Stock based compensation for fast growing technology businesses — The headache caused by lower stock prices
How many times have we heard the phrase “what a difference a year makes?” when it comes to lamenting all things related to financial markets. As 2022 rolls to a close, we wanted to visit a topic which has become deeply intertwined in the rise and fall of markets — how Stock Based Compensation (SBC) has been deployed in high growth public companies and what we can learn from recent experience in an environment of lower stock prices.
What got us thinking about this is the apparent increase in equity grants as stock prices have fallen. The table below shows that, of the ~75 companies in the Bessemer Cloud Index, the 10 whose stock prices have fallen the most in the past 12 months have experienced a 4x increase in equity grants via Restricted Stock Units (RSUs) year-to-date 2022 compared to the full year 2021. The table below summarises these findings. The median stock price reduction for this group over the last 12 months is 55%.
As long term investors, it feels strange to us that when stock prices become depressed (especially when driven by widespread market moves), employees get more shares and investors experience more dilution. This implies to us that the system is both short term focused, and anchored to current stock prices rather than fundamental valuations. At the employee level it becomes clearer how this situation has unfolded.
It is not unusual for employees to receive 20–30% of their total compensation in SBC. In addition to an initial grant, most employees will receive annual ‘top up’ grants. Since the SBC an employee receives each year is expressed as a dollar value and the “valuation” used is essentially the stock price at the time of issue, the number of RSUs or Options an employee receives is highly dependent on the prevailing stock price. In simplistic terms, this could mean the number of RSUs or Options granted to an employee doubles if the stock price halves. This excludes any one off top up grants which a company may choose to make to assist with employee retention.
Arguably the outcome we are seeing now, in the form of increased SBC issuance and dilution, has been built into the system. When stock prices were high, a virtuous circle was created whereby higher stock prices provided a cheaper currency to pay employees (ie. for a given dollar value of SBC, less dilution occurred). Now the cycle is operating in reverse.
What happened to the “long” in “long term incentive”?
The system’s excessive focus on current stock prices is driven by the fact employees get to realise value from SBC relatively soon after the grant date.
Many companies allow vesting to begin from month 1 and almost all begin vesting no later than 12 months from the grant date. There is usually no restriction on selling stock once it has vested.
This means that even new employees can realise material cash rewards from their equity plan after just 12 months (or less) of employment. Equity grants are typically thought of as a form of “long term incentives” but to this extent, when used with these conditions are merely operating as nothing more than dressed up short term incentives.
No wonder they obsess about the current stock price!
Is there a better way?
It’s interesting to consider how behaviours may change if the shares employees receive upon vesting were restricted from sale for, say, 4 years. This is akin to how a private company long term incentive would work, whereby vesting may occur evenly over 4 years but employees cannot access liquidity until a later date.
Adopting this structure could change the conversation with employees;
A hypothetical conversation under the status quo (employer to employee)…
“you will receive $100,000 dollars this year in RSUs. If you’re lucky, the stock price will go down as the grant date approaches so the number of shares you receive will increase. Then you should hope the share price rises at the time vesting begins so you can maximise value from the sale of your stock.”
An alternative conversation path could, with some more thought, go something like this …
“You will receive 100,000 RSUs this year. You shouldn’t focus on the current stock price. The important thing to focus on is what the company could be worth in 4 years time when you are able to sell your stock. We will help you to understand the financial scenarios that could result in a strong stock price in a 4/5 year timeframe and how you and your team could contribute to that outcome.”
The two approaches set out above, while both ostensibly for the same purpose of creating a long term incentive with stock ownership, are diametrically opposed.
The second approach reduces the need for significant grant changes in either over inflated or depressed equity market conditions — it better equips companies and employees to look through the cycle and to focus on long term value and its creation.
How TDM Growth Partners approaches equity incentives
At TDM Growth Partners, when we are working with executive teams and Boards we are constantly trying to focus them on the financial outcomes and valuations 4–5 years out, and therefore the stock price today is far less relevant.
Below is a basic summary of how we approach equity incentives. It is important to note that we have a view on what “ideal” looks like when it comes to equity incentives, however in reality there are many company specific reasons why our final approach may and does change. For example, the level of competition for talent in a particular market would be one reason for flexing our approach away from the “ideal” approach set out below:
Step 1: define an appropriate share of value creation to go to employees
We typically recommend that between 5 and 15% of the shareholder value created is allocated to employees. However, this is dependent on a range of factors including size of company, the mix between once-off grants and annual top ups, likely number of recipients (eg. top executives versus several layers below), whether or not the Founder is included in the plan, and forecast shareholder returns over a 4–5 year period.
Step 2: determine structure for value sharing
There is no “one size fits all” approach to this, however we normally think of the payoff profile for an employee being akin to a stock option — ie. if the company valuation does not grow, there is no payoff, and if the company value does grow then the employee can get a leveraged payoff to the upside. We have also adopted different structures, including stock grants with specific performance hurdles, based on particular circumstances.
Step 3: define the recipient group
We recommend that this group is defined by those who can have significant impact on business outcomes over a 4–5 year period. At the very least, this includes the executive leadership team, but will often extend to the next layer down, including “rising stars” who are potential leaders for the future.
Step 4: allocate to individual recipients
Individual allocations should be based on likely individual contribution to long term business outcomes. Naturally, the CEO typically receives the largest share and the remaining allocations flow from there. The key principle is to only include individuals who BOTH have the ability to impact business outcomes AND the capacity to understand and appreciate/value equity ownership.
The goal is to allow for “life changing” wealth creation for individuals who contribute to exceptional shareholder outcomes. If shareholder outcomes are poor, nobody gets significant financial rewards via the equity plan.
Step 5: educate recipients
Education is a critical and often overlooked step in effective deployment of equity based incentives. This takes effort from the board or compensation committee but is essential.
We work with the executive leadership team to ensure there is alignment around a 5 year financial model which the team believes they can deliver on. Often, there will be a few scenarios (eg. low case, base case, high case) to encapsulate different degrees of execution success.
We then attempt to estimate a fair valuation multiple to assign to the company in year 4 or 5. The valuation multiple reflects the expected rate of growth of the business at that time as well as the future expected margin, competitive advantage and other factors relevant to business quality. We put a fun and very simple four minute video together on how we think about valuation.
This is very similar to the process we would go through internally at TDM to estimate future investment returns for each of our portfolio companies.
Our goal is to be very clear on the linkage between the results management execute on, and the financial outcomes for them as individuals. This includes covering the factors that drive the valuation multiples investors will be willing to ascribe to the business in the future, and the role management can play in influencing those (for example, excessive customer concentration is negative, multiple growth options positive). If we can help recipients connect their actions to value creation and instil a sense of long term ownership, the power of the equity incentives is unlocked.
The table below summarises how we ideally like to set up long term equity incentives compared to what we see as the “typical” US public growth company equity compensation approach. Once again, we express this as an ideal starting point which is then adapted depending on Company specific circumstances
We want equity recipients to focus on a simple message — if execution is good, all you need to know is that you’re with a winning company and the stock price will take care of itself over the long term! Looking through this lens employees are more likely to be comfortable not receiving a lot more stock if stock prices plummet and a lot less if stock prices soar.
With this mindset, major advantages accrue to those companies who train their employees to truly think like long term owners. Companies successful in getting employees thinking more about their role in future value creation and less about the current stock price will have a much better shot at retaining the best talent while keeping dilution at a reasonable level.
Ben Gisz is one of the founding members of the TDM Investement Team.
