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For years, the lavish stock grants and options handed out by tech companies went largely ignored by investors. Now, the practice is finally getting attention, and it’s likely going to bring bad news for software investors.
As growth rates have tumbled and scrutiny has increased, the high levels of equity-based compensation are now a structural problem for the tech industry. The coming dilution of shareholder ownership from stock-based compensation is a recipe for underperformance, says SVB MoffettNathanson analyst Jackson Ader who has studied share issuance across the software industry.
Stock-based compensation has been a noncash way for companies to supplement employee salaries, primarily through awarding stock options or restricted equity grants—a promise to deliver stock at a future date upon predetermined conditions.
The trend has particularly taken off in the last decade. The average stock-based compensation for the industry rose from just 4.2% of revenue in 2012 to 10.5% in 2020, accelerating to 22.5% in 2021, according to SVB MoffettNathanson. The full numbers for 2022 aren’t yet available.
It’s “become part of the culture and the expectation from software company employees,” Ader says.
The industry touts the benefits of employee stock issuance. Theoretically, there is an alignment of interest with overall company performance, giving an ownership incentive for employees to work harder. Management, meanwhile, appreciated the flexibility of paying less cash for staff salaries, enabling more resources to be shifted to R&D and marketing.
As long as stock prices went higher, engineers and salespersons enjoyed ever-rising levels of total compensation. Elevated valuations allowed companies to issue fewer shares to retain their best talent.
Investors didn’t complain about dilution as long as stock prices were rising. In Wall Street models, stock-based comp usually got stripped out of earnings figures, as if the payments didn’t exist.
But those times are over. Revenue growth has slowed, and stock prices have tumbled from their peaks. The
iShares Expanded Tech-Software Sector
exchange-traded fund (ticker: IGV) has declined by some 35% since the November 2021 peak—and cloud software stocks are down more.
Many newly public companies that used stock-based compensation still do not have earnings on a GAAP, or generally accepted accounting principles, basis. Now, even with stocks well off their highs, companies may be forced to issue more shares to their employees that have grown accustomed to substantial awards.
Ader says the net result is an increasing amount of shareholder value being transferred to employees and away from investors, as companies dole out more stock at lower prices.
“It’s the golden age of dilution because employees still demand to be made whole,” Ader says. The “dilution number is going through the roof.”
Ader says that rising dilution will harm future returns and is cautioning investors of the risk.
According to SVB MoffettNathanson’s analysis, investors who invested in the 20% of software companies with the most conservative stock-based compensation rebalanced each year from 2004 to 2022 would have more than doubled their total return, versus owning the quintile with the highest stock-based compensation expenses.
“It is durable across time periods,” Ader says. “The higher [stock-based comp] is as a percent of revenue, the worse their stock performance is in the coming year.”
With stock-based comp a growing percentage of revenue at many firms, the underperformance trend could get worse from here.
There are ways for companies to mitigate the dilution, according to Ader. Management teams can lower the overall level of stock-based compensation by paying higher salaries, decreasing stock vesting schedules, and increasing stock buybacks. Thus far, though, there isn’t much evidence that companies are taking those steps.
Among stocks covered by SVB MoffettNathanson, Ader says Okta (OKTA),
Confluent
(CFLT),
Snowflake
(SNOW), and
HCP
) screen the highest for stock-based compensation as a percentage of revenue.
With the latest reports this past week, Okta spent 36% of its revenue on stock-based compensation over the past fiscal year. It posted an annual loss of $815 million. Snowflake spent 42% of its revenue on stock-based compensation for the same period, and it lost $797 million.
On the other side of SVB MoffettNathanson’s list are
Microsoft
(MSFT),
Adobe
(ADBE),
Paycom Software
(PAYC), and
Intuit
(INTU). They screen lowest for stock comp as a percentage of revenue.
Stock comp could become a more significant issue as investors become more discriminating about their investments. Ader says fund managers are increasingly asking him how to properly account for the dilution from stock-based comp, so they can avoid the worst offenders.
At least one high-profile investor has spent years flagging stock comp during investment decisions: Warren Buffett always assesses the actual cost to companies.
“When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings,” he wrote in a 1998
Berkshire Hathaway
annual letter.
Investors should follow Buffett’s lead.
Write to Tae Kim at tae.kim@barrons.com