Weekly Thoughts: Stock-Based Compensation
Here is a topic that caught our eye this week:
Last month, Microsoft announced a deal to acquire LinkedIn for $26.2 billion. While most people have been focusing on the magnitude of the deal or the implied price per LinkedIn user to compare it to other social networks (it’s about $60, 2x that of Twitter), we have been reading about the company for an entirely different reason. In the past, we have written about compensation with a general focus on employee engagement and motivation, but this week we were interested to learn about the magnitude to which stock-based compensation is used among technology companies and the problems the practice can create.
According to Mark Mahaney, a technology analyst at RBC Capital Markets, “LinkedIn is among the most aggressive in using share-based compensation — there is no question about that.” To put some quantitative context around that statement, LinkedIn paid employees $510 million in stock in 2015, representing 17% of its revenues and a staggering 96% of its operating income (Twitter ranks first in this category with stock-based compensation totaling 39% of revenue). The trend is also industry-wide with data from Equilar indicating the median number of shares granted to executives and employees at tech companies is 77% more than across the entire S&P 1500.
In addition to the scale of the expense itself, the financial disclosure surrounding it is worth noting. While the cost is fully captured under GAAP accounting, the expense is non-cash, leading companies to back the cost out of reported earnings to produce Non-GAAP adjusted numbers, which they tout as more indicative of the operating performance of the business. This is fairly common for public companies (GAAP isn’t perfectly suited for all companies) but a look below at a Motley Fool table of three large stock-based compensation paying tech companies paints a pretty obvious picture that “profitability” generally depends on these adjustments.
When growth is strong and stock prices are on the rise, these adjustments tend to get taken at face value. Recently, however, investors have started to pay more attention to this line item as an indicator of earnings quality. “There are a variety of ways to look at this issue, but our general bias is that the lower the dependence on stock-based compensation, the higher the quality of the P&L,” says Mahaney in a recent research report. Warren Buffett, in his annual letter to shareholders, is even more critical of the practice:
“It has become common for managers to tell their owners to ignore certain expense items that are all too real….Stock-based compensation is the most egregious example. The very name says it all: ‘compensation.’ If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”
In LinkedIn’s case, their stock-based compensation program turned burdensome when the stock dropped 40% in one day after guiding to weaker than expected growth in 2017. With competition for talent at tech companies notoriously fierce, employees have options (pun intended) elsewhere and have little patience to weather a drop in implied pay of that magnitude. “If the stock had stayed down, [LinkedIn] would have seen employee churn,” said Mahaney. Rather than re-striking employee options or simply issuing more shares to make them whole (and further increasing the burden of stock-based compensation on earnings), LinkedIn found a different option: sell out. Of course, you won’t hear LinkedIn management saying that the weight of their stock-based compensation forced their hand, but founder Reid Hoffman does admit that the trend in employment played a role: “The biggest companies in the Valley — Facebook, Google and a few others — had pulled way ahead of the pack by increasing and earning the largest valuations, making it harder for smaller tech companies to attract top talent.”
At Chenmark, we are always interested in finding ways to get employees to think like owners, and there is no simpler way than for them to be actual owners. That said, our reading this week highlights that too much of a good thing can, in fact, be bad. Whether it is not fully realizing the earnings impact of non-cash compensation or the increased sensitivity of employees to fluctuations in the share price, stock-based compensation is not the silver bullet of aligned incentives. For our part, we will continue to hunt for the right balance of ownership-like reward in a long-term, fiscally responsible way.
Have a great week,
Your Chenmark Capital Team