SBC is such a meaty topic that I had to turn this into a 2-Part Series. This is Part 2 that covers C) Valuation implications of SBC and D) Managing SBC impact.
In Part I of this series, we uncovered the significant stock-based compensation (SBC) overhang in the software industry using various heuristics (SBC as a % of revenue, SBC as a % of FCF, dilution), and also discussed the controversies of A) Overreliance on SBC as an incentive tool and B) SBC as a smoke-screen to “flatter” financials.
Picking up from where we left off in Section B, there isn’t yet a standardized method across the industry to account for SBC impact especially as it relates to valuation — some ignore it completely in the discounted-cash-flow model, some add back SBC to free-cash-flow/EBITDA, some consider fully-diluted shares outstanding, some add back AND consider dilution, etc.
But investors are increasingly leveraging their own approaches to quantifying the impact of SBC on a company’s stock price. Why now? Following the market pullback in 2022, cost of equity has increased, and many investors have put a renewed focus on SBC not just because of closer scrutiny on true profitability profile of companies, but also because they are trying to understand how severely valuations can bottom out as a result of incremental dilution risks and repricing events. This perhaps explains why conversations around SBC overreliance tend to be amplified cyclically during down markets, while critics are less vocal during bull times.
In this piece, we’ll wrap up the series by digging into the dilution narrative further to understand C) Valuation implications of SBC and D) Managing SBC impact.
C. Valuation implications of SBC
Unsurprisingly, public software companies with a higher SBC burden trade at a discount (on a growth-adjusted basis) compared to peers with less SBC intensity (see chart below). Using this methodology, an interesting observation is that Rule of 40 companies with high SBC intensity trade lower than companies that do not meet the Rule of 40 threshold but have lower SBC burden; this could be an indication that investors are not being fooled by companies that may be intentionally leveraging SBC to “flatter” their FCF margins.
Can SBC valuation impact be quantified on a marginal basis? Morgan Stanley found that for software companies with 30%+ revenue growth, each additional point of SBC-based dilution above the industry average of 4% lowered enterprise value by 7-10%:
For software companies with 15-30% revenue growth, each additional point of SBC-based dilution above the industry average of 2.5% lowered enterprise value by 5-7%:
Sophisticated investors have been quick to notice and capitalize on this dislocation. An interesting article from Arda Capital recently proposed that the SBC burden on public company valuation has created a unique opportunity for private equity sponsors to capture value:
D. Managing SBC impact
With the increased attention on SBC and the very material impact of SBC on valuation, companies are taking heed and addressing concerns in different ways:
Changing compensation structure: Some companies such as Twilio have shifted employee compensation more toward cash. In a similar vein, Amazon has increased the cash component cap of employee compensation. Others such as Shopify are tackling this issue creatively by developing “flex comp” systems to allow employees to allocate their preferences between cash and SBC.
Accounting for SBC in core profitability metrics: Companies such as Block have begun to include SBC explicitly in their profitability goals:
“While adjusted EBITDA margin is one of the key profit disclosures we focused on in the past, we recognize it excludes certain expenses like stock-based compensation, which is a real meaningful ongoing cost to operating our business… As a result, we're shifting our focus to an adjusted operating income margin. With this metric, profit margins will include certain noncash expenses like stock-based compensation and depreciation and amortization. With the Rule of 40, we are targeting the sum of our gross profit growth and adjusted operating income margins to be at or above 40% over the long term.” - Block Q4 2022 Earnings Call (2/24/23)
Publicly setting SBC targets: Several companies announced specific SBC targets in their latest earnings calls. Some examples:
“We'll continue to actively manage share count and stock dilution. And on an annualized net dilution basis, we're driving net dilution from 4.7% in FY22 to 3% to 4% for FY23. Our goal over the long term is to bring that dilution down even further.” - Confluent Q4 2022 Earnings Call (1/30/23)
“We are also addressing stock-based compensation. We’re making a concerted effort to reduce this over time, and we’re now targeting that this will be lower as a percent of revenue in 2023 than 2022, and will decline to 10%-12% of revenue for 2027.” - Twilio Q4 2022 Prepared Remarks (2/15/23)
Executing share buybacks: In recent times, stock repurchase programs have emerged as a popular measure that cloud companies are leveraging to mitigate SBC impact:
Source: Goldman Sachs, Perspectives on Software Market (Feb 2023)
Share buybacks, which were considered a form of market manipulation until 1982, have always been controversial, but the issue of share repurchases primarily used as means to offset SBC garners even more contentious responses. Criticisms range from arguments that such programs are a reactive (rather than proactive) response to managing SBC so it does not necessarily solve the root of the problem, to the contention that such a cash outlay proves that SBC is a “real” economic expense, bringing us full circle on the debate we discussed in Section B.
The harshest critics go so far as to call this a “silly parlor trick” that promotes moral hazard (tweet above) and even a “red flag on capital allocation competency” when repurchases are not made at value-accretive prices. As Warren Buffett previously noted in Berkshire Hathaway’s 1999 shareholder letter:
Sometimes, too, companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This 'buy high, sell low' strategy is one many unfortunate investors have employed -- but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.
Regardless of where you stand on this debate, the data is startling: Wellington found that large cap SaaS companies are spending a sizeable portion (30%) of their cash flow on share repurchases but shares outstanding are still rising (+7%). In contrast, the S&P 500 cohort (excluding IT sector and com services) is spending 22% of cash flow on repurchases and seeing a 2% reduction in shares outstanding.
As the cloud community comes to terms with SBC overreach within the industry, there have been heated and diverse reactions from various stakeholders, even on seemingly first-principle questions. What is the best way to measure SBC impact? Do you view SBC overhang in the software industry as an opportunity to improve or as an embedded challenge? How can SaaS companies best manage SBC impact? Leave a comment below to share your thoughts on this debate.
Love your work, thanks for making me smarter.
Humbled to be mentioned in this outstanding article. Thank you Janelle!
Buy-backing shares to offset dilution is not necessarily bad if done at a price well below the intrinsic value. However the adverse incentive to keep purchasing also at irrational prices is a real risk. I would value case by case.
"large cap SaaS companies are spending a sizeable portion (30%) of their cash flow on share repurchases but shares outstanding are still rising (+7%)" = insane.