Key Points:
- Stock-based compensation (SBC) is frequently used as a recruiting and retention tool for growth software and tech companies.
- Overreliance on SBC could backfire on companies with dramatic pullbacks in their share prices.
- In lieu of SBC, we believe companies can issue more restrictive stock units, reprice options, shift compensation to cash, or consider a hybrid approach.
- Stock dilution can result in “share creep” and compound meaningfully over time.
As part of continuing series on software primers, we thought it would be a good time to focus on the controversial topic of stock-based compensation.
We believe this topic is especially relevant given the major pullback in growth names and the 60%-80% decline in software stocks from their peaks. In response to these trends, many investors are now seeking safety in high-quality, profitable software companies and pushing back on names with high levels of SBC.
Our latest research evaluates SBC from different perspectives and suggests ways for companies to consider reducing or being overreliant on it.
Why overreliance on stock compensation can backfire
Stock-based compensation is heavily used by technology and software companies for several reasons, including recruiting and retention and executive and shareholder alignment.
Although we acknowledge these benefits, we also believe some software companies (especially growth software) over-rely on issuing heavy amounts of stock compensation. This practice comes at the expense of shareholders and makes a financial model look more attractive than it is because it pushes investors to look at “non-GAAP” results and inflating free cash flow.
We also believe overreliance on SBC could backfire on companies with dramatic pullbacks in their share prices. After all, it’s hard to convince employees to stay when their options are meaningfully underwater and the value of the restrictive stock units (RSUs) are meaningfully lower than what employees were promised.
We believe companies can respond by:
- Issuing more RSUs and options to incentivize employees to stay
- Repricing options
- Shifting more compensation to cash, or
- Taking SBC away, or doing a hybrid approach
In our view, dilution does matter. While growing share count by 5% annually may seem like a minor point, it can result in “share creep” and compound meaningfully over time.
For example, if a company has 5.5% annual share dilution, then the market cap of a company could grow by 30%+ over five years, but due to dilution, the actual stock price remains unchanged. If we apply this lens to profitability, a company can grow its net income by 30% over five years, but its EPS remains unchanged because of dilution.
How companies can reduce SBC and dilution
- Use some of the cash on the balance sheet for buybacks. Many companies we cover have built up strong cash balances and continue to generate healthy cash flow, so buying back shares can make sense, especially if shares are undervalued. This would offset dilution and allow companies to use SBC for recruiting and retention.
- Shift more compensation to cash. Although we believe SBC, when used properly, is an important tool, more cash could help a company recruit in this environment.
- Treat stock like cash. In our view, many management teams have treated RSUs and options like “free money”, when, in fact, it comes with a cost, just deferred. In fact, we believe companies that treat $1 of stock like $1 of cash will be more disciplined than those that don’t.
- Don’t make employees whole. Although making employees whole made sense even 90 days ago, the hiring environment has eased up significantly for software companies. This has been compounded by the numerous hiring freezes and layoffs, as well as declining job postings across technology firms.
- Hire in lower cost geographies. Given that remote/hybrid work is here to stay, companies can take advantage by hiring salespeople and engineers in lower cost geographies such as overseas (e.g., India, Poland), or lower cost U.S. regions such as Austin or Denver.
In our view, these are a few important steps that a company in a strong financial position can take to bring down SBC and dilution.
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ESG Stratify™ encompasses all of RBC Capital Markets’ ESG thought leadership and insights, including our monthly ESG Scoop series and industry-specific publications from our research analysts. RBC’s Equity Research Group delivers thorough, comprehensive assessments of companies spanning all major sectors, along with macro insights and stock-specific ideas to help guide portfolio management decisions.
Rishi Jaluria, Matthew Hedberg, Sara Mahaffy, Dan Bergstrom, and Matthew Swanson authored the research report “RBC Software Primers: Addressing the Stock-Based Compensation Debate,” published on August 1, 2022. For more information, please contact your RBC representative.
