania found that overall benefit-cost ratios ranged from 1.95-3.75.
Hiring: SBC can be an attractive recruiting tool, especially for high-growth companies where there could be a perception of significant upside potential to the company’s stock.
Incentive alignment: Following principal-agent theory, SBC could help align incentives since employees, especially senior executives who may be paid heavily in stock, have ownership in the company.
Cash conservation: Growing companies that are cash consumptive and need to be mindful of burn can leverage SBC to remain competitive in the race for talent and still offer market rate compensation by shifting cash pay to stock.
To summarize - leaning heavily on equity allows you to retain key employees, hire better employees, align incentives across execs, and conserve cash. These are all on the Mount Rushmore of priorities for high growth tech companies.
We’re gunna need a bigger boat
As smarter people than myself have pointed out, the mouse has turned into a molehill (did I do that right?). And the easiest way to see if SBC is growing is to flex it against revenue.
“We estimate that SBC was about $270 billion in 2022, or 6 - 8 percent of total compensation for public companies in the U.S.”
-Morgan Stanley
Damn! It’s more than tripled since 2006!
What was once a “phantom expense” that no one talked about is now too big to miss - especially in software, comms, and fintech.
Fighting the good fight
It’s hard to put the toothpaste back in the tube, but we damn well might try. And the best way to offset the impact of SBC is through share buybacks.
This is when the company uses cash on its balance sheet to repurchase its own shares in the market, and then cancel them. This has the effect of decreasing the number of shares outstanding, or decreasing the denominator, by which the company’s earnings get peanut butter spread across.
Since SBC decreases earnings, share buybacks essentially ctrl + alt + delete shares so each share gets more earnings per share. Boom!
Source: Wall Street Prep
It’s as real as you make it
Stock based comp is as real as the person you ask. While it might not directly affect cash flow from operations, it can have indirect cash flow implications through taxes, share issuance, and dilution.
The gangsters at MS sum it up nicely:
“SBC is like any other form of capital allocation where a company’s goal should be committing resources intelligently and effectively to create long-term value per share.”
When you sit back and think about it, SBC is really just a tool. And you don’t want to start hacking around with it blindly, since it’s a tool that can cut both ways.
(Tool tangent: I once went absolutely HAM with a power auger while helping my cousin put in fence posts. I ended up drilling a hole like three feet too deep because I was having so much fun. You could say I over-rotated. So I had to use another tool, a shovel, to manually fix my error (kinda like stock buybacks)).
Now, I’m not here to make believers one way or another. But I do think it’s important people know what SBC is, and recognize that it’s there. People are getting paid (in a different structure other than straight cash, homie). And cap tables are taking a hit.
Actually, now that I think about it, I think Slim Shady had something to say about SBC:
To shatter the picture in which of that as they paint me
As a monger of hate and Satan, a scatter-brained atheist
But that ain’t the case, see it’s a matter of taste
We as a people decide if Shady’s Stock Based Comp’s as bad as they say he it is
Or is he SBC the latter, a gateway to escape?
Media scapegoat, who they can be mad a today
-Renegades, Eminem and Jay-Z
A lot of blame seems to be put on SBC. But as Eminem points out, maybe we are just made at ourselves for denying SBC was real all along?
