Insights

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.

An Australian perspective on SBC

There is a considerable level of SBC usage in ASX listed companies outside of the technology industry. The table below lists some of the largest absolute dollar payers of SBC on the ASX for the year ended 31 December 2022.

Whilst there are some technology companies on the list (Life 360, Novonix and Iress) it also includes a number of other sectors including gambling companies (Betmakers, PointsBet, and Tabcorp), fund managers (Janus Henderson and Pendal) and retailers (Kogan and Lovisa).

Our portfolio has holdings in both Iress and Life 360. Both companies are expected to be cashflow profitable for 2023 and onwards. Iress is currently undergoing a potential major transformation and refocus under a new CEO. This may see SBC come under greater scrutiny than it previously had under its prior tech-based CEO. As for Life 360, this is a US based global tech business and its large SBC is mainly due to consolidating its recent acquisition of Tile, the location devices business. We have conveyed our cautious views on SBC to the management and believe they are very focused on not growing SBC in absolute terms (i.e. declining as a % of future revenue). We are hopeful SBC will decline in absolute terms in future as profitability increases and employee expectation around remuneration change. Whilst the company will be profitable pre SBC in 2023, it plans to be profitably on a statutory basis (post SBC) from 2025 onwards.

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, Eiger Capital