What You as a Shareholder Should Know About Stock-Based Compensation (SBC)

It is important to understand that SBC is important to shareholders for two different reasons, which should not be confused with each other.

An important aspect of the analysis of technology and growth stocks is the consideration of stock-based compensation (SBC). In this article, I want to explain what really matters when it comes to SBC and why I am often not as critical of the high cost of SBC as some other observers.

What is Stock-Based Compensation (SBC)?

Especially in startups and fast-growing companies, an attractive employee stock ownership program is essential to attract and retain a sufficient number of high-caliber talent.

Employees in the US tech sector, for example, typically receive a stock package as part of their remuneration in addition to a fixed salary. This can be in the form of actual shares or stock options, which give the employee the right to buy shares at a specified strike price.

These employee packages are usually subject to 'vesting', i.e. in practice employees have to 'earn' their shares in the following years by investing their labour in the development of the company. If employees leaves the company prematurely, they cannot expect to receive the full agreed package.

In practice, this usually takes the form of multi-year stock option plans in which, for example, a certain number of stock options vest each month over a period of four years.

Two effects of SBC of different importance to shareholders

For existing shareholders, the employee shares and share options have two very different effects, which should not be confused and should be considered separately:

1. Shareholders are diluted by the SBC as new shares are issued for the share (option) schemes. Dilution means a reduction in the percentage of ownership of the shareholders due to an increase in the outstanding number of shares.

2. Under US GAAP, SBC is booked as an operating expense under personnel expenses. Therefore, SBC reduces the GAAP operating income EBIT and therefore the net income. However, the expense for SBC is not relevant for cash flow as the employees do not receive a cash payment but an allocation of shares or options.

Many non-professional analysts focus on this second point when evaluating SBC, regularly calculating what percentage of the company's revenue was spent on SBC.

Some of the best high-growth companies have very high SBC cost ratios, such as Snowflake SNOW 0.00%↑ , which spent over 40% of revenue on SBC in their last fiscal year.

I keep reading that it would be a very bad sign for a high-growth stock if the SBC cost ratio (i.e. SBC as a percentage of sales) does not fall as quickly as possible in the years following the IPO.

I take a more relaxed view. For me, SBC is much more important in terms of dilution. In other words, when analyzing growth stocks, I advise you to pay more attention to the total number of shares issued and the change in that number.

Of course, from a cost perspective, SBCs are also relevant to the financial results of a growth company. In practice, SBC bookings regularly result in companies with positive cash flows still showing a loss on the income statement. But what really matters to institutional investors is the dilution ratio. This ratio can have a negative impact on the valuation of a share if it is unusually high.

Dilution in Practice

Fortunately, even for high-growth companies with exorbitant SBCs, dilution is often not as dramatic as one might think. Here are some examples of dilution ratios for companies that have often been critizised for their high SBCs:

Dilution of some SaaS Companies

Dilution in the SaaS companies I follow tends to be between 1% and 5% per year. If the dilution is significantly higher, there are often other reasons for the dilution, such as an acquisition that was (partially) paid for in shares, or a convertible bond that was issued.

In my conversations with other professional investors, I haven’t found that they pay much attention to SBC as long as it doesn’t result in significant dilution to existing shareholders.

I can't remember an analyst call where SBC was a major topic. If at all, it is always about dilution, i.e. the development of the outstanding number of shares issued.

Ideally, a high-growth company can buy back its own shares out of positive cash flow and thus successfully counteract the dilution caused by the SBC. Airbnb ABNB 0.00%↑ is such an example from my sample portfolio.

One more comment on SBC: Some analysts subtract SBC from the GAAP cash flow to get the "real" cash flow from a shareholder perspective. I don't do that. For me, cash flow is always first and foremost a question of whether, or to what extent, a company can finance itself internally, i.e. without the injection of external capital.

Conclusion

It is important to understand that SBC is relevant to shareholders for two reasons: Firstly, they reduce earnings (according to GAAP) and secondly, they lead to shareholder dilution.

In my opinion, investors should focus on the dilution effect in "their" companies. Relatively high SBC alone is not necessarily a red flag. In fact, SBC is an excellent tool for fast-growing companies to finance themselves internally as quickly as possible.

If you would like to read more of my articles on investing in technology and growth stocks, you can

If you missed it, you might want to read some earlier articles I already published about the foundations of my proven high growth investing strategy:

High-Growth-Investing 101

When is the right time to exit a stock?

The Rule of 40 - A better alternative to value growth stocks

RPO - The superior metric for analyzing a software stock