
Lies, Damned Lies, and Stock-Based Compensation - pvsukale3
https://tanay.substack.com/p/lies-damned-lies-and-stock-based
======
cletus
So people have a tendency to read a headline/submission title like this and
without reading the article they launch onto their soapbox about their pet
issue like, for example, equity compensation at startups should be treated as
being worth $0 if the company is not listed.

The article isn't about that. It's about companies misrepresenting their
expenses by not accounting for stock-based compensation ("SBC") costs, which
is completely fair. Google and Facebook (quoted in the article) do. Others (eg
Workday, Splunk, Okta and Atlassian are quoted) seem to muddy the waters by
stating they're unprofitable on a GAAP basis (which includes SBC since 2004)
but profitable on a non-GAAP basis (where SBC isn't treated as an expense, I
assume?).

So, caveat emptor for investors, basically.

~~~
sergiotapia
are you cletus from stackoverflow lmao you used to help me so god damn much
back in 2008 during my college years when i was writing c#. small web!

~~~
paloaltokid
Yep, that's him.

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whack
Here's a thought experiment that helped me reason through SBC and GAAP.

Scenario A: Company hires an engineer with a base salary of 100k/year, and
100k/year worth of SBC.

Scenario B: Company convinces an investor to invest 100k/year... and also
hires him as an engineer with a base salary of 200k/year.

From a business fundamentals and margins perspective, the two scenarios are
identical. And yet, in scenario A, the company is spinning their non-GAAP
annual expense as being 100k. Whereas in scenario B, the company wouldn't even
try to spin their annual expense as being anything other than 200k.

The above thought experiment becomes particularly powerful if the hypothetical
company has no other expenses and an annual revenue of $150k. Using the non-
GAAP estimates from scenario A can mislead investors into thinking that the
company has a very healthy gross margin, and is a lucrative investment.
Whereas the actual GAAP numbers from both scenarios A and B, make it clear
that the business is not profitable at all.

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wolco
If you can convience employees to trade 100,000 cash for stock then is it
really an expense or a risk shifted to the employee?

~~~
hansvm
It read to me like they were intentionally ignoring details like the risk
adjusted value of the SBC, not because they don't matter, but because they
obscure the point being made that employee payment schemes can be used to
sweep unprofitability under the rug.

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otoburb
We should be glad that public companies are forced to comply with FASB and
issue GAAP financials that (since 2004) mandate that stock-based compensation
be classified as a non-cash expense. By definition, non-GAAP figures are up to
the company to specify and state, which indeed means that investors should be
_actively_ updating their own models when making investment decisions if
looking at non-GAAP.

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throwaway_81726
> “ On February 28, 2017, the Compensation Committee of the Board of Directors
> of the Company (the “Board”) granted Mr. Hu a time-based stock option for
> 900,000 shares of the Company’s Class A common stock vesting over four
> years, three performance-based stock options for an aggregate of 555,000
> shares of the Company’s Class A common stock, each with a per share exercise
> price equal to the closing price of the Company’s Class A common stock on
> the date of grant, and a time-based restricted stock unit grant for 100,000
> shares vesting over four years. Each equity grant is subject to the terms
> and conditions of the Company’s 2016 Stock Option and Incentive Plan (the
> “2016 Plan”) and the applicable form of award agreement thereunder.” [1]

I’m surprised Twilio isn’t listed. Just there COO alone was issued ~1.5M
shares. At today’s market price ($208) his shares alone are worth $312M. Their
annualized revenue is ~1.4B. So just their COO alone was issued SBC of 22% of
the companies revenue.

And that doesn’t factor in the SBC of all of the other employees either.

[1]
[https://www.sec.gov/Archives/edgar/data/1447669/000110465917...](https://www.sec.gov/Archives/edgar/data/1447669/000110465917014048/a17-7474_18k.htm)

~~~
otoburb
Good catch about Twilio missing from the SBC as %revenue chart. Without
digging into Twilio's 8-K's I feel compelled to note that options would be
expensed as each tranche vests. So as a very rough estimate the COO being
issued ~1.5M shares over 4 years wouldn't be 22% of annualized company revenue
but perhaps something on the order of 6%, notwithstanding the vague language
about the performance-based options conditions and vesting schedules.

>> _And that doesn’t factor in the SBC of all of the other employees either._

You're right -- that probably pushes Twilio's SBC %revenue higher to the
Salesforce line.

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ineedasername
It's not cash, so where does the money come from? Isn't the answer
"investors"? Wouldn't their decreased share value from the dilution be the
source of "value" used to pay these options to employees?

~~~
Denzel
Exactly this. I find the article unconvincing as far as its conclusion is
concerned. At the end of the day, shareholders pay for the stock-based
compensation with dilution. There’s no expense to the “company”.

As a thought experiment: say someone works for $0 in salary and 100 shares of
Worthless Corp. After a year of work, our employee attempts to sell their
shares, only to find no buyers. Unsurprisingly, their shares of Worthless Corp
are worth $0. Did Worthless Corp incur an expense somewhere?

As far as I can tell, Worthless Corp received a years worth of work at no
expense.

