Stock-Based Compensation: Walking the Balance Beam of Growth

A classic double edged sword with investors usually leaning on the overly punitive side

Every time stock-based compensation (SBC) gets mentioned I feel like this :)

This Twitter mention by Long Way Capital brought me back into the discussion. The tweet below highlights a portion of the conversation on Bill Brewster’s podcast where we talk about SBC, if you’d like to listen to more of it, here’s the link.

Long Way @LongWayCapital

@BucknSF Exactly If you're estimating growth, opex, etc., then you can do the same for dilution. A lot easier to whine about SBC tho. @shomikghosh21 addressed this really well on the Business Brew. Basic gist in screenshot, but the convo in that episode was very thoughtful and balanced

What is Stock-Based Compensation

It’s self-explanatory but essentially SBC is what companies give to employees in order to help align employees incentives to the long term health of the business. In some cases, it’s given because companies can’t afford to pay the full salary of the employee that they received at a larger company (common in startups). It’s also given as an incentive to stick around for longer at the company (typically 4-year vesting schedules for options), additional compensation for a job well done (RSUs), or simply to keep incentivizing employees to work at the company as the stock will help build wealth.

How does Stock-Based Compensation Affect Company Valuations?

Here’s the thing about SBC, every times shares are granted or vest, those shares add to to the total diluted share count of the business. So say you have 100 shares at the time that you start the company at a $1 per share price. The company has a market cap of $100.

Now say that you give 10 shares to employees that fully vest in a year. However, over that year, because of random circumstances the business didn’t grow much so it’s still valued at a market cap of $100. Now there are 110 shares that own part of the business = $0.91 per share. Said differently if you owned 10% of the business before the shares were given to employees, you now own 9.1%. Your ownership stake in the business has been diluted down and your shares are worth less even though the market cap of the company is the same as when you first got your ownership stake.

Why the Hullaballoo Over SBC?

So why is there always so much noise around SBC. Well as you can imagine, people don’t like to lose money. So if the business is not generating value over time but is still granting equity to employees, then every existing shareholder is getting diluted and losing money.

The noise around SBC gets amplified in down markets like we are experiencing now. Investors will look at companies and analyze the amount of stock that is being given to employees. In down markets, that money looks like a lot being given to employees. Meanwhile because share prices and valuations are down, it also looks like the company is doing so in the face of existing shareholders losing money!

Investors also like to look at benchmarks and percentages. So they will look across an industry and say well company A is achieving x amount of growth with this much SBC while company B is achieving y amount of growth with much more SBC. What gives?! They will also compare the SBC as a percent of revenue to show what companies are spending more on employees than others.

Conclusions will then be drawn saying Company A is executing much better than Company B and cares more about shareholders. Or simply, eh I have no clue what all that SBC is going towards.

The Mistake in Focusing Too Much on SBC

I see too many people using SBC as a crutch to either justify overvaluation of a company, point to it as poor execution, or simply validate their existing biases.

Share dilution of course matters but importantly it really can only be carefully judged knowing the potential outputs associated with this one input.

So take a business like Coca-Cola, SBC definitely matters. The business is barely growing revenue annually (in some years revenue and profit is actually declining). So in this case extreme SBC can really hurt the business. Since the business is not necessarily meaningfully growing free cash flow (although the duration of that cash flow stream lasting is quite long), each new share granted takes away from the money existing shareholders can expect to make from the business.

Now take a business like Salesforce. Revenue is still growing 20%+, gross profit is still growing rapidly, and free cash flow with and without SBC is still growing rapidly (although the total notional amount of that free cash flow changes dramatically if you include it or not). A lot of people look at Salesforce and say, “they’re barely generating any free cash flow once you account for SBC”. This is a true statement. However, it misses the forest for the trees (or whatever the idiom is).

Salesforce’s entire business is built on human capital. If everyone left Salesforce today, the servers would not be provisioned, code would not be deployed, Salesforce’s software would cease to exist for customers’s to use (except for some who are self-managed I guess). Now take Coca-Cola, if everyone left Coca-Cola the physical ingredients would still exist, there would even still be some leftover inventory to sell. The product would still exist.

Given that, growth of Salesforce’s business relies on…you guessed it, humans! More employees are needed to build, market, sell and enable the product. In order to grow, you must invest behind that growth. Just like you need to buy an airplane before you can generate revenue from it. You need to hire employees before you can generate revenue. The level of what that SBC should be is also very hard to figure out. Do you as an outsider know all the initiatives that Salesforce is working on? I can guarantee you that the answer is no. Investors were saying SBC was too high when Salesforce first went public and then when they expanded into Commerce Cloud, Marketing Cloud, Service Cloud, etc.

So What’s the Takeaway?

SBC should absolutely be considered by founders, investors, employees, etc since it reduces the value at that point in time of everyone’s shares. However, for investors it comes down to 1) trusting that management is investing in the right growth vectors, 2) understanding what the major drivers of SBC are and what initiatives those lead to, and 3) factoring all of that into an analysis of the company’s potential to capture market shares.

For founders and management, it is important to consider the potential value added by an individual hire. Most management teams don’t hire people just because they like doing it (although empire building does happen). But it doesn’t hurt to step back from time to time and assess progress towards initiatives and if those initiatives still make sense in the current paradigm.

I would remind everyone that Amazon failed on the fire phone, multiple different categories of retail products and much more all while SBC increased. SBC also ramped up into the unveiling of AWS and I’m pretty sure no one is crying over that.

So before jumping too quick to do point in time analysis, consider if the time is spent in the right place. It may feel nice to pull out a spreadsheet and do nice math that leads to share prices in the future, but that does not help understand a company’s valuation. Factors such as culture, product wedges, distribution channels, hiring ability, etc all have weight on the company’s future value creation potential. These all link back to SBC especially in high growth companies. You need to do the work.

Take Snowflake for example. The company has clearly laid out product directions in analytical workflows, data lake functionality, security, data sharing and much more. These are all massive market opportunities that take a lot of upfront investment in human capital to make possible. The payoff is uncertain of course but at least we all should evaluate the company from that perspective rather than simply saying, “SBC is too high especially compared across the benchmarks of software companies”. That is lazy analysis and not helping anyone.

Arguments about SBC being too high are as old as Wall Street and will never stop. Hopefully, my above rant helps clarify why simply looking at SBC in a vacuum is not helpful at all and usually is not actually a useful exercise in determining the fundamental drivers of the business and valuation. The more folks who focus on it too much, the less competition for the rest of us :)

Please feel to comment or reach out to me if you’d like to discuss (argue/battle?) more!

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Some stuff I really enjoyed reading this week:

Monzo Co-Founder sharing the early days of trying to build product, hiring mistakes, doing things that don’t scale, etc: https://tomblomfield.com/post/691384431502557184/monzo-growth

Adam DuVander’s presentation on how to market to developers: https://everydeveloper.com/marketing-to-developers-is-not-hard/

Alex Bank’s podcast with Jamin Ball on enterprise software trends, public/private multiples, and much more: