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Stock-Based Comp: The Usual Opinions
Part 1: Show me the incentive and I'll show you the opinion
“The greatest trick Silicon Valley ever pulled was convincing everyone SBC didn’t exist.”
Silicon Valley wants , arguably expects, investors to ignore stock-based compensation (SBC) when evaluating company fundamentals and their Rule-of-40 Operating Models.
I agree. Investors should ignore GAAP stock-based comp expense.
If you really care about capital discipline and shareholder-aligned equity compensation, focus on understanding the decision-making and rationale behind the equity grants and not the accounting expense which can misrepresent and arguably understate what’s actually going on.
For Part 1, I’m going to share some “big picture” opinions, observations, and outlooks regarding stock-based compensation. I’ll get into more specific concepts, dynamics, and quirks regarding SBC in future write-ups.
Spoiler alert, don’t ignore that “gut” feeling you have - but can’t explain - that equity dilution seems much worse and more value destructive than the already high SBC dollar amounts being disclosed. Hopefully, by the end of this multi-part series, you’ll be able to bridge that “gut” feeling to specific mechanics, dynamics, and concepts.
Ignore GAAP Stock-Based Comp
Simply put, when it comes to examining stock-based comp and its value impact, GAAP stock-based comp expense is the wrong metric to focus on.
The reality is we’re about to enter a very dilutive equity granting cycle in 2023, and GAAP accounting won’t properly capture the puts-and-takes of what’s happening.
For instance, companies are already under a lot of pressure to “lower” their stock-based comp so investors shouldn’t be surprised if/when companies guide down, or slow the pace of, GAAP SBC in 2023. Just don’t assume this step-down equates to newfound capital discipline and less dilution. Burn rates (i.e. shares granted / total shares) will be going up materially:
“Gross burn rates will increase materially over the next 1-2 years for many companies. Increases will be softened by signals from the investor community that they will closely watch share-based compensation.” - Semler Brossy (source)
This is why GAAP stock-based comp should be “ignored”. There’s a lot of “noise” embedded in its calculation, and companies are highly incentivized to find ways to lower GAAP stock-based comp to offer “cover” for higher burn rates.
Also, be aware there are ways to issue/adjust/reset equity comp to reduce GAAP expenses (or be expense neutral) while giving insiders more shares - with material upside potential - that isn’t properly accounted for in GAAP.
These “tails I win, heads you lose” actions further dilute shareholder value in favor of insider interests while creating the optics that there’s improved alignment with shareholders via lower GAAP stock-based comp expenses.
Frankly, companies and Boards who “lower” GAAP SBC while egregiously ramping share dilution should be penalized and not rewarded for this behavior. It’s the kind of behavior that extends beyond stock-based comp and leads to bigger problems.
Of course, the “2nd level” hot take is investors will mistake “lower” GAAP stock-based comp as improving capital discipline and stocks will pop as a result. Don’t be surprised if companies are banking on this to happen.
This false sense of security (analysis) is how stock-based comp becomes stock-based heist, and why it’s really important to go through a company’s stock compensation program to really understand the puts-and-take of what’s happening.
Shameless Plug: Connecting Incentives to Outcomes
Note: If you were previously a premium subscriber, a friendly reminder pro-rated refunds were issued and you’ll need to re-subscribe to receive premium emails again.
Charlie Munger famously said, “Show me the incentive, and I will show you the outcome,” but connecting incentives to outcomes can be tricky. It’s such a simple and straightforward idea, but can surprisingly have a lot of moving parts.
The (re-launched!) Premium Newsletter is my attempt to connect incentives to potential outcomes through the lens of corporate governance.
For example, I explore “real time” situations and look for interesting governance signals, like indicators of strategic options and other noteworthy inflections, before they potentially happen and/or gets priced in. No guarantee the speculated event actually happens, but it’s a fun way to learn corporate governance and explore how incentives can drive outcomes. Emphasis on LEARN.
Premium’s mission is to “teach you to fish”, not “give you fish” so please manage your expectations accordingly. You still have to do your own fundamental work to determine feasibility, actionability, risks, trade-offs, etc. of the governance “connections” being explored.
If you’re curious to read past premium pieces I’ve unlocked a few past pieces (and may unlock a few more) that are listed in my about page.
Back to the write-up!
The Usual Opinions
The debate over stock-based compensation has been going on for decades. 20 years ago, people were arguing over whether or not stock options were an expense:
It is a basic principle of accounting that financial statements should record economically significant transactions. No one doubts that traded options meet that criterion; billions of dollars’ worth are bought and sold every day, either in the over-the-counter market or on exchanges. For many people, though, company stock option grants are a different story. These transactions are not economically significant, the argument goes, because no cash changes hands.
