Stock-Based Compensation (SBC)

A detailed overview.

We recently wrote two articles on The Trade Desk Inc (TTD) which can be read here and here. These included some comments on Stock Based Compensation (SBC). SBC is an important topic for investors but is one, for understandable reasons, does not get discussed often. 

Historically, public companies paid management and employees in just cash. Until the 1940s, chief executive officers (CEOs) of public companies in the U.S. were paid essentially in 100% in cash. As recently as the 1970s, about 85% of CEO pay was in cash.

Large, quoted companies suffer from a Principal-Agent Problem. Company executives are Agents who manage the firm on behalf of the (mostly external) shareholders, who are the Principals. Significant costs arise when executives who are in control of the assets make decisions that benefit themselves at the expense of external shareholders.  The problem is increased by information asymmetry in that managers know much more about the operations and performance of the company than external shareholders. 

Think about a small private company run by the founding shareholders who provided 100% of the equity (or risk) capital.  The manager and provider of capital are the same and the company does not have a Principal-Agent Problem. The only sources of capital are retained profits and debt.  These will be limited.  The lack of additional equity capital will limit the speed at which the company can grow.

The company could respond to this by raising external capital, perhaps by a listing and a series of follow-on sales of shares. Over time, a large proportion of the company’s equity will be owned by external entities and the percentage owned by management will decline perhaps quite significantly.  A Principal-Agent Problem will arise in this case.   

The median percentage direct ownership of stock by CEOs of the top 120 American public companies in the mid-1970s was one-sixth of what it had been in the 1930s.  Economic theory assumes companies maximise profits as they are driven by profit-maximising entrepreneurs.  However, in the 1960s, economists argued that this was not the case in America.  The era of entrepreneurial or shareholder capitalism has been replaced by managerial capitalism.  Large companies were run by professional managers who owned little or no stock in the company and, therefore, had little incentive to chase profits.  Instead, their salaries, benefits and prestige were positively correlated with the size of the company. Therefore, managers pursued revenue growth rather than profitability. Managers often preferred inorganic growth to create large companies which were often bureaucratic, diversified conglomerates.         

Thing started to change in the 1980s.  Many of the large conglomerates were trading at valuations that were below a sum of the parts valuation.  Conglomerates were out of favour in the stock market. Shareholders and Corporate Raiders realised that value could be unlocked by breaking up conglomerates and creating many focused smaller companies by divestments, spin-offs etc. They were encouraged by lenders and corporate financiers to agitate for change. An active market for corporate control developed.  Companies and CEOs, who wanted to avoid losing control of their companies had to change, cut costs, and implement other measures to boost the share price.   It was thought that management had to be given “skin in the game” to incentivise them to create shareholder value.

Boards shifted the mix of pay for executives from cash to equity and then started to pay employees well below the executive ranks with equity as well.   Today, SBC is a large majority of executive pay, and almost 80 percent of SBC is paid to employees who are not high-ranking executives.

It was argued that managers should have “skin in the game” and capital invested in the company so that they benefit when the share price rises and alternatively suffer erosion in their wealth, if the share price falls. Having skin in the game means they are incentivised to manage in a way that encourages long-term stock appreciation, and their interests are aligned with those of other shareholders. There is nothing wrong with that.  The devil however is in the detail. 

• How many shares should be allocated to management and employees and at what prices? 

• How challenging should the targets that need to be met before shares (or cash) are allocated? 

• How long should the lock-up periods be?

The risk for outside shareholders is that management will take advantage of information asymmetry to get shares at too low a price and as a reward for achieving targets which are either too easy, or based on criteria management has little influence over. Another risk is that the lock-up period may be too short and managers sell too quickly, and their interests are fully aligned with shareholders for a very short time.

If some or all of these factors occur, a disproportionate share of the benefits will accrue to managers and insiders and too little to the external providers for risk capital.   As long-term minority investors, we must understand the compensation culture and practices of companies and incorporate them in our valuation models.  

We need to understand is the accounting treatment of SBC.  SBC increased in importance in the 1980s and 1990s but did not appear in the accounts and financial statements except as a footnote.  Some investors campaigned for a more meaningful incorporation of SBC in the financial statements but companies, especially in the tech sector, lobbied against it.   One of the most cogent proponents of expensing SBC was Warren Buffett who made the argument in his trademark, pithy way.  His argument was simple: “If stock options are not a form of compensation, what are they? And if compensation is not included as an expense item, in which part of the income statement should they be?”

