What to do about Stock Based Compensation?

Eiger Capital

April 2023

The tech sector sell-off that began in early 2022 has seen a renewed investor focus on 'disciplined growth'. We think this is investor code for a shift to positive operating free cashflows and the end of equity market funding of operating losses. Lossmaking tech is now on the nose.

The equity market sell-off has also led to greater scepticism at the increasing use of alternative corporate earnings measures such as 'underlying' profits. These are often presented by companies that want to adjust (i.e. increase) statutory reported earnings for 'one-offs' and 'non-cash' items.

A common adjustment of concern for investors, especially popular with companies in the tech sector is the issue of SBC. Companies are able to report higher underlying earnings (or more to the point reducing underlying losses) by using the justification that SBC is a 'non-cash' item and thus should be added back to statutory earnings.

We are unconvinced with this argument as we reason below. SBC is a real cost of employment and thus should be accounted for in reported statutory earnings.

Let's start with a "101" on SBC - what is it?

SBC is quite simply an alternate form of compensation paid to company employees, often as a substitute for a cash salary.

There are two main types. SBC is equity in the business that employees work for and is most typically issued either in the form of employee stock options or otherwise as restricted stock units (RSUs). It is common for both types of SBC to vest over a specified time period and often subject to some conditions (most commonly just tenure at the company). SBC is not a new innovation. It has been around in the US for more than 70 years. Although employee stock options did exist in the US pre-WW2 their unfavourable tax treatment meant they were little used. Very few executives had executive stock options prior to 1950¹.

Then shortly after the war their issuance started to rise quickly with the introduction of the 1950 Revenue Act. This new law allowed for lower capital gains tax treatment on the sale of executive options. As a consequence, executive stock option issuance jumped to around 18% of top US executives remuneration, just one year later.

Nevertheless, stock options remained mostly restricted to top company executives until the early 1960's. Late that decade Robert Noyce and Gordon Moore (of "Moore's law fame), two of the original founders of Fairchild Semiconductor (the inventor of the silicon chip) established a new company called Integrated Electronics. This company was later renamed Intel and was one of the first companies to use employee stock options more broadly as a tool to incentivise the staff of their new company. 

Once again, their use rapidly increased during the dot-com boom of the late 1990's. This popularity was again sunk by dotcom bust of 2001. Many recipients of SBC found themselves on the hook for large tax bills despite the value of their options now being mostly worthless.

More recently, SBC has again blossomed with the FANG led tech bull market of the late 2010's / early 2020's. High inflation and the end of zero interest rates globally from mid 2022 has led to a tech industry selloff that has again put SBC back onto investors' radars.

Why do companies issue SBC?

SBC is most commonly issued to staff by early stage 'startup' tech businesses for a number of reasons.

1. It better aligns employees with the performance of an early-stage business. Such businesses, usually in the tech sector, often have the promise of significant 'blue sky' potential and SBC is a way of sharing this with the small highly motivated teams typical of these businesses. They want to incentivise their staff to work harder for greater upside reward than salary alone.
   The SBC dynamic is more difficult to create in larger more established businesses where it has less of an enterprise based motivational impact on staff. In these businesses, individual employees are merely small cogs in a big machine with little realistic impact on the prospects of the entire enterprise. For these larger businesses especially in the tech industry SBC has become just a cost of doing business (see discussion below).
2. Early-stage businesses are generally cash constrained. SBC allows them to pay for staff using less of their scarce cash reserves that can be directed to other critical areas. Larger businesses generally have less need to manage their cash reserves as intensely so there is less of a reason to use SBC.
3. SBC helps smaller tech companies attract and retain the best staff they can. It offers employees an equity kicker to compensate for lower cash salary versus what larger tech companies can offer them. The vesting schedules often attached to SBC help companies retain staff as equity typically only vests to the employee after a period of time.
4. The upside potential of SBC is usually inversely proportional to the size and maturity of the tech business. Large tech enterprises can pay higher salaries than early stage tech start-ups but their SBC will rarely have equivalent 'blue sky' upside. Accordingly, larger companies suffer an SBC competitive disadvantage to smaller early-stage tech companies.

What are the problems with SBC?

There are a number of concerns for investors arising out of the payment of SBC and not just the issue of the cost of SBC not being appropriately reflected in earnings.

