Before 1995, the Financial Accounting Standards Board (FASB) didn’t consider stock-based comp (SBC) an expense. However, just because cash wasn’t going out the door when stock was issued, didn’t mean the expense was imaginary. As Warren Buffett aptly put it (what good blog post doesn’t have a WEB quote in the opening paragraph after all?),
“If options aren’t a form of compensation, what are they?”
Since then, investors have gawked at big SBC numbers, because, after all, dilution is a real thing. My goal in this post is to get you thinking about SBC in a slightly different way, especially for the software industry, where options have been heavily used. Ok, let’s hop right in.
In software, who are the suppliers? Software companies don’t manufacture physical goods. They aren’t middlemen. They aren’t retailers. So, who supplies the product?
Well, software engineers do. And, a good portion of their compensation is in stock. If you read any software company’s annual report though, only the salaries of support reps get aggregated into the cost of revenue. The “suppliers”, the engineers who actually produce the product, are usually part of the R&D force. So, when it comes to GAAP, (generally accepted accounting principles) that SBC is an operating expense instead of cost of revenue. The first interesting issue is addressing this.
Investors balk at investing in a company that has $[X] million dollars of SBC. But, as in anything, context matters. If a software company has 75% gross margins, that’s very high compared to nearly every other industry. And maybe this company has $100 million in SBC. Too high, right? Well, what if we contributed half of that SBC to cost of revenue? Now, instead of $100 million, would you be more comfortable with $50 million, while reducing gross margins slightly? Voila! (pronounced wa-la 😁).
We’re violating accounting standards, but now we can get more comfortable with the absolute level of SBC if you’re still skeptical. Again, context matters, specifically in understanding how the accounting lines up with reality. As we’ll talk about later, a helpful tip is looking at SBC as a percentage of revenue. Once you start consistently doing this, you’ll have an idea of what’s high and what’s low. (To give you a context shortcut, over 20% is high).
Another way to get more comfortable with SBC is thinking about maintenance and growth capex. In a traditional, non-software business, growth capex would be buying another factory or another storefront. On the other hand, maintenance capex would be replacing the carpets or servicing equipment. What is the equivalent for a software company? To be clear, the definition of maintenance capex is investments that sustain the business. The key to sustaining business in a recurring revenue business like software is retention. If the key word in real estate is location, the key word in software is retention. Low churn rates (the inverse of retention) mean high customer lifetime values and therefore more ability to invest now for future growth. That’s why companies love moving upmarket. The lifetime values are so high. Anyway, back to the main point: what does maintenance capex look like in the world of software? Retention, right? And what line items on the income statement are responsible for retention?
Well, this one is tricky. Who’s to say anyone is responsible? Maybe the customer was going to stay anyway and didn’t need any “retaining.” But let’s think about it a little more. Say the company’s annual churn rate was 10%. That implies a 10-year lifetime. And let’s say a company spent $100 million on SBC for sales and marketing, with half of that going to account managers, responsible for retaining customers. It’s hard to say what the churn rate would be if there were no account managers (read: maintenance capex). But bear with me and let’s say churn would be 20% instead. Of the $50 million in SBC for account managers, maybe we can allocate 10% of that to maintenance capex instead of sales and marketing expenses. Now, based on that small adjustment, all-of-a-sudden our hypothetical company is operating income positive.
Once again, the point isn’t that this is FASB-certified, it’s understanding the true levers of the business model based on traditional accounting methods. These are just two examples of manipulating the income statement based on the underlying function of the SBC. To summarize, context is important when evaluating SBC. To get people thinking about this in a different way, we used two examples:
1) What if we could move R&D expenses (SBC) to reduce gross margins?
2) What if we could shift S&M expenses (SBC) to maintenance capex?
But, like FASB recognized in 1995, we can’t just ignore SBC as an expense. Especially since it has real dilution power. So, let’s scrap that talk of reallocating expenses for now and talk about how I handle SBC as a part of my research process.
First, we have to bring valuation into the mix. Just like when a VC-backed company raises a round of funding, the higher valuation, the lower the dilution for the company. As a rough estimate, the dilution of a company can be a function of two things (when it’s not GAAP profitable):
1) SBC as a % of sales
2) Price-to-sales (PS) ratio
For example, if a company does $1 billion in revenue and $100 million in SBC at a PS of 10, the annual dilution will be 1%. Not terrible. We can just include that in our forward expected returns in the stock. If we thought it could return 10%, well now we think 9%.
The problem is when the valuation shrinks though. Using our example, let’s say the PS ratio all of sudden shrank a CRAZY amount, from 10 to 2. Now dilution would run at a super high amount of 5%.
Of course, this is overly simplified. If that happened, granted that the SBC was in the form of options, those options would likely expire worthless. Further, for restricted stock, since the price was lower, profitability would look better since they are expenses after all.
This is not to say that an investor should speculate on a high PS ratio to be sustainable, it’s just highlighting how to handicap a company’s forward returns using these two vectors.
Once again, it’s not necessarily the absolute amount of SBC that investors should be worried about. The context matters and ultimately the dilution matters. If you can get comfortable with both of those things, SBC shouldn’t need to be something that stops you from investing in a company. Further, there are real benefits to employees feeling like owners of the business. That doesn’t necessarily show up in the numbers, but it has an impact on how hard people work and how incentivized they are.
Now obviously there are upper limits to this. You don’t want to get diluted at 5% annually while the employees/exec team are just milking shareholders. Like I said, if SBC as a % of revenue is over 20%, it’s time to start getting worried. To use a real-life example, a company that I would not invest in based on how much stock it issues is Splunk. Over the past 5 years, the company has issued about $2 billion in SBC and its market cap is $22 billion. Sure, the stock has done well but that’s not the type of capital allocation I would like to be associated with as an investor.
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