Why Top CFOs Are Rethinking Stock-Based Compensation

I. Introduction

In the wake of recent market volatility, a silent but significant challenge is emerging for CFOs across the technology sector and beyond: the growing impact of stock-based compensation (SBC) on corporate financials and shareholder value. Once hailed as a golden tool for attracting top talent and aligning employee interests with company success, SBC has now reached levels that demand a critical reassessment.

Consider this stark reality: according to RBC Capital Markets, SBC as a percentage of revenue for EMCLOUD (Emerging Cloud) companies averaged a staggering 21% in the latest fiscal year, compared to just 2% for S&P 500 companies [1]. This ten-fold difference highlights the outsized role SBC plays in the tech sector's financial landscape.

The magnitude of this issue becomes even clearer when we look at individual companies. Data from tanay.substack.com reveals that some SaaS companies are seeing SBC consume more than 50% of their revenue [2]. This level of compensation overhang raises serious questions about long-term profitability and shareholder dilution.

Moreover, the problem isn't confined to smaller, high-growth companies. Even mature tech giants are grappling with SBC's impact. Goldman Sachs reports that for large-cap SaaS companies, SBC is growing faster than revenue at 1.1x, compared to 0.9x for S&P 500 companies [3]. This trend suggests that the issue may be structural rather than merely a growing pain of young tech companies.

As market conditions tighten and investors increasingly focus on profitability and cash flow, CFOs are finding themselves at a crossroads. The traditional approach to SBC is no longer sustainable, yet abandoning it entirely could put companies at a disadvantage in the fierce competition for talent.

In this evolving landscape, forward-thinking CFOs are recognizing the need to reevaluate their SBC strategies. By doing so, they have the opportunity to unlock hidden value, improve financial transparency, and better align compensation with long-term shareholder interests. The following sections will explore why and how top CFOs are rethinking SBC, offering insights and strategies for those ready to tackle this critical challenge head-on.

II. The Evolution of SBC: From Dot-Com Era to Today

The story of stock-based compensation (SBC) in the tech industry is one of rapid evolution, marked by regulatory changes and shifting market dynamics. To understand why CFOs are now rethinking SBC strategies, it's crucial to examine this historical context.

In the late 1980s and throughout the 1990s, SBC gained popularity as a way for cash-strapped startups to attract talent. However, accounting for these stock options was a contentious issue. Prior to 2004, companies were merely "encouraged" to expense the estimated fair value of stock grants, with most opting to disclose this information in footnotes rather than on the main financial statements [1].

This approach drew criticism from notable figures like Warren Buffett, who argued vehemently for the recognition of SBC as a real expense. In his 1998 Berkshire Hathaway shareholder letter, Buffett wrote, "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?" [2]

The landscape changed dramatically in late 2004 with the introduction of SFAS 123R (now ASC 718), which required companies to record stock options as an expense. This new standard aimed to provide more transparency, but it also sparked a trend of companies reporting non-GAAP metrics that excluded SBC [1].

Fast forward to today, and the use of SBC has reached unprecedented levels, particularly in the software industry. Recent data from Wellington Management shows that for large-cap SaaS companies, SBC represents a significant 39% of current free cash flow (FCF), compared to just 4% for S&P 500 companies [3].

Even more striking is the trend among mature tech companies. Goldman Sachs reports that for large-cap SaaS firms, SBC is growing faster than revenue at a rate of 1.1x, while for S&P 500 companies, this ratio is 0.9x [4]. This indicates that even as tech companies mature, their reliance on SBC is not diminishing – a trend that raises questions about long-term sustainability.

The current state of SBC usage in the tech sector is perhaps best illustrated by looking at individual companies. Data compiled by RBC Capital Markets shows that some software companies have SBC levels exceeding 50% of revenue, with several others falling in the 20-40% range [3]. These figures stand in stark contrast to the 2% average for S&P 500 companies, highlighting the tech sector's outlier status in SBC utilization.

