Stock-based compensation (SBC), where a company pays its employees partly with shares, is table stakes when attracting talent for growing companies. And for good reason too.
Employees value SBC as it allows them to profit from a potential rise in a company’s stock price. From a shareholder perspective, SBC is also useful as it aligns employees’ interests with theirs. This is critical for high-level management who make executive decisions in a company; the idea is that executives who earn SBC will make decisions that drive shareholder value.
In addition, using shares instead of cash for compensation also improves a company’s cash flow. For cash-strapped businesses, SBC can be a good way to attract talent without breaking the bank.
But SBC is not without its drawbacks. This is becoming more apparent in recent times as stock prices of many fast-growing companies fall.
How does SBC work?
Before discussing some of the drawbacks of SBC, I’ll first quickly go through how SBC works. There are a few types of SBC. The most common forms of SBC that I’ve seen so far are restricted stock units (RSUs) and options.
RSUs are shares that are given to employees over a period of time. They are typically granted when an employee initially signs for a company or renews an employment contract. These RSUs vests over a few years. For example, an employee may start his employment at a company and be granted 100 RSUs that vest over four years. Essentially, the employee will get 25 shares of the company every year for four years.
The other common form of SBC is options. Options give the employee the right to buy shares of the company at a pre-determined price. Employees are also typically given options that vest over a number of years. For example, an employee may be given 100 options, with an exercise price of $100 per option, that vests over four years. This means that in each year, the employee will collect 25 options and he or she can decide whether to exercise the option and convert it into shares. The employee will need to pay the company $100 in exchange for the shares. If the share price is more than $100 in the open market, the employee can sell the shares and pocket the difference.
What’s the real cost?
Although SBC does not result in any cash expense for a company, it does have a cost – shareholder dilution.
This is because by giving away new shares to employees, the total number of the company’s outstanding shares increases. The higher number of shares outstanding means existing shareholders now own a smaller cut of the pie.
For instance, as of 30 September 2022, Palantir had around 2.08 billion shares outstanding. However, it also had around 331 million unvested or unexercised options and 131 million unvested RSUs. When vested (and if exercised), the outstanding share count will increase by 22%. Ultimately, what this means is that Palantir’s economics will have to be split among 22% more shares and each share will be entitled to lesser economics.
When stock prices fall, employees are unhappy
SBC is designed to reward employees when stock prices rise. It also encourages employees to stay with the company in order to collect the RSUs and options that vest over time. But when stock prices fall, these RSUs are worth less and there is less incentive to stay.
For example, in March of 2021, Okta’s president of field operations, Susan St Ledger, was given 43,130 RSUs that vest over four years. At the time, Okta’s stock price was around $228; today, it’s around $67. St Ledger has around 26,956 RSUs that have yet to vest. At the time of the grant, these unvested RSUs were worth $6.1 million. Today, her remaining unvested RSUs are worth just $1.8 million.
Okta announced recently that St Ledger is retiring. Although there are many possible reasons for her retirement, the decline in value of her unvested RSUs may have played a role in her decision.
Making up for shortfalls
As shown above, falling stock prices can have a big impact on the actual dollar value of unvested RSUs. To retain existing employees, some companies may opt to increase the number of RSUs that employees receive in order to make up for the decline in the dollar value of the unvested RSUs.
Zoom is one company I know of that has done just that. In its latest annual report, Zoom said, “In October 2021, we added a feature to new and existing stock awards that provide employees with additional awards based on certain stock price criteria.” The key word here is “existing“.
In typical employee contracts, the company is not required to increase the number of RSUs if the stock price falls. This is supposed to be the risk to employees for agreeing to SBC, and employees are meant to be impacted by lower SBC, which should drive them to work harder to increase the company’s stock price. But Zoom decided to step in to make up for the loss in RSU value by increasing the number of shares paid to employees over and above what was previously agreed.
Zoom has a reputation for emphasising employee welfare and pay packages are undoubtedly part of that equation. But retroactively increasing RSU grants is at the expense of shareholders who are getting more dilution in the process.
Offering more stock to new hires
Besides increasing the number of RSUs initially agreed upon for existing employees, companies need to offer higher number of shares to attract new talent and as “stock refreshers” to retain employees.
Let’s say a potential new hire wants a pay package that includes $100,000 worth of RSUs per year. If the stock price is $100 per share, the company would need to offer the employee 1000 RSUs per year. But if the stock is only trading at $50, the company will need to offer the employee 2,000 RSUs per year. This will lead to two times more dilution.
Unfortunately for shareholders, this is exactly what is happening to many companies in the stock market today. Take Facebook’s parent company, Meta, for instance. The total value of RSUs granted in the first nine months of 2022 and 2021 were around US$20 billion and US$16 billion, respectively, at each grant date. This only a 22% increase in dollar value.
But the true cost is the number of RSUs granted. In the first 9 months of 2022, Meta granted close to 100 million RSUs, while in the same period in 2021, Meta awarded 53 million RSUs. This is an 86% increase.
The discrepancy between the increase in value versus the increase in the number of RSUs is because the weighted average grant price in the first nine months of 2022 was US$201 compared to US$305 in the first nine months of 2021. The lower stock price meant that Meta needed to promise more RSUs to provide the same dollar-value compensation to employees.
As you are familiar with by now, more RSUs granted means more dilution down the road. And it may get worse. Meta’s stock price has fallen to around US$123 as of the time of writing, which will result in even more RSUs needing to be offered to match the dollar value of compensation.
And it’s not just Meta that is facing this issue. Companies like Zscaler, Snowflake, Netflix, Okta, Docusign, Amazon, Shopify, and many more have all granted multiples more RSUs and/or options so far this year compared to a year ago.
Final thoughts
SBC is a difficult topic to fully understand. Although it’s not a cash expense, it does have a very real impact on shareholders as it ultimately results in shareholders’ split of profits being diluted down.
When stock prices are high, dilution from SBC is low and it’s not too concerning. But when stock prices are low like today, dilution from SBC can become a real problem.
This issue should not be lost on investors. We need to monitor how our companies handle this issue and whether they are doing the fiscally responsible thing for shareholders.
In my view, SBC should be reserved for executive management who make important decisions for the company and its shareholders. Other employees should be paid less in SBC and predominantly or exclusively in cash, especially when the company has sufficient cash. Employees who want stock can use cash compensation to buy stock on the open market. This reduces dilution to shareholders. This is particularly important when stock prices are low and somewhat undervalued. Companies should be trying to buy back shares at these prices rather than issuing new shares.
Although the increase in SBC is leading to more dilution, it is not totally out of control yet. For example, Meta’s dilution (the number of grants awarded against the number of outstanding shares) this year is still only in the low single-digit percentage range.
But companies need to start being more prudent with their SBC before dilution gets out of hand. I believe that businesses that are able to find the right balance in times such as these will likely be the big winners once this downturn is over.
The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in Meta, Docusign, Amazon, Okta, Zoom, Shopify and Netflix. Holdings are subject to change at any time.