1. The biggest issue of SBC for equity investors is one of shareholder dilution. SBC dilutes the equity participation of the company's shareholders on a per share basis. The issuance of SBC over time erodes earnings per share for other shareholders, regardless of the company's expense recognition policy.
   If the company is self-funding then this is a lazy capital issuance practice that surreptitiously reduces per-share value over time. It might be a case of 'out-of-sight, out-of-mind' but only whilst share prices are going up. Investors are more willing to 'look the other way' during these good times and ignore or dismiss the gradual creep in the share count that robs them of their previous level of participation in the profits of the enterprise. Those times appear to be over.
2. Adjusting for SBC (by adding it back to profits) will cloud and misrepresent a company's earnings. The pretence that SBC is not a real cost (due to it's 'non-cash' nature) ignores the reality of the impact of SBC on other shareholders. We strongly disagree with the notion that SBC is not cash.
   SBC is intrinsically just the netting-off of two separate transactions, an expense transaction and a financing transaction. Firstly we have a salary cash payment to an employee. It needs to be treated as an expense. This is concurrently implemented with an equivalent micro equity issue to the same employee in exchange for the cash salary already paid. This needs to be treated as a financing event.
   Whilst the net cash impact is zero, the impact on enterprise value is not. The unbundling of SBC into its two distinct sub-components makes it impossible to argue that SBC is a non-cash expense that should be excluded from underlying earnings.
   
   Warren Buffet² said it best in his 1992 letter to shareholders when opining on this issue:
3. SBC adds complexity for investors. SBC is often poorly understood by equity market investors (and often undervalued by staff who receive it - see below). Few investors fully understand how the expense of SBC is calculated (compounded by the restrictions often attached to SBC) and how to calculate the equity dilution resulting from it.
4. SBC doesn't always properly align employees. Whilst SBC seeks to align staff incentives with the operating performance of companies they work for, in reality this only happens in a rising share price / equity value environment. In environments of falling valuations it will more often than not have the opposite effect of de-motivating staff (or worst still imprisoning staff if SBC is matched with a recourse loan that is in negative equity).
   Staff may feel cheated for not being fairly compensated for their work when the value of their SBC is declining. The aftermath of the dot-com bust saw much of the stock options that had been issued suffer material value destruction. In the end those staff had in fact been working for salary alone with the value of much of their SBC rendered worthless post crash.
5. Not always fully valued by recipients. As a consequence of point 4, staff may not always fully value the SBC they receive at its true accounting / expensed value. They may see it more as an equity 'kicker', akin to a jackpot payout for them if the business is very successful. In these situations a cash salary may have proven more of a motivator than SBC.
6. SBC is now overused and abused. SBC has long-ago moved beyond the realm of early-stage businesses and is now broadly used by many well established tech industry companies as a standard component of staff remuneration. Clearly, executive management see SBC as a useful mechanism that allows them to report higher 'underlying' earnings whilst the cost of dilution goes unspoken.

A recent Barrons³ article highlighted the now more common practice of many large companies in the tech industry. More of them are using SBC for a greater proportion of their total employee compensation. As revenue growth rates have slowed and correspondingly tech valuations have dived, this practice is increasing the anxiety of many investors who consternate at the growing ownership dilution of their business.

The article points out that average stock-based compensation for the US tech industry rose from just 4.2% of revenue in 2012 to 10.5% in 2020, and then more than doubling a year later to 22.5% in 2021.

At these levels SBC has moved well away from its tech industry origins as a tool to align and motivate small teams in early-stage businesses. Instead it is now "part of the culture and the expectation from software company employees"… with the consequence being that… "an increasing amount of shareholder value (is) being transferred to employees and away from investors, as companies dole out more stock at lower prices".

Perhaps the most egregious recent example of the above practice has been pandemic beneficiary Zoom. SBC became very entrenched as part of employee expectations during the good times when the share price ran up from US$70 in Dec 2019 to a peak of almost US$600 (+760%) less than a year later in Oct 2020. However rolling forward to late 2022 with the share price back at US$70 (-88%), employees who unlike shareholders need to be compensated for the lower share price, requiring the company to issue significantly more SBC than when its share price was US$600.

According to Kelly Steckelberg, Zoom's CFO, this was done to ensure workers were not "feeling that they're being undervalued"⁴. Unfortunately this resulted in very large levels of dilution for suffering shareholders, who's feelings were apparently less important to the CFO.

The one possible fly in the ointment for employee SBC is that the rising level of tech industry layoffs is eroding the current culture of expectation. If tough times continue then tech sector remuneration will undoubtedly come under more pressure. The consequences will not only be lower levels of SBC but also possibly lower levels of total absolute compensation, although evidence of the latter is yet to be seen.

Not all of the tech industry has been exploiting SBC-adjusted underlying earnings. Some of the larger profitable tech companies such as Alphabet (Google)⁵ and Meta (Facebook)⁶ have long since moved away from an 'underlying' earnings measure that excludes SBC. They recognise that it is indeed a true cost of attracting and retaining staff and account for it as a proper expense.

Unfortunately many other large but still unprofitable tech companies continue to rely on SBC as an 'underlying' earnings adjustment to help hide the fact that their margins are miserable on a fully costed basis. The tables and charts below show some well-known names such as Adobe and DocuSign as the biggest serial users of SBC.