As we move forward, CFOs face the challenge of navigating this complex landscape. The evolution of SBC from a footnote disclosure to a major component of compensation packages has created both opportunities and risks. Understanding this history is crucial for developing strategies that balance talent attraction and retention with financial prudence and shareholder value creation.

III. The Hidden Costs of Overreliance on SBC

While stock-based compensation (SBC) offers apparent benefits, its overuse can lead to significant hidden costs that CFOs must carefully consider. This section examines three key areas of concern: dilution, impact on financial metrics, and retention risks.

A. Dilution Concerns: Recent Trends in Tech Companies

Dilution from SBC has become a pressing issue, particularly in the tech sector. According to data from Goldman Sachs, the median annual dilution for software companies has increased dramatically in recent years. In 2022, it reached nearly 4%, up from approximately 2% in 2020 [1]. This trend is alarming, as it indicates that existing shareholders are seeing their ownership stakes diminished at an accelerating rate.

To put this in perspective, a company diluting at 4% annually would see its share count increase by over 21% in just five years, assuming no buybacks. This level of dilution can significantly impact shareholder returns and potentially lead to investor dissatisfaction.

B. Impact on Free Cash Flow (FCF) and Valuation Metrics

The treatment of SBC in financial reporting, particularly its exclusion from non-GAAP metrics like adjusted free cash flow, can mask the true economic cost to shareholders. A study by Morgan Stanley found that across 67 FCF-positive software companies, the median cash accounting costs of SBC represented a staggering 99% of FCF on average [2].

This finding suggests that many software companies appearing cash-flow positive might actually be barely breaking even or even cash-flow negative when accounting for the real cost of SBC. Such discrepancies can lead to inflated valuations and misallocated capital.

Furthermore, Wellington Management's research shows that SBC represents 39% of current FCF for large-cap SaaS companies, compared to just 4% for S&P 500 companies. It also inflates FCF margins by 12% for SaaS companies versus only 1% for the S&P 500 [3]. These stark differences highlight how SBC can distort key financial metrics, potentially misleading investors and complicating valuation processes.

C. Retention Risks in Volatile Markets

While SBC is often touted as a retention tool, overreliance on it can backfire, especially in volatile market conditions. When stock prices decline sharply, as seen in the recent tech market correction, employees may find their stock options underwater or their restricted stock units (RSUs) worth significantly less than expected.

This scenario creates a retention risk, as noted by venture capitalist Bill Gurley, who asserts that "95% of RSUs are sold on vest," potentially defeating the purpose of giving employees long-term skin in the game [4]. Companies faced with this situation may feel pressured to issue more stock to compensate, leading to further dilution, or to increase cash compensation, putting pressure on margins.

The dilemma is clear: do nothing and risk losing talent, or take action that could further impact financial health or shareholder value. This predicament underscores the need for a more balanced approach to compensation that doesn't overly rely on SBC.

IV. Why Top CFOs Are Rethinking SBC

The mounting evidence of SBC's hidden costs has prompted forward-thinking CFOs to reassess their approach to stock-based compensation. This section explores the key drivers behind this shift in perspective.

A. Balancing Growth Incentives with Long-term Shareholder Value

CFOs are increasingly recognizing the need to strike a delicate balance between using SBC to fuel growth and preserving long-term shareholder value. The traditional view that SBC is a "free" way to compensate employees is being challenged by the reality of its dilutive effects.

For instance, a 15-year discounted cash flow (DCF) model comparison shared by Thomas Reiner illustrates how SBC can significantly impact company valuation. In his example, a company with $100 million in revenue and 30% FCF margins sees its implied fair market value drop from $24 per share to $20 per share when SBC is treated as a cash expense. This 19% decrease in value underscores the tangible impact of SBC on shareholder returns [1].

B. Addressing Investor Scrutiny and Market Pressures

As investors become more sophisticated in their analysis of SBC's impact, CFOs are facing increased pressure to provide greater transparency and justify their compensation strategies. The market's reaction to high levels of SBC has been evident in the recent pullback in valuations for companies with significant SBC expenses.

