Beware of stock-based compensation in tech Beware of stock-based compensation in tech Beware of stock-based compensation in tech

Beware of stock-based compensation in tech

Equities 8 minutes to read
Picture of Peter Garnry
Peter Garnry

Chief Investment Strategist

Summary:  Silicon Valley wants investors to believe in the non-GAAP metric and essentially ignore stock-based compensation expenses. Not only is this misleading, it's everything that's wrong with tech, venture capital, and cheap money in general.


Last week I was engaged in a conversation over Box, Inc.’s Q3 results and co-founder and CFO Dylan Smith's comment that: ”…we’re on track to deliver our first quarter of non-GAAP profitability in Q4”. Think about this for a minute: it has taken a company 13 years to become profitable and this is apparently such an amazing milestone that it has to be marked.

In my opinion, it’s embarrassing, and it tells you everything that’s wrong with cheap money, the venture capital industry and Silicon Valley. Later today I will extend this conversation to startup exits and why I believe we have a systemic problem in our economy. But first, back to Box’s Q3 result and why it offers important lessons for investors looking at technology companies (whether private or public).

Stock-based compensation is a cost

When Box’s CFO says that the company is likely to achieve profitability in Q4, it is based on something called non-GAAP metric – a metric that has been criticised multiple times by the US Securities and Exchange Comission. According to Box’s Q3 financial statements, the US GAAP net loss was $40.2 million in Q3, but it was only $8.4m measured in non-GAAP terms.

This is done by subtracting the $31.8m stock-based compensation expense. Box wants essentially investors to ignore this expense as if it’s irrelevant; at least, that’s how we must interpret the company's statement about profitability. Box does not care about stock-based compensation. We will come back to why that’s a big mistake.
Stock-based compensation
Source: Box Q3 2018 earnings release
But first, a quick primer on stock-based compensation or share-based payment as it’s called in the International Accounting Standards' IFRS 2. The treatment is almost similar to US GAAP. When stock options are granted (there are several ways this can be done so we will skip the finer details) they are booked at fair value under the equity section on the balance sheet. As the options vest, they are expensed over the income statement.

Prior to 2005, the US Financial Accounting Standards Board did not treat stock options as an expense, leading obviously to perverse use of these compensation instruments for executive pay as they did not hit the bottom line; the trick was to link executive compensation to net income. After the 2005 change, US companies were quick to innovate and started linking compensation to EBITDA (earnings before interest, taxes, depreciation and amortisation) which excludes stock-based compensation. So again, the link is to an accounting measure not incorporating the cost of the compensation – it's really quite smart.

Warren Buffett was always clear in this debate, arguing that stock-based compensation is an expense and should be booked accordingly. The reason is simple: stock options are non-cash compensation so if they are not used, the company would likely have a higher cash salary expense. This quote from Box’s Q3 earnings release confirms this view: “...additionally, in the case of stock-based compensation expense, if Box did not pay a portion of compensation in the form of stock-based compensation expense, the cash salary expense included in cost of revenue and operating expenses would be higher, which would affect Box’s cash position.”

In other words, stock-based compensation is clearly an expense and often a quite sizeable one. In the case of Box, stock-based compensation is around 20% of revenue in Q3. This means that if Box shows a non-GAAP profit in Q4, the actual profit margin including stock-based compensation is still around -20%, and this after being in business for 13 years! As frequent readers of our analyses will know, we are always using EV/EBITDA metrics in our valuation analysis but we have erred in not adjusting the EBITDA numbers for stock-based compensation. This naturally makes the EV/EBITDA more attractive on a relative basis for companies using a lot of stock options; we will make efforts to correct this going forward.

When everything else fails, use the cash flow statement. This has always been the mantra in financial analysis of companies because the cash flow statement is more difficult to manipulate. In the case of stock-based compensation, however, it masks the true nature of the employee expenses, which are typically cash-based and thus subtract in the cash flow from operations.

In the last nine months (ending October 31), Box reported $24m in net cash from operating activities; this is the true number. But as the company stated concerning stock-based compensation, if it could not issue those options the cash-based salary expense would be much higher. If we assume that the fair-value of stock-based compensation, at the grant date, is higher than what would have been the true cash-based salary to attract the employees, then we should not adjust cash flows from operations by the full amount of the stock-based compensation. Assuming a deduction factor of 0.5, the $24m in cash flows from operations would still be -$20.6m for the past nine months – a big difference when analysing Box.

Ignore non-GAAP metrics

The message is clear: don’t use the non-GAAP metrics provided by many US companies. They may be published with good intentions but they portray the wrong picture for a potential or existing shareholder. Our warning is very important for investors investing in technology companies as these are the heaviest users of stock-based compensation.

Another recent example of misuse of non-GAAP metrics came when Groupon wanted to IPO using gross billing as its revenue figure, obviously to inflate the numbers. But the SEC declined this use and stated that net revenue (Groupon’s cut of the gross billing) is the right and proper metric to publish. According to S&P Global data from 2015, the total equity-related remuneration was $30.4 billion or 12.1% of pre-tax profits for the 67 technology companies in the S&P 500 at the time. This is a significant adjustment in valuation figures for an entire sector.

The fact that stock-based compensation is a sizeable expense for shareholders in technology companies is one thing. Even more worrying, though, is that it’s quite likely that companies, and hence shareholders, end up paying too much for labour as the stock-based compensation has a convex payoff profile in the case of success. It would probably be much better for VC firms in the pre-IPO phase to inject more cash into startups, paying with cash and not stock options. To provide some valuable colour on why using company shares as payment in acquisitions or to attract employees, we will end this discussion on stock-based compensation with a wonderful story from Warren Buffet:

"I made an even worse mistake when I said “yes” to Dexter, a shoe business I bought in 1993 for $433 million in Berkshire stock (25,203 shares of A). What I had assessed as durable competitive advantage vanished within a few years. But that’s just the beginning: By using Berkshire stock, I
compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion – to buy a worthless business.
" — Berkshire Hathaway, 2007 shareholder letter
 

Quarterly Outlook 2024 Q3

Sandcastle economics

01 / 05

  • 350x200 peter

    Macro: Sandcastle economics

    Invest wisely in Q3 2024: Discover SaxoStrats' insights on navigating a stable yet fragile global economy.

    Read article
  • 350x200 althea

    Bonds: What to do until inflation stabilises

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain inflation and evolving monetary policies.

    Read article
  • 350x200 peter

    Equities: Are we blowing bubbles again

    Explore key trends and opportunities in European equities and electrification theme as market dynamics echo 2021's rally.

    Read article
  • 350x200 charu (1)

    FX: Risk-on currencies to surge against havens

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperform in Q3 2024.

    Read article
  • 350x200 ole

    Commodities: Energy and grains in focus as metals pause

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities in Q3 2024.

    Read article

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)

Saxo Bank A/S (Headquarters)
Philip Heymans Alle 15
2900
Hellerup
Denmark

Contact Saxo

Select region

International
International

Trade responsibly
All trading carries risk. Read more. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more

This website can be accessed worldwide however the information on the website is related to Saxo Bank A/S and is not specific to any entity of Saxo Bank Group. All clients will directly engage with Saxo Bank A/S and all client agreements will be entered into with Saxo Bank A/S and thus governed by Danish Law.

Apple and the Apple logo are trademarks of Apple Inc, registered in the US and other countries and regions. App Store is a service mark of Apple Inc. Google Play and the Google Play logo are trademarks of Google LLC.