~~~
YokoZar
It's a bit weird to try and conceive of the corporation without thinking of
its actual owners. They're the ones who the accounting is ultimately for.

If Worthless Corp had 100 shares outstanding before this employee, the expense
was half the company - whatever the valuation ends up being.

This is not the same as "nothing", and accounting should at least attempt to
reflect that - such as by placing an estimated market value on the shares.

~~~
kelnos
That's only true if it happens to be true for a specific scenario. If giving
some new employee 100 shares (doubling shares outstanding) actually increases
the value of the company by at least 2x by some measure, then the investors
holding the original 100 shares should be happy.

Regardless, this is a silly, contrived example. No public company is minting
anywhere close to 100% of their total share count every quarter in SBC. It'll
be a fraction of a percent, probably? And investors shouldn't care, as long as
the company is performing well at metrics that actually matter: acquiring
paying customers, where the cost of that acquisition is less than the new
customers spend. That, and things like efficiency improvements that cut costs,
are the only things that actually matter, because those things are what drive
stock prices up.

~~~
YokoZar
Half a percent per quarter means you've given away a quarter of the company in
14 years. That's not something an accounting rule should allow you to just
hand-wave away.

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GASCap
The wild thing is, if ones accepts modern financial theory, from the eyes of a
risk-neutral investor, stock-based compensation is actually much more costly
because of imbedded option value and time value of money.

Say one needed to hedge the other side of a 4y employee stock grant. Let's
assume the new cliff-less, monthly vest structure that is now market at some
of FAANG. The counter-party would need to borrow a large amount of money to
buy some fraction of the shares that the employee is likely to vest based on
historical data. This also assumes they are just "delta hedging." There is
definitely a "negatively convex" situation where if the stock price increases
employees are less likely to leave and if it goes down, employees will find a
new job that pays market.

Given the immense volatility in earlier stage companies, the counter-party may
elect to hedge the gamma exposure as well, meaning they may need to buy calls
in the open market against the RSU position.

In my opinion, Netflix has realized this, and given the implications decided
to just pay cash. Dollar for dollar, to a well enough capitalized employee,
the stock package is much better. This advantage increases with the volatility
of the underlying asset. This completely ignores the career risk of working
for a failed startup, but the culture in SV seems to minimize that.

~~~
kelnos
Not sure I get this; who is this "counter party" you are referring to? My
understanding was that the company doesn't actually buy shares on the open
market when an employee vests RSUs or exercises options, but instead they
either have a pool of shares waiting around (which they've never sold before),
or they just mint new shares (and dilute existing investors).

For the pool structure, sure, there's an opportunity cost (the company could
instead sell those shares on the public market). But in neither case does the
company have to go out and spend money to buy up shares.

~~~
GASCap
In modern financial theory valuation = cost of replicating the position. One
can approach that cost from how the company or the employee would replicate
it. My point here is that it is much more expensive than just paying the
employee cash due to the optionality and the financing costs associated with
such.

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s17n
For mature companies it's pretty simple, stock-based compensation can be
valued using the current share price and standard accounting principles.

For young companies, employees typically believe that their equity is worth
_more_ than the fair market value. So if anything, the non-gaap income should
use a higher number for stock-based compensation expenses.

~~~
kelnos
> _For young companies, employees typically believe that their equity is worth
> more than the fair market value. So if anything, the non-gaap income should
> use a higher number for stock-based compensation expenses._

That's backwards, no? If employees are delusional and over-value the stock,
they'll be willing to accept less of it and be just as happy, which reduces
the amount of the "expense".

~~~
s17n
Right, and this reduced expense is the one that is in fact reflected in the
GAAP numbers. But it might be useful for investors to know how much salaries
would cost if they had to be payed in cash, which would be a higher number.

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alkibiades
what’s the issue with this as long as the investors are also provided with the
GAAP numbers? it’s not like the compensation is hidden

~~~
kelnos
I never got this criticism either. If investors are too inept to look at both
numbers and do their due diligence to figure out why there are differences
(and whether or not those differences are in some way legitimate), then that's
on them.

And I also just don't agree that SBC is an "expense" that materially impacts a
business to the degree the article implies it does. I think there are a lot of
other numbers that change between GAAP and non-GAAP that are much more
relevant and interesting to look at. It seems like missing the forest for the
trees to pick on SBC like this.

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remote_phone
This is a shitty article. He doesn’t spend a single sentence defending why he
thinks SBC should be included in non-GAAP reports. He just states it should be
but never once says why. It’s a terrible article and a waste of time.