Some critics of stock option expensing argue, as venture capitalist John Doerr and FedEx CEO Frederick Smith did in an April 5, 2002, New York Times column, that “if expensing were … required, the impact of options would be counted twice in the earnings per share: first as a potential dilution of the earnings, by increasing the shares outstanding, and second as a charge against reported earnings. The result would be inaccurate and misleading earnings per share.”
It’s a classic and timeless Silicon Valley opinion: “It’s a lot of value to me, but that shouldn’t be seen as an expense to you.”
This shouldn’t come as a complete surprise. Our incentives can deeply shape our opinions and behaviors.
Keep this in mind when you hear VCs, founders, and management teams push the view that stock-based comp should be ignored or de-emphasized. The plot points, behaviors, and characters today aren’t that unique nor different from the past.
At a high-level, these equity debates usually revolve around the (accounting) costs of (excessive) stock-based comp, and rarely does the conversation turn to the material “agency costs” and value destructive behaviors these free-wheeling grants often introduce.
Case in point, when Silicon Valley was arguing over stock options in the early 2000s, the debate was primarily focused on the accounting treatment and expense recognition of options when the real cost was the shareholder misaligned behaviors and actions - brought on by aggressive option grant - that seeped into the culture and value-system of these companies, and ultimately led to the options backdating scandal.
More “guardrails” have since been added after the options backdating saga, but a lot of questionable behaviors and core beliefs tied stock-based comp arguably remain.
It hasn’t gone over my head we’re once again debating the “cost” of stock-based comp expenses, and ignoring the behaviors and actions - brought on by aggressive equity compensation - that have once again ramped “agency costs” and introduced value destructive behaviors and beliefs in the company culture.
These persistent behaviors and actions are the real cost of stock-based comp.
Stock-Based Comp is Capital Allocation
To be clear, I’m not opposed to high equity burn rates and leveraging stock-based comp if it creates the requisite long-term shareholder value. It’s when stock-based comp decouples from (risk-adjusted) long-term value creation that we end up with “excessive” value dilution, if not outright destruction.
I know I’m stating the obvious, but stock-based comp is a form of capital allocation, and all capital allocation decisions need to meet a return expectation to justify its deployment.
And when you look at stock-based comp through this returns-based capital allocation lens, it becomes clear not many companies are going to achieve a compelling return on their stock-based comp (especially through a cycle). And to be honest, I think most companies and leaders aren’t thinking about stock-based comp through this capital allocation lens.
Cynically, the only return-hurdle being considered when granting equity is return on insider. It’s a different kind of “ROI” that tells me a lot of insiders are quite capable of being good capital allocators if they just applied that return mindset to the entire company and not just themselves.
When the market is in an up-cycle, thinking about capital allocation “returns” on stock-based comp gets (temporarily) distorted or ignored, and introduces all sorts of nonsense and self-dealing. Inevitably, a reckoning happens in a down-cycle, and either the issue is addressed or insiders double down to load up on equity before exiting.
Few things are as frustrating as seeing management teams sell companies at the “bottom”, and IPO the company again at the “top” for great personal gain at the expense of public shareholders.
Again, this dynamic isn’t novel considering it occurred last cycle with aggressive stock option grants. And like the last cycle, these things will get sorted out eventually. Unfortunately, it can take longer than investors would like to see.
In the meantime, it’s important to recognize old habits die hard and companies are going to do what they can to maintain status quo on their existing equity compensation practices.
For investors, just being aware how “excessive” value dilution is enabled and supported in the market is an important first step in compelling companies and management teams to look at stock-based compensation through the lens of shareholder returns and discourage decisions made primarily to the benefit of “insider returns”.
Dilution Adjusted Accountability
Right now, there’s a push for companies to be more “profit focused” and rein in equity compensation. Profitability is certainly an important “North Star” long-term and necessary to truly control your own destiny in public markets.
That said, my concern is the path to profitability is gamed near-term and companies report profit trends that are more transitory than structural. Also, the focus on total profitability doesn’t account for the increased share dilution that’s going to happen as a result of companies meaningfully upping burn in 2023.
I don’t know what the right approach would be to account for dilution, but maybe it’s as simple as redefining executive compensation targets (i.e. growth, profit, etc.) to be “per share”.
Again, this isn’t a novel concept and harkens back to Jeff Bezos’ free cash flow per share “North Star” at Amazon:
“Our ultimate financial measure, and the one we most want to drive over the long-term, is free cash flow per share.” - Jeff Bezos
Alternatively, given Rule-of-40’s popularity and it being Silicon Valley’s default operating model, consider embracing “Rule-of-40 per share” that uses a fully loaded non-GAAP diluted share count when assessing Rule-of-40.
Whatever the approach, more accountability and focus is needed on dilution.