Buffett prevailed and SBC has had to be recognised as an expense on the income statement under U.S. generally accepted accounting principles (GAAP) since in 2006. In an informative paper on SBC, Michael Maboussian and Dan Callahan estimated that SBC was about US$270 billion in 2022, or 6%- 8% of total compensation for public companies in the U.S.  SBC went from 0.2% of sales in 2006 to 1.3% of (much increased) sales in 2021. SBC is much higher for younger companies than older companies.  Employees require more of the equity upside as compensation for the risk of joining a smaller company or a start-up. Young companies often require capital to grow and may not be able to pay as much as cash remuneration as a larger more-established company.  In some sectors, such as IT or Communication Services, SBC (as percentage of sales) is much higher than others such as Consumer Staples / Utilities.

As the inclusion of SBC tends to reduce reported GAAP earnings, more than 95% of public companies also now report non-GAAP results and give them a prominent place in their press releases and presentations etc. The adjustment from GAAP to Non-GAAP often involves adding back SBC expenses to the income statement thereby boosting net profit and then recalculating (higher) EPS and other numbers. It sometimes also involves reversing the effect of SBC on the number of shares outstanding.  In recent years nearly one-fifth of companies have reported non-GAAP EPS with shares outstanding different from what GAAP designates. For this reason alone, Long-term investors should take everything a company says about non-GAAP results with a pinch of salt.

The fact that income statements now recognise SBC in GAAP numbers is a positive development. However, granting stock options is a non-cash item so it does not affect operating or free cash flows. In our article on TTD, we noted that in 2022, Operating profit was about US$ 113mn while Operating Cash Flow was about US$ 548mn. SBC in 2022 was US$ 487mn. If we adjust Operating Cash Flow for SBC it would fall from US$ 548mn to US$ 61mn. Similarly Free Cashflow would change from US$ 457mn to – US$ 30mn. This shows, Operating and Free cashflows can fall significantly when SBC is taken into consideration.

In a DCF valuation, which involves determining the present value of Future Free Cash Flows, the resulting valuation will be lower if Free Cash Flow is adjusted (reduced) for SBC than if it is not. 

Expensing and adjusting Free Cash Flow is not the only way to deal with SBC.  SBC is also recognised as a claim on Equity. So instead of expensing and reducing Free Cash Flow, the analyst could deal with SBC by modelling the dilution it gives rise to.    In a DCF model the cashflows of the futures must be divided by the number of shares outstanding.  The analyst should adjust (increase) the number of shares outstanding to reflect the likely increase in shares outstanding.  How can this be done?

For profitable companies, the analyst should start with fully diluted shares and increase the shares over time to capture anticipated dilution due to SBC.   For unprofitable companies, add shares that have already been granted to current shares outstanding, and then increase further for likely future issuance. Modelling dilution is tricky, since a lot of assumptions must be made but the goal is to try to value the dilution.  It is better to approximately right than completely wrong.  Any estimate of the impact of SBC will be wrong but it is better than ignoring it altogether.

 In this case, SBC is dealt with not by reducing Cash flows but by ensuring that future per share calculations are divided by the higher number of shares outstanding reflecting the effect of SBC.  This method recognises the dilution effect of SBC.

Both the Free Cash Flow reduction approach and the equity claim/ dilution method result in lower valuations for the stock compared with the case where SBC is not considered.  

So far, we have talked very generally about SBC.  There are two main types of SBC. The company can just grant stock mainly in the form of Restricted Stock Units (RSU) or they can give employee stock options (ESO).  There has been a broad shift from employee stock options (ESOs), which were the dominant form of stock-based compensation in the 1990s, to RSUs.   

RSUs typically have a vesting schedule and the fair value is calculated on the initial grant date under a straight-line schedule.

Let us take a simple example.  Suppose an employee receives RSUs of a company whose stock was trading at US$ 100 per share on January 1st, 2023. The company granted US $100k worth of shares on that day i.e., 1,000 shares.  If the vesting schedule is recognised in a straight line over four years, the employee will receive 250 shares of the company on the 1 Jan every year for the next four years. Each year the SBC cost in the Income statement will be shown as US$ 25,000 irrespective of the actual share price in the following four years.   If the Share prices falls afterwards, the SBC will be overstated.  If Shares rise afterwards, the SBC will be understated.  It will only be accurate if the share price does not change.  The SBC number on Income Statement is almost always wrong and the error will be greater, the more volatile the stock. GAAP does a poor job of depicting reality in the period of stock price volatility.  The accounting treatment of ESOs is different but we do not have space to consider it here.

Subtracting the stated SBC from the Free cash Flow is better than nothing but will not give an accurate result.  Arguably, investors should just model SBC dilution instead.  Dilution occurs when a company issues new shares, lowering the percentage ownership of the existing shareholders.  Investors will have to look at factors such likely staff growth, compensation trends, likely growth in SBC to estimate the level of stock issuance and therefore the dilution over the forecast period.