This scrutiny has led to calls for greater candor in financial reporting. As highlighted by the Altimeter SBC Gold Standard Index, companies that are best-in-class at accounting for and managing stock-based compensation are gaining recognition. This index tracks companies that keep SBC at 20% below the percentage of free cash flow, setting a new standard for transparency and efficiency in SBC management [2].

C. Preparing for Potential Regulatory Changes

While current accounting standards require the expensing of SBC, there's ongoing debate about the adequacy of these measures. CFOs are aware that regulatory bodies may introduce more stringent requirements or disclosure rules in the future.

The increasing divergence between GAAP and non-GAAP metrics, particularly in how they treat SBC, has not gone unnoticed. As noted in the documents, some companies report being profitable on a non-GAAP basis while being unprofitable under GAAP due to SBC [3]. This discrepancy could attract regulatory attention, prompting CFOs to proactively address these issues before potential mandates are imposed.

Moreover, the evolving landscape of executive compensation disclosure rules and increasing focus on pay equity are additional factors that CFOs must consider in their SBC strategies.

By rethinking their approach to SBC now, top CFOs are not only addressing current challenges but also positioning their companies to adapt more easily to future regulatory changes. This proactive stance can help avoid potential compliance issues and the need for drastic adjustments down the line.

In conclusion, the combination of shareholder value considerations, increasing investor scrutiny, and the potential for regulatory changes is driving CFOs to reevaluate their SBC strategies. As we'll explore in the next section, this reassessment is leading to innovative approaches in managing and reporting SBC.

V. Innovative Approaches to SBC Management

As CFOs grapple with the challenges of SBC, innovative approaches are emerging to better manage and report on stock-based compensation. These strategies aim to balance the benefits of SBC with the need for financial transparency and shareholder value creation.

A. Adjusting Metrics: SBC-aware FCF and Rule of 40

Forward-thinking CFOs are adopting new metrics that provide a more accurate picture of company performance. For instance, some are now focusing on "SBC-adjusted Free Cash Flow" to better reflect the true economic cost of compensation.

The traditional "Rule of 40" for SaaS companies (where the sum of revenue growth rate and profit margin should exceed 40%) is also being reevaluated. Thomas Reiner's analysis introduces an "SBC Adjusted Rule of 40," which accounts for the impact of stock-based compensation. This adjusted metric provides a more realistic view of a company's efficiency and profitability [1].

B. Hybrid Compensation Models: Balancing Cash and Equity

To mitigate the risks associated with overreliance on SBC, some companies are moving towards hybrid compensation models. These models aim to provide a more balanced mix of cash and equity compensation, reducing dilution while still offering employees upside potential.

C. Strategic Use of Buybacks to Manage Dilution

Another approach gaining traction is the strategic use of share buybacks to offset dilution from SBC. While this doesn't eliminate the economic cost of SBC, it can help manage the impact on existing shareholders.

D. Enhancing Transparency with Advanced Reporting

In response to investor demands for greater transparency, companies are developing more sophisticated reporting methods for SBC. This includes providing detailed breakdowns of SBC impact on various financial metrics and offering clear explanations of compensation strategies in investor communications.

For example, some companies are now including SBC-adjusted metrics alongside traditional GAAP and non-GAAP measures in their earnings reports. This approach, exemplified by companies in the Altimeter SBC Gold Standard Index, allows investors to better understand the true cost of compensation and its impact on shareholder value [2].

E. Leveraging Technology for SBC Management

CFOs are increasingly turning to advanced analytics and modeling tools to better understand and manage their SBC programs. These technologies allow for real-time analysis of dilution impacts, scenario planning for different compensation structures, and more accurate forecasting of long-term SBC costs.

By leveraging these tools, CFOs can make more informed decisions about compensation strategies, balancing the need to attract and retain talent with the imperative to protect shareholder interests.