Final thoughts

We may in the not-too-distant future see SBC returning to its origins of tech start-up land. It is here where the cost of equity dilution to investors is more than offset by the 'blue sky' value creation potential that a highly motivated and well-aligned small tech team can deliver.

Author: Victor Gomes, Principal and Portfolio Manager

Funds operated by this manager:

Eiger Capital Australian Small Companies Fund

¹ https://secfi.com/learn/history-of-employee-stock-options
² https://www.berkshirehathaway.com/letters/1992.html
³ https://www.barrons.com/articles/okta-confluence-snowflake-tech-stock-based-comp33588231
⁴ https://www.businessinsider.com/stock-based-compensation-wrecking-tech-shares-stock-slump2022-12
⁵ Google, 2017 "SBC has always been an important part of how we reward our employees in a way that aligns their interests with those of all shareholders. Although it's not a cash expense, we consider it to be a real cost of running our business because SBC is critical to our ability to attract and retain the best talent in the world. Starting with our first quarter results for 2017, we will no longer regularly exclude stock-based compensation expense from Non-GAAP results"
⁶ Facebook, 2017 "we are no longer reporting Non-GAAP expenses, income, tax rate or EPS. Given that stock is an important part of our compensation structure, we believe that investors should focus on our financial performance with stock-based compensation included"
⁷ https://tanay.substack.com/p/lies-damned-lies-and-stock-based

This material has been prepared by Eiger Capital Pty Ltd ABN 72 631 838 607 AFSL 516 751 (Eiger). It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Any projections are based on assumptions which we believe are reasonable, but are subject to change and should not be relied upon. Past performance is not a reliable indicator of future performance. Neither any particular rate of return nor capital invested are guaranteed.

The Rate Debate - Ep37 -  

Did the RBA fuel the fire or douse the flames?

Yarra Capital Management

April 2023

Funds operated by this manager:

A once in a generation opportunity

Insync Fund Managers

April 2023

A revolution in global consumption is occurring. Imagine a world where the centre of economic gravity shifts away from Europe & North America. This presents a staggering $10 trillion consumption growth opportunity over the next decade. This global megatrend has reached a critical tipping point. The rapid expansion of middle-income sectors across developing countries, particularly in Asia, is reshaping the global economy.

Not Just a China Story

Whilst China's middle-class growth is well-known, it is less recognized that of the 1 billion Asians joining the middle class by 2030, 380 million will come from India, the largest contributor to this increase. India's consumer market is set to triple to $6 trillion by 2030, making it one of the biggest consumption stories.

India's consumer class is characterized by a young, geographically dispersed population. It offers significant potential for growth in consumer spending.

In contrast, China's consumer class is older and aging, although more affluent, and is concentrated in cities.

Smaller nations in Asia are still juggernauts when compared to say, Australia. Indonesia's middle-income class is the size of Australia's entire population. Then there is Malaysia, Vietnam, and so on.

Navigating the risks

Investing in the emerging middle-income consumer requires smarter research and better insight than ever before. It also requires strong risk management.

Simply buying a basket of offshore companies with large 'footprints' in these regions is no longer sufficient. Nor is investing directly due to the more risky and volatile nature of local stock exchanges.

International brands face challenges when embracing Guochao due to potential repercussions in both Human Rights and political considerations. Nike and Adidas lost market share in China to locals such as Anta Group as a result. Guochao is especially popular amongst the 270 million Gen Z-ers. They're redefining China's consumer economy and will continue to do so throughout their life stages. This is neither new nor particularly Asian. It shares similarities to the emergence and power of the USA Baby Boomers decades earlier. The preferences and spending habits of this large rapidly growing group are therefore crucial to understand.

With a higher-income middle class estimated to hold 160 million households by 2030, China remains a critical target group for consumer brands. They are driving demand for higher-quality goods and services, from healthcare and education to luxury goods and travel.

Given the dangers and challenges in these markets however, how can an investor benefit without taking on undue risks?

Being focused and careful

Insync's research targets only the most viably attractive companies, focused especially on the increased spending by higher-income middle-class consumers (annual disposable income is $45,000-$100,000 (PPP)). Global companies are usually better placed to then allocate capital to these economies and manage currency and political aspects from a stronger position than fund managers.

Our work has determined that the number of companies benefitting from this trend that can also grow profitably going forward is fewer than what was available pre-Covid.  Stock selection is key.

Funds operated by this manager:

Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

Magellan Global Fund Update

Magellan Asset Management

April 2023

Global Portfolio Managers Nikki Thomas, and Arvid Streimann, discuss the unfolding interest rate cycle and the effect it's having on market sentiment and company valuations. They provide an update on the portfolio's recent performance and its positioning for the current environment.

