Spending Money to Make Money…aka Stock-based Compensation…aka Listen up, Founders!

There has been a lot of talk recently about why LinkedIn sold to Microsoft. One of the more popular theories about why they sold was around LinkedIn’s use of Stock Based Compensation (SBC) — as advanced succintly here by Andrew Ross Sorkin.

This isn’t the first time that people have started to question SBC — but not for the reasons you may think. SBC isn’t bad. In fact, it is really good and a powerful tool to motivate and reward management and employees. The bigger issue has been related to how it is accounted for under GAAP (Generally Accepted Accounting Principles) and how some tech companies, specifically, have taken advantage of a lenient interpretation, therein, to potentially mask their true performance.

Why is this important? It’s important because Silicon Valley seems to always be under a microscope — of bubbles, of funding, of unicorns, etc. But more generally, these are all ways for the rest of the world to constantly ask themselves, and us, if we deserve to have credibility and be on the world stage. SBC is working hard to be a candidate for the next test.

When our ability to build profitable, standalone companies in a transparent way is questioned, it can create a long term trend of tepid funding, marginal liquidity and mistrust by markets. That serves none of us (founders, employees, investors) well so we should understand why this is becoming a bigger issue and also understand some things we can do to measure and think through the implications of our decisions.

Need more motivation? Warren Buffett had something very pointed and direct words to say on this topic in Berkshire’s annual letter this year and the entire issue was summarized well here.

Let’s begin…

Building companies is hard. It takes a lot of luck and impeccable timing. But none of that matters unless you also have great people. Great people usually join companies because of the scope and freedom of their work, the quality of the people they get to work with and the impact of the product they are building. But they also join because, no matter how mission driven people are, they expect to be rewarded (richly, so) through stock options or its cousin, the RSU.

In 2008 (or thereabouts) after Facebook raised money from Microsoft, we had to come to terms with the fact that stock options became less enticing to prospective employees. Why? Despite the fact that options can result in long term capital gains (ie more value via less taxes), the strike price of the options became so high as to make the likelihood of any meaningful outcome less certain in the eyes of potential employees.

In response to this, we used RSUs (Restricted Stock Units) that behaved like a combination of stock and cash. The RSUs could track the value of the company’s increasing value (like a stock option) but there would be a baseline amount of guaranteed value.

Sidebar: Options vs RSUs

Options vs RSUs

As you can see above, the RSU is equivalent to giving someone cash (ie a guaranteed payment in all cases) while an option gives someone exposure to upside but no guaranteed payout at all. As you can imagine, this can impact and create huge distortions in the behavior of those who hold options vs RSUs.

Why?

Options incentivize both employees and management to set high hurdles and beat them — only rewarding value creation above the point at which the option was issued — because otherwise the option is worthless. This is clearly different from RSUs, which inevitably incentivize the status quo and a focus on vesting since the payment is guaranteed.

Consider the payoff graph below which illustrates this point:

Options reward risk seeking while RSUs allow mitigation of downside risk.

Said in yet another way, options push management and employees to achieve OKRs that would likely push stock prices up. If the OKRs are not achieved, the grant would not dilute existing shareholders and the options would be worthless. In the case of RSUs, the dilution is certain regardless of OKRs being met or not or whether the stock price goes up or not.

Now that the differences between an option and an RSU are clear, what if I told you that GAAP had strict accounting for options but a loose accounting for RSUs?

How to account for legitimate expenses? The RSU/SBC quandary…

So now ask yourself the following question: if you are an investor who wants to invest and support a company or a prospective employee about to join a company, and you are shown a P&L so you can make your decision about the economic health of that company, would you expect that RSUs are treated equivalent to someone’s salary and are treated as a legitimate expense in the primary P&L used or only reported as part of a separate P&L? Again, Buffett and Sorkin (and many others) think it should be part of a company’s primary P&L.

Until now, stock-based compensation hasn’t received much criticism, and the practice of unicorns and certain public companies issuing RSUs in place of options (and inheriting a squishy way of accounting for them) has been generally accepted. But that’s starting to change, since most reporting around SBC has been far from straightforward and the frustration has grown to an almost fever pitch amongst sophisticated investors. It’s interesting to note that during all of this, the companies driving this change are industry stalwarts Facebook and Amazon.

Why are Facebook and Amazon including SBC in GAAP financials?

I suspect it is because they realize that not only are they using SBC as a way to spend richly on management and employee compensation, but that it is justified because it ends up driving massive shareholder value far in excess of the cost.

Moreover, while its true for the likes of Facebook and Amazon, they’ve likely measured and seen that it isn’t true for some/many of their competitors or acquisition targets. And by potentially influencing others to report SBC as a primary GAAP metric, I suspect these companies start to look even better — to shareholders and prospective employees.

And this likely matters since it will allow them to have even more shareholder support as they continue to aggressively spend on the future by innovating in far flung ideas or inorganically grow through M&A.

The other side of the coin is equally true. If a company spends richly on SBC, then there will be an expectation that somehow, somewhere in the near future, performance of the company will show that those costs and dilution were worth it.

So putting ourselves in the shoes of Facebook and Amazon’s CFOs, we built a few simple charts that I suspect they already looked at and are handy ways for anyone interested in this to do the same. And while I’ve highlighted Facebook as a positive example of how to use SBC below, you can see in these graphs why Sorkin came to the conclusion he did with respect to SBC potentially driving LinkedIn’s decision to sell.

Take a look…

What this means is that Facebook spends 15% of every dollar in revenues on SBC.

What this means is that Facebook spends 27% of every dollar of profits on paying their management and employees.

And all of these RSUs end up diluting existing Facebook shareholders by 5.5% every year (ie if you owned 1% this year, you would own 0.945% next year). Note that Apple is negative because they are net buyers of their own stock.

But it’s clearly worth it since the market cap of Facebook went up $44.66 for every $1 of SBC.

What happens, then, if SBC continues to grow at a company? Again, it depends on what the company does. If the company is working on a compelling strategy, innovating on new products and generally crushing it, the stock will go up and everyone will be happy.

But if, on the other hand, earnings flatten then multiples will contract and the stock will go sideways or down which can have a material impact to morale and ability to recruit.

Conclusion

At some point, if you are lucky enough to be a part of founding or working at a viable company, understanding options vs RSUs and how to account for SBC will be as important as how you should think about comp, long term business model, profitability and earnings. SBC gone awry can destroy your expectations of long term value creation as a stockholder. SBC used in smart ways can be a force multiplier on value creation.

In all cases, however, we should probably start preparing for a world where SBC becomes a standard part of how we all measure ourselves…