Conclusion: The Path Forward for CFOs

As we've explored throughout this article, the landscape of stock-based compensation is evolving rapidly, presenting both challenges and opportunities for CFOs. The path forward requires a delicate balance between leveraging SBC as a tool for attracting and retaining talent, and managing its impact on financial health and shareholder value.

A. The Opportunity to Unlock Hidden Value

By rethinking their approach to SBC, CFOs have a unique opportunity to unlock hidden value within their organizations. This can be achieved through:

1. Enhanced financial transparency: By adopting more comprehensive reporting practices that fully account for the impact of SBC, companies can build trust with investors and provide a clearer picture of their true financial position.
2. Improved alignment of incentives: Thoughtful SBC strategies can better align employee and executive compensation with long-term shareholder interests, potentially driving sustainable growth and value creation.
3. More efficient capital allocation: By treating SBC as a real expense in decision-making processes, companies can make more informed choices about resource allocation and investment.

B. Looking Ahead: The Future of SBC in a Changing Market Landscape

As we look to the future, several trends are likely to shape the evolution of SBC practices:

1. Increased investor scrutiny: As evidenced by initiatives like the Altimeter SBC Gold Standard Index, investors are paying more attention to how companies manage SBC. This trend is likely to continue, putting pressure on companies to adopt more disciplined approaches [1].
2. Potential regulatory changes: Given the growing divergence between GAAP and non-GAAP treatments of SBC, it's possible that regulatory bodies may introduce new guidelines or requirements for SBC reporting and disclosure.
3. Technological advancements: The development of more sophisticated analytics and modeling tools will enable CFOs to better understand and manage the long-term impacts of their SBC strategies.
4. Evolving compensation models: As the limitations of traditional SBC approaches become more apparent, we may see the emergence of new, hybrid models that better balance the interests of employees, companies, and shareholders.

In conclusion, the challenge of managing SBC effectively presents a significant opportunity for CFOs to demonstrate leadership and create value. Those who can navigate this complex landscape - balancing talent attraction and retention with financial prudence and transparency - will be well-positioned to drive sustainable growth and shareholder value in the years to come.

As Warren Buffett once noted, "If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?" [2]. It's time for CFOs to heed this wisdom and take a fresh look at how they approach stock-based compensation. The future success of their companies may well depend on it.

[1] RBC Capital Markets, "Addressing the Stock-Based Compensation Debate" (8.1.22)

[2] tanay.substack.com, "Lies, Damned Lies, and Stock-Based Compensation"

[3] Goldman Sachs, "Perspectives on Software Market" (Feb 2023)

[4] Harvard Business School case study on the evolution of SBC accounting (referenced in the provided documents)

[5] Warren Buffett's 1998 Berkshire Hathaway shareholder letter (quoted in the provided documents)

[6] Morgan Stanley, "Stock-Based Comp in Software – A More Expansive Perspective?" (6.30.22)

[7] Bill Gurley's assertion on RSUs (mentioned in the provided documents)

[8] Thomas Reiner, "Seven Ways to Look at Stock-Based Compensation & Dilution"

[9] Brad Gerstner's quote from "Unraveling stock-based compensation overhang in the SaaS industry (Part 1)"

[10] Altimeter SBC Gold Standard Index description (from the provided documents)

[11] BKNG 2022 Proxy Statement (referenced in the provided documents)

[12] UBER 2022 Proxy Statement (referenced in the provided documents)

[1] RBC Capital Markets, "Addressing the Stock-Based Compensation Debate" (8.1.22) [2] tanay.substack.com, "Lies, Damned Lies, and Stock-Based Compensation" [3] Goldman Sachs, "Perspectives on Software Market" (Feb 2023)

[1] Harvard Business School case study on the evolution of SBC accounting (referenced in the provided documents) [2] 1998 Berkshire Hathaway shareholder letter (quoted in the provided documents) [3] RBC Capital Markets, "Addressing the Stock-Based Compensation Debate" (8.1.22) [4] Goldman Sachs, "Perspectives on Software Market" (Feb 2023)