One relevant question is, should one consider the number of shares offered to employees or the dollar amount of SBC per headcount.   The answer is likely to be the latter.  If company believes an employee’s fair compensation is say US$ 300,000 per annum. They may choose between US$ 150k salary plus US$ 150k SBC or US$ 200k salary and US$ 100k SBC.   SBC is viewed in US$ terms rather than in terms of the number of shares.  This implies that if they want to dilute the shareholders less, they will have to lower the total compensation to employees.

We also need to consider stock buybacks.  Many companies have programmes for buying back stock. It is sometimes assumed that stock buybacks are always a good thing.  I noted in a recent article that this is not always the case.  It depends critically on the price at which the shares are bought relative to the intrinsic value of the shares. 

1. If shares are bought at a price which is a non-trivial discount to its (conservatively estimated) intrinsic value, share buybacks are likely to be value-additive to the company.

2.  If shares are bought at a price which is a non-trivial premium to its (conservatively estimated) intrinsic value, share buybacks are likely to be value destroying to the company.

Some companies use share buybacks primarily to partly or completely offset the dilution caused by SBC.  This is a red flag for at least a couple of reasons.

First it means the stock buying is likely to be done every year and will be driven by the SBC and be done without any consideration of the price paid.     

Second, buybacks are funded with excess cash, debt, or cash flows attributable to equity holders. Buybacks involve an outflow of cash. So, SBC, which does not usually involve any cashflow, is offset by stock buyback which involves a cash outflow – the net effect likely to be negative. Buybacks with excess cash reduce firm value and have no impact on value per share unless the shares are mispriced and well below intrinsic value.

Does SBC reduce agency costs?

SBC can reduce agency costs by creating proper incentives, by providing a mechanism to retain talent, and creating an ownership mentality among employees.

Academic research suggests that SBC overall, and stock options, can provide an incentive for executives but the effect is much more muted for non-executives. Only about 20 percent of total SBC goes to executives. But restricted stock units (RSUs) do a relatively poor job of incentivizing executives to make risky investments that create value.  Cash bonuses based on strategic goals can provide more of an incentive than SBC.

SBC is a neglected topic.

SBC can be an important source of the reduction of shareholder return. So, shareholder must take account of it.  However, they will not get any help in this endeavour.  I must have listened to or read the transcripts of over 500 analysts conference calls with companies but have never heard any sell-side analysts question the management on the subject.  Analysts try to have a good relationship with company managements and questions about compensation are unlikely to help in this regard.  The only companies which are happy to discuss it are those which have a very different approach to it.

Warren Buffett for example is well known for his reluctance to issue shares.  All acquisitions are paid for in cash, never in Berkshire shares, Berkshire pays managers bonuses’ (sometimes quite generously) in cash only if they meet performance targets. Managers can always buy shares at the market price which is the price for all other shareholders as well.  Buffett has only ever himself a modest salary and has never paid himself with ESOs or a (discounted) RSU. Greg Abel, the vice chairman of Berkshire Hathaway, increased his equity stake in the company recently by buying in the open market. According to an SEC filing, Abel purchased 55 shares of Berkshire Hathaway Class A stock on March 10, 2023, for a total of $25 million. Abel is a potential successor to Warren Buffett as CEO of Berkshire Hathaway. All this reflects the fact Buffett views his company as a partnership with all shareholders and therefore he or his managers do not get a better deal than that which is available to other shareholders.    

 Mark Leonard is the CEO of a very successful Canadian Company called Constellation Software (CSU).  CSUs compensation policy is the gold standard since it eschews any favourable treatment for insiders and insists on a long-term capital commitment. Operating Group managers at Constellation are required to earmark 75% of their after-tax bonuses to purchasing CSU stock on the open market. Stock ownership is widespread, encompassing more than just the senior management team, which owns ~9% of the company’s shares, as all employees above a certain comp threshold must invest in CSU shares and hold them for at least 4 years (The CEO claims the average holding period is much longer). CSU even mandates that Board members invest the after-tax comp they receive into Constellation Software shares.

Conclusions

• Stock-based compensation (SBC) is an important but poorly understood topic for investors.

• A poor SBC scheme can strongly dilute the returns for investors in otherwise very successful companies.

• Investors must adjust future estimates in their valuation models to adjust for the impact of SBC. 

• This is best done by considering the dilution that results for the increase in shares outstanding because of SBC. 

• This is not an issue that sell side analysts will ever raise with companies, so investor must do their own work in this area. 

• A poor SBC policy can be used to enrich insiders in the company at the expense of shareholders who are the providers of risk capital.

•  Minority shareholders are particularly exposed in this regard.