Funds operated by this manager:

Magellan Global Fund (Hedged), Magellan Global Fund (Open Class Units) ASX:MGOC, Magellan High Conviction Fund, Magellan Infrastructure Fund, Magellan Infrastructure Fund (Unhedged), MFG Core Infrastructure Fund

Important Information: This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 ('Magellan') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should read and consider any relevant offer documentation applicable to any investment product or service and consider obtaining professional investment advice tailored to your specific circumstances before making any investment decision. A copy of the relevant PDS relating to a Magellan financial product or service may be obtained by calling +61 2 9235 4888 or by visiting www.magellangroup.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any strategy, the amount or timing of any return from it, that asset allocations will be met, that it will be able to be implemented and its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of a Magellan financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Magellan makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material.  Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Magellan. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.

Any trademarks, logos, and service marks contained herein may be the registered and unregistered trademarks of their respective owners. This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Magellan.

Hedge Clippings | 12 May 2023

Treasurer Jim Chalmers was understandably pleased to be able to hand down a budget forecasting a surprise surplus, but according to more than a few economists the real surprise will be whether it eventuates or not. As has been widely questioned, the risk is that the selected spending initiatives will be inflationary, leaving the RBA with no alternative but to either increase interest rates further or keep them higher for longer. Meanwhile, on the revenue side, there is still no appetite from either the government nor the opposition to fix or address the reliance on personal income tax. The opportunity has been lost for another year, as it has every year since the Henry Tax Review in 2010, and no doubt will be put in the too hard basket again next year as well.

Hedge Clippings is not going to dwell on the budget too long - it is covered more than enough elsewhere. However, it was interesting, if not alarming, that a research paper out of the RBA this week estimates the chance of a recession next year at 80%. If inflation does continue at an elevated level as many believe it will, and the RBA sticks to its determination to address it, a recession, whether with a "hard" or "soft" landing, is likely to be the outcome. It's going to be a delicate balance, or as Philip Lowe describes it, a "narrow road".

Turning to markets and managed funds. Market shocks, such as the '87 crash, the tech wreck of 2000, or the GFC, tend to create opportunity - particularly for the brave - after extended periods of investor exuberance, which when coupled with excessive leverage lead to stretched valuations. The past two to three years however have been different, but according to many managers we have spoken to, could be considered one of the most challenging periods in recent memory. Certainly there were stretched valuations, particularly in the tech and growth sectors, post GFC thanks to QE and central bank intervention, but little could have prepared markets for the combined effects of COVID, Russia's invasion of Ukraine, and the resultant outbreak of global inflation.

The small cap sector always takes the brunt when investors switch from risk on to risk off - having paved the way and outperformed in the first place. Over the year to December 2022, the average performance of the 86 funds which make up the Australian Mid and Small Cap Peer Group fell by 19% compared with the Australian Large Cap Peer Group, which fell on average only 4%. By contrast they topped the performance tables three years before. This cycle is not unusual given the lack of liquidity often accompanying stocks outside the ASX200 (and sometimes within it) but there's little doubt that as a result the lack of interest, or appetite for risk accentuates the losses, and in turn creates opportunity.

The key of course comes in the timing, so earlier this week we hosted a webinar discussion with three "small cap" fund managers, namely Dean Fergie from Cyan Investment Management, Steven Johnson from Forager Funds Management, and Gary Rollo from Montgomery Investment Management, to ask them the sometimes difficult question about their experiences over the past two years or so, but more importantly, if the worst of the current market was behind them?

You can watch a recording of the discussion below, but there were some key take-aways from each of them. None of them shied away from the difficult questions but were all consistent in their view that trying to time the bottom or turning point in the market was an impossible exercise. Each gave examples of oversold companies or markets, and each reiterated that holding profitable, successful businesses, with strong balance sheets (sometimes trading at or below asset, or even cash backing) will provide outsized future returns, rather than selling them at current depressed valuations.

Of interest is the fact that while the small cap sector has still underperformed the ASX200 in the six months to the end of April (+3.83% to +8.71%) at least it is positive, while over the past three months while marginally negative, the small cap peer group has just outperformed (-0.70% to the ASX200 at -0.80%).

Maybe the tide is about to turn?

News & Insights

New Funds on FundMonitors.com

The Future for Small Caps Webinar Recording

Magellan Global Fund Update | Magellan Asset Management

A once in a generation opportunity | Insync Fund Managers

April 2023 Performance News

Bennelong Australian Equities Fund

4D Global Infrastructure Fund (Unhedged)

Skerryvore Global Emerging Markets All-Cap Equity Fund

Delft Partners Global High Conviction Strategy

Bennelong Twenty20 Australian Equities Fund

Bennelong Kardinia Absolute Return Fund

Quay Global Real Estate Fund (Unhedged)

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