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.
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.
Scenario C: Company hires an engineer with zero base salary and $200k/year worth of stock that gets paid monthly with the correct number of shares to get $16.7k in value. The shares can immediately be sold back to the company for the full value.
The engineer clearly receives $200k of economic value. Whether the stock is sold or not has no effect on the value transfer.
Does this hypothetical company have 1) a 100% profit margin, or 2) is it losing money?
If you picked 1), let's say the engineer quits and for whatever reason the company needs to pay the replacement $200k/year in cash. To do so, the company sells $16.7k of shares to an investor each month. Is it still a 100% margin company?
You've now got an extra $100k in the bank for other requirements. Effectively the SBC makes the employee an investor also, exchanging labour for equity (instead of just for cash). This seems to me to be different. Obviously there is some dilutive effect to the share allotments, but especially in earlier stage non public companies you probably always want to have more non cash vs cash expenses if you have the option?
As an outside investor, if a company is not profitable accounting for stock compensation then the book value of your stake (or your share of the NPV of future profits, or whatever) is going down.
I interpreted TFA to cast the Buffet quote in a positive light, and not as an equivocation.
>>As an outside investor, if a company is not profitable accounting for stock compensation then the book value of your stake (or your share of the NPV of future profits, or whatever) is going down.
Sounds like you, Buffet and the FASB are completely aligned on this point -- all the more reason to use/weight the GAAP numbers more heavily than the non-GAAPs and adjust our decision models appropriately.
You’re talking about the balance statement, which it would benefit but unrelated to profit.
In other words, yes they have more money, but no, it does not make them more profitable.
In other words, yes they have more money, but no, it does not make them more profitable.
They're not profitable in either Scenario because they don't have any income in either. But in one scenario, they have $100k spendable cash, and in the other all they have is sweat equity that they claim is worth $200k compensation. With spendable cash, you have runway and the opportunity to acquire external products or services that they need for the business. With sweat equity, you have sweat and dreams of success.
2nd point: GP said "invest 100k/year", thus he do make additional investments.
At the simplest level, you can buy things and services with the $100k cash in Scenario 2 at the start of the year as soon as the investment is made. You don't have that cash in Scenario 1.
Consider the difference if the employee quits or is fired before vesting their options.
Consider the difference if the company is sold for less than the strike price of the options.
Then again, the companies that are doing so are generally the ones using GAAP earnings and including SBC. Companies still using options are often private, which means that Scenario B isn't even an option for the general public, and the only way for a non-accredited investor to own stock is to work for them.
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.
>>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.
He was only given 100,000 shares ($5 million/year).
The options only give him the right to purchase shares at today's price in the future. If the stock goes up substantially, he can profit on it, but the options could also be worthless if the stock price remains flat or goes negative. If the stock goes up 10%, the options would be worth ~$29 million (option to buy 1.4 million shares at a price of 208 then sell them at the future market price of 228)
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.
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.
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.
I absolutely agree with you. I just don't agree with the conclusion this article reached: that stock-based compensation must be accounted for as an expense that affects income because, in the case where shares are issued via dilution, it doesn't affect income.
Is there a better way to present this to owners than GAAP vs. non-GAAP? I think so. Have I given it much thought? Not really. I just don't agree with including dilution as an expense that makes companies appear as if they're losing money hand-over-fist.
I'm open to being convinced otherwise, but this article didn't do it for me.
> This is not the same as "nothing"
Well, in the example, the valuation ended up being "nothing", and it seems fair to say that half of nothing is indeed the same as nothing. The owner in that scenario can retake 100% equity by paying nothing for the outstanding shares.
If a company can just dilute, there's no real tangible expense outside of the company transferring value from the shareholders via dilution. If a company has to buyback shares from the market, then I absolutely agree that stock-based compensation needs to be recorded on the income statement as a real expense.
As an investor, sure, I'd want to know how much the company was diluting me every quarter by issuing new shares, but the only thing that materially affects me is the absolute value of the stock price when I want to sell (and the value of a dividend, if they have one, which most of the referenced tech companies don't).
The stock price doesn't need to reflect anything about the level of SBC. As long as people are bullish on the company's prospects at actually continuing to make real money from more and more real customers, then the price should go up, or at least not decline.
In the absence of dividends, stock prices are just a speculation game. If I'm not actually getting a share of future profits, it's just about whether the company will perform well enough (for whatever definition investors feel like that is) to increase speculative buyer demand, which increases the price.
Put another way, SBC doesn't affect money in the bank, or cash flows. A potential customer is not going to be turned off because a company gives out too much stock to its employees. It doesn't affect COGS, capex, or what the company can charge for its product.
I get why GAAP requires disclosing it, as it's a material fact regarding how the company runs its business. It's a risk: if the stock does not perform well, talent that is depending on that stock price for future income may bail, which could then hurt the company's revenue; the amount of SBC gives a window into how bad that problem could be. But docking it as a simple expense makes no sense to me.
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.
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.
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".
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.