Employees as Stakeholders: The CFO's Guide to Balancing Ownership and Compensation

I. Introduction

In Silicon Valley's ever-evolving landscape, a new paradigm is reshaping the relationship between companies and their employees. At the heart of this transformation lies stock-based compensation (SBC), a tool that has become both a blessing and a burden for tech giants and startups alike. As of 2024, the average SBC as a percentage of revenue for EMCLOUD companies stands at a staggering 21%, dwarfing the 2% seen in S&P 500 companies, according to a recent RBC report.

This seismic shift has thrust Chief Financial Officers into the spotlight, tasking them with a delicate balancing act: leveraging SBC to attract and retain top talent while safeguarding shareholder value. The stakes are high, as mismanagement of SBC can not only erode profitability but also attract unwanted attention from activist investors. As Brad Gerstner of Altimeter Capital pointedly remarked, "Adjusted EBITDA excluding stock-based compensation is a fairy tale."

In this new reality, treating employees as stakeholders is no longer just a feel-good corporate philosophy—it's a financial imperative. CFOs must now navigate the complexities of employee ownership while keeping a watchful eye on the looming threat of hedge fund activism. This delicate dance between employee satisfaction and shareholder returns is redefining the role of financial leadership in tech, making the management of SBC one of the most critical challenges facing CFOs today.

II. The Growing Significance of SBC in Tech

The meteoric rise of stock-based compensation in the tech sector is not just a trend—it's a seismic shift that's reshaping the financial landscape of Silicon Valley and beyond. As we delve deeper into the numbers, the stark contrast between tech and traditional industries becomes even more apparent.

According to a 2023 Goldman Sachs report, the median SBC as a percentage of revenue for software companies has exploded, with some firms surpassing the 50% mark. This isn't just a startup phenomenon; even mature tech giants are doubling down on SBC. Data from RBC shows that for large-cap SaaS companies, SBC is growing faster than revenue at a rate of 1.1x, compared to 0.9x for S&P 500 companies.

The allure of SBC is multifaceted. It serves as a powerful retention tool, with a 2017 University of Pennsylvania study finding benefit-cost ratios ranging from 1.95 to 3.75. For cash-strapped startups and high-growth firms, it's a lifeline, allowing them to compete for top talent without burning through precious capital. Moreover, it theoretically aligns employee incentives with company performance, creating a workforce of owner-operators.

However, this reliance on SBC has not gone unnoticed by the watchful eyes of activist investors. Hedge funds, armed with sophisticated analysis and a hunger for immediate returns, are increasingly scrutinizing tech companies' SBC practices. As one industry insider put it, "SBC is the new leverage on tech balance sheets, and activists are circling like sharks."

The threat of activist intervention looms large. In recent years, we've seen hedge funds target companies they believe are overusing SBC, arguing that it masks true profitability and dilutes shareholder value. This new battleground has forced CFOs to become not just financial stewards, but also strategic defenders against potential activist campaigns.

The message is clear: while SBC offers undeniable benefits, its growing prominence is a double-edged sword that CFOs must wield with unprecedented skill and foresight. As we'll explore in the next section, the challenges of managing this new form of compensation are as complex as they are crucial.

III. The Double-Edged Sword of SBC

As the tech industry's love affair with stock-based compensation intensifies, CFOs find themselves walking a tightrope between employee satisfaction and financial prudence. The allure of SBC is undeniable, but its pitfalls are becoming increasingly apparent, especially in the current market climate.

The overreliance on SBC has created a precarious situation for many tech companies. As Bill Gurley of Benchmark Capital astutely observed, "95% of RSUs are sold on vest," which undermines the very purpose of giving employees skin in the game. This behavior pattern suggests that SBC may not be as effective at aligning long-term interests as previously thought.

Moreover, the impact of SBC on financial metrics and valuation is profound and often underappreciated. A 2023 Morgan Stanley study of 67 FCF-positive software companies revealed a startling fact: the median cash accounting costs of SBC represented 99% of free cash flow on average. This staggering figure calls into question the true profitability of many tech darlings.

The dilution effect of SBC is another thorn in the side of CFOs and shareholders alike. Goldman Sachs data shows that dilution rates for software companies have skyrocketed in recent years, with some firms experiencing annual dilution of over 5%. This steady erosion of ownership not only impacts existing shareholders but can also make a company less attractive to potential investors.

The volatility of tech stocks further complicates the SBC equation. In a bull market, SBC seems like a win-win. However, when stock prices plummet, companies face a difficult choice: issue more shares (causing further dilution), increase cash compensation (pressuring margins), or risk losing talent. This conundrum was painfully evident during the 2022 tech stock selloff, where many employees found their options underwater and their paper wealth evaporated.

Hedge fund activists are keenly aware of these issues. They argue that excessive SBC obscures true economic realities and can lead to misaligned incentives. As one prominent activist investor put it, "SBC is often the Achilles' heel of tech company financials. It's where we look first for signs of mismanagement and opportunities for intervention."

For CFOs, the message is clear: the days of treating SBC as a magic bullet for compensation are over. A more nuanced, strategic approach is needed—one that balances the benefits of employee ownership with the harsh realities of financial performance and shareholder expectations.

IV. The CFO's Balancing Act

"The era of simply doling out options and RSUs without strategic consideration is over," says Bob Mylod, former CFO of Booking Holdings and a veteran of the tech finance world. "Today's CFOs need to approach SBC with the same rigor they apply to capital allocation decisions."

