How Is Stock-Based Compensation Accounted For?

Most people think that the expression “more money, more problems” is nonsense. However, when it comes to stock-based compensation, there is some truth to the saying – at least in terms of accounting for the expense.

It’s not easy to incorporate stock-based compensation into financial reports, and there is a lack of consistency among analysts and investors on how stock-based compensation should be considered when it comes to a company’s valuation.

In addition to the issues that crop up during accounting for stock-based compensation, the entire stock-based compensation program can collapse when the market is struggling. Declining stock value reverses the intent of stock-based compensation, which is typically offered to retain and motivate top talent.

Does that mean stock-based compensation is bad? Should employees and investors avoid companies that rely on this method of rewarding employees?

What Are The Advantages Of Stock-Based Compensation?

There are several appealing benefits to this method over standard cash payments. Examples include:

• Employees are motivated to contribute to the business, as their interests are aligned with the company’s success.

• There is a reduction in turnover, as employees have a financial incentive to remain with the company due to lengthy vesting periods.

• If the company grows as expected, stock-based compensation becomes more valuable than cash alone.

• Stock-based compensation reduces the company’s cash outlay, which increases the amount of cash available for reinvestment into the organization’s growth.

• Investors like to see the higher non-GAAP earnings, operating cash, and free cash flow that come along with the use of stock-based compensation.

The beauty of the system is that each of these factors works with the others to create a positive feedback loop. The system is enhanced, and growth is amplified with happier employees, leaders, and shareholders.

Unfortunately, there are also disadvantages to the system – and the positive feedback loop can become a negative feedback loop with little warning.

What Are The Disadvantages Of Stock-Based Compensation?

The trouble with stock-based compensation becomes clear when the market goes down. Never has this been more evident than in 2022.

High inflation levels and rising interest rates dealt a heavy blow to growth companies as investors fled to safer alternatives. Tech stocks were especially hard hit. The Nasdaq, which has a larger proportion of tech stocks than the NYSE, ended the year down by 33.47 percent.

It wasn’t just startups that felt the pressure. All of the Big Tech companies suffered, too. In 2022, Apple lost nearly 20 percent of its value, and Microsoft declined by more than 25 percent. Alphabet’s losses topped 35 percent, Nvidia’s stock dropped 42 percent, Amazon lost 46 percent, and Meta Platforms (Facebook) went down a whopping 65 percent. All in all, the six tech giants lost an astonishing $3.8 trillion in market cap.

While the lion’s share of those losses was felt by non-employee investors, employees relying on stock-based compensation saw tremendous declines in the value of their compensation packages. That, in a nutshell, is the biggest disadvantage of stock-based compensation. The program is intended to retain and motivate top performers, but such losses can lead to disengagement and attrition.

Unfortunately, business leaders and decision-makers in the compensation space tend to overlook this risk when planning compensation and benefits packages. They assume the business will grow and the market will go up in a semi-steady and reliable manner. When that doesn’t happen, they are left with few choices – none of them good.

They can reduce the amount of stock-based compensation and increase the amount of cash compensation, which negatively impacts margins. They can increase the number of shares offered to employees as stock-based compensation, which amplifies dilution, or they can ride it out – leaving open the likelihood of losing skilled employees to competitors.

How Is Stock-Based Compensation Accounted For?

Accounting for stock-based compensation gets a bit complicated, and even the experts disagree on the nuances. At the most basic level, it works like this:

Stock-based compensation requires two accounting entries, which essentially cancel each other out. The first deducts the stock-based compensation from payroll expenses, which means non-GAAP earnings, operating cash flow (OCF), and free cash flow (FCF) are all higher than they would be if employees were paid an equivalent amount in cash.

For example, if a company’s total compensation comes out to $500 million, half paid in cash and half paid in stock, only $250 million is calculated into non-GAAP earnings, OCF, and FCF. In other words, these figures are $250 million higher than they would be with 100 percent cash compensation.

The second accounting entry adds the stock-based compensation to the company’s outstanding diluted shares. In the example above, $250 million in stock-based compensation when a company’s stock is trading at $50 per share would add five million shares to the company’s total share count.

This method of accounting for stock-based compensation creates a gray area for certain key figures. Because there are two entries offsetting each other, it is common for investors to omit stock-based compensation when they calculate earnings and cash flow to determine a company’s valuation.

It’s also customary for business leaders to leave stock-based compensation out when reporting on certain performance metrics. Are these practices technically acceptable? Yes. Do they offer the clearest picture of the company’s financial standing? No – and that can mean problems down the road.

How Does Stock-Based Compensation Affect Stock Price?

Stock-based compensation increases the number of outstanding shares, which necessarily causes dilution. Existing stock is worth less because the company’s value is divided among more shares. Consider this example:

Matterport’s 3D technology was in high demand when COVID paused most travel. The company’s client list exploded as facilities all over the world rushed to create a virtual experience for their visitors. Matterport stock peaked at more than $27 per share when the entire tech industry saw an influx of investors in November 2021. The windfall didn’t last, and today the stock trades below $4 per share.

The trouble is that when demand for its products increased in 2020 and 2021, Matterport needed specialized skills that were expensive and hard to come by. Luring employees away from highly-paid positions with established tech companies like Google and Microsoft wasn’t practical because Matterport didn’t have the cash necessary to match existing salaries, much less exceed them. Instead, Matterport went with a robust stock-based compensation program that would – assuming share prices went up – give participating employees more than they were making with competitors.

In December 2022, analysts determined that Matterport’s trailing 12-month (TTM) stock-based compensation cost totaled $183.5 million – or 151.7 percent of TTM revenue.

Between stock-based compensation and other new stock issues, Matterport’s total outstanding shares increased from 196.5 million to 286.5 million from September 2021 to September 2022. Put another way, shareholders with a stake in Matterport prior to September 2021 had their investment diluted by approximately 45 percent.

Those figures should alarm any current investor – and any Matterport employee relying on stock-based compensation. At this point, it would take explosive growth to return value to shareholders, and instead, Matterport’s value has declined considerably.

Suffice it to say that it would be very difficult to persuade candidates from competing companies to leave their current roles for Matterport using stock-based compensation as an incentive. More importantly, it is unlikely Matterport will be able to retain its top talent under these circumstances.

That’s the negative feedback cycle – disengaged employees and high attrition disrupt the company’s ability to grow, which in turn pushes share prices down. That further disengages the remaining employees, along with current and prospective investors.

Is Stock-Based Compensation Bad?

Stock-based compensation can be a useful component of a total compensation package, particularly in that it aligns employees’ interests with the company’s interests, and it can result in higher compensation than cash-based salary alone. However, there can be too much of a good thing when stock-based compensation is overused.

One of the best ways to find balance between cash and stock-based compensation is to account for it as a cash expense for valuation purposes as well as in the calculation of performance metrics. That ensures a clear, accurate picture of the impact of stock-based compensation, rather than using the offset mechanism to exclude stock-based compensation from key figures.

The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.