So people have a tendency to read a headline/submission title like this and without reading the article they launch onto their soapbox about their pet issue like, for example, equity compensation at startups should be treated as being worth $0 if the company is not listed.<p>The article isn't about that. It's about companies misrepresenting their expenses by not accounting for stock-based compensation ("SBC") costs, which is completely fair. Google and Facebook (quoted in the article) do. Others (eg Workday, Splunk, Okta and Atlassian are quoted) seem to muddy the waters by stating they're unprofitable on a GAAP basis (which includes SBC since 2004) but profitable on a non-GAAP basis (where SBC isn't treated as an expense, I assume?).<p>So, caveat emptor for investors, basically.
Here's a thought experiment that helped me reason through SBC and GAAP.<p>Scenario A: Company hires an engineer with a base salary of 100k/year, and 100k/year worth of SBC.<p>Scenario B: Company convinces an investor to invest 100k/year... and also hires him as an engineer with a base salary of 200k/year.<p>From a business fundamentals and margins perspective, the two scenarios are identical. And yet, in scenario A, the company is spinning their non-GAAP annual expense as being 100k. Whereas in scenario B, the company wouldn't even try to spin their annual expense as being anything other than 200k.<p>The above thought experiment becomes particularly powerful if the hypothetical company has no other expenses and an annual revenue of $150k. Using the non-GAAP estimates from scenario A can mislead investors into thinking that the company has a very healthy gross margin, and is a lucrative investment. Whereas the actual GAAP numbers from both scenarios A and B, make it clear that the business is not profitable at all.
We should be glad that public companies are forced to comply with FASB and issue GAAP financials that (since 2004) mandate that stock-based compensation be classified as a non-cash expense. By definition, non-GAAP figures are up to the company to specify and state, which indeed means that investors should be <i>actively</i> updating their own models when making investment decisions if looking at non-GAAP.
> “ On February 28, 2017, the Compensation Committee of the Board of Directors of the Company (the “Board”) granted Mr. Hu a time-based stock option for 900,000 shares of the Company’s Class A common stock vesting over four years, three performance-based stock options for an aggregate of 555,000 shares of the Company’s Class A common stock, each with a per share exercise price equal to the closing price of the Company’s Class A common stock on the date of grant, and a time-based restricted stock unit grant for 100,000 shares vesting over four years. Each equity grant is subject to the terms and conditions of the Company’s 2016 Stock Option and Incentive Plan (the “2016 Plan”) and the applicable form of award agreement thereunder.” [1]<p>I’m surprised Twilio isn’t listed. Just there COO alone was issued ~1.5M shares. At today’s market price ($208) his shares alone are worth $312M. Their annualized revenue is ~1.4B. So just their COO alone was issued SBC of 22% of the companies revenue.<p>And that doesn’t factor in the SBC of all of the other employees either.<p>[1] <a href="https://www.sec.gov/Archives/edgar/data/1447669/000110465917014048/a17-7474_18k.htm" rel="nofollow">https://www.sec.gov/Archives/edgar/data/1447669/000110465917...</a>
It's not cash, so where does the money come from? Isn't the answer "investors"? Wouldn't their decreased share value from the dilution be the source of "value" used to pay these options to employees?
The wild thing is, if ones accepts modern financial theory, from the eyes of a risk-neutral investor, stock-based compensation is actually much more costly because of imbedded option value and time value of money.<p>Say one needed to hedge the other side of a 4y employee stock grant. Let's assume the new cliff-less, monthly vest structure that is now market at some of FAANG. The counter-party would need to borrow a large amount of money to buy some fraction of the shares that the employee is likely to vest based on historical data. This also assumes they are just "delta hedging." There is definitely a "negatively convex" situation where if the stock price increases employees are less likely to leave and if it goes down, employees will find a new job that pays market.<p>Given the immense volatility in earlier stage companies, the counter-party may elect to hedge the gamma exposure as well, meaning they may need to buy calls in the open market against the RSU position.<p>In my opinion, Netflix has realized this, and given the implications decided to just pay cash. Dollar for dollar, to a well enough capitalized employee, the stock package is much better. This advantage increases with the volatility of the underlying asset. This completely ignores the career risk of working for a failed startup, but the culture in SV seems to minimize that.
For mature companies it's pretty simple, stock-based compensation can be valued using the current share price and standard accounting principles.<p>For young companies, employees typically believe that their equity is worth <i>more</i> than the fair market value. So if anything, the non-gaap income should use a higher number for stock-based compensation expenses.
This is a shitty article. He doesn’t spend a single sentence defending why he thinks SBC should be included in non-GAAP reports. He just states it should be but never once says why. It’s a terrible article and a waste of time.