This new approach requires a multi-faceted strategy:

1. Rightsizing SBC: CFOs must carefully calibrate SBC levels to avoid overreliance. Data from Altimeter Capital suggests that SBC exceeding 10% of revenue should raise red flags. By keeping SBC within reasonable bounds, companies can maintain financial flexibility and reduce their vulnerability to activist critiques.
2. Balancing Cash and Equity: As the market has shown, an over-reliance on equity compensation can backfire when stock prices fall. Smart CFOs are exploring hybrid models that combine cash and equity, providing stability for employees while preserving upside potential.
3. Addressing Underwater Options: The tech stock selloff of 2022 left many employees with worthless options. Proactive CFOs are exploring strategies such as option repricing or exchange programs, but these must be carefully structured to avoid further shareholder dilution.
4. Transparent Communication: Perhaps most critically, CFOs must become masters of communication, clearly articulating their SBC strategy to both employees and investors. As one Silicon Valley CFO put it, "Transparency is our best defense against activist intervention."

By treating employees as a bona fide shareholder class, CFOs can foster a culture of ownership that aligns with good governance practices. This approach not only motivates employees but also demonstrates to external stakeholders that the company takes its fiduciary responsibilities seriously.

"When employees think and act like owners, it creates a natural defense against short-term activist pressures," notes Gavin Baker of Atreides Management. "It's harder for an activist to argue that a company is mismanaged when its employees are deeply invested in its long-term success."

However, this approach is not without its challenges. CFOs must navigate complex accounting rules, evolving investor expectations, and the ever-present threat of talent poaching by competitors. The key lies in striking the right balance—one that motivates employees, satisfies shareholders, and keeps activist wolves at bay.

VI. Avoiding Hedge Fund Activism

As Brad Gerstner of Altimeter Capital astutely observed, "Unlevered FCF - SBC is the new EBITDA." This shift in focus has put CFOs on high alert, forcing them to reevaluate their SBC strategies to ward off potential activist incursions.

The threat is not just theoretical—it's imminent and growing. The recent Starboard Value LP letter to Autodesk shareholders serves as a stark reminder of the scrutiny tech companies face. Starboard, with a $500 million stake in Autodesk, raised significant concerns about the company's SBC practices, linking them directly to issues of governance, oversight, and accountability.

To mitigate this risk, forward-thinking CFOs are adopting proactive strategies:

1. Rigorous SBC Budgeting: Implementing strict controls on SBC issuance, treating it as a scarce resource rather than an infinite well. As Starboard pointed out with Autodesk, misalignment between stated SBC policies and actual practices can lead to severe consequences.
2. Enhanced Disclosure: Providing clear, detailed breakdowns of SBC impact on financials. The Autodesk case underscores the importance of transparent communication about SBC practices to avoid misleading investors.
3. Regular Shareholder Engagement: Maintaining open lines of communication with major investors to address concerns before they fester. Starboard's letter highlights the potential fallout when shareholders feel their concerns are ignored.
4. Performance-Linked SBC: Tying equity grants more closely to concrete performance metrics, demonstrating a commitment to shareholder value creation. This approach can help avoid the pitfalls Autodesk faced with its free cash flow manipulations.

As one prominent tech CFO noted, "In today's environment, managing SBC isn't just about compensation—it's about corporate defense. We're not just competing for talent; we're safeguarding our strategic autonomy."

The Autodesk case serves as a cautionary tale, illustrating how mismanaged SBC can lead to activist intervention, reputational damage, and potential legal action. It underscores the critical need for CFOs to treat employees as a true shareholder class, ensuring that SBC practices align with both talent retention goals and shareholder interests.

VII. Conclusion

As we've explored throughout this article, the management of stock-based compensation (SBC) has become a critical battleground for CFOs in the tech industry. The stakes have never been higher, with activist investors like Starboard Value LP scrutinizing every aspect of SBC practices and their impact on shareholder value.

The data is clear and compelling. As Thomas Reiner's analysis shows, companies in the "Death Zone" - those with low growth and high dilution - are particularly vulnerable to activist intervention. Names like Box, Twilio, and Zoom find themselves in precarious positions, diluting shareholders at rates of 5-6% annually while struggling to accelerate growth. This is precisely the kind of situation that attracts activist attention, as we saw with Starboard's intervention at Autodesk.

On the other hand, companies like Booking.com and Netflix have emerged as "shareholder heroes," topping Reiner's Dilution Leaderboard with best-in-class SBC practices. These companies demonstrate that it's possible to attract and retain top talent while also respecting shareholder interests.

The message for CFOs is clear: treating employees as a shareholder class is no longer optional - it's a financial imperative. As we've seen with Autodesk, mismanagement of SBC can lead to severe consequences, including activist interventions, reputational damage, and potential legal action.

Moving forward, CFOs must adopt a more nuanced and strategic approach to SBC. This includes:

• Implementing rigorous SBC budgeting processes
• Enhancing disclosure and transparency around SBC practices
• Engaging regularly with shareholders to address concerns proactively
• Tying equity grants more closely to concrete performance metrics

The tech industry is at a crossroads when it comes to SBC. As growth rates normalize and investors demand more accountability, CFOs who can successfully navigate this new landscape will be the ones who create lasting value for all stakeholders. The era of unchecked SBC is over; the era of strategic, shareholder-aligned compensation has begun.