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The double-edged sword of share-based compensation

Share-based compensation (or stock-based compensation) has become a prominent practice in the contemporary business landscape, particularly within the dynamic realm of technology companies. Its widespread adoption can be attributed to its effectiveness in aligning the interests of employees and shareholders, attracting and retaining top-tier talent, fostering a performance-driven work environment, and nurturing a sense of ownership among employees.

Notably, share-based compensation also serves as a strategic mechanism for financing a firm’s growth, eliminating the need for immediate cash outflows. In this article, we will explore the concept of share-based compensation, highlighting its significance and examining its potential implications for a company’s financials and growth trajectory. By gaining insights into the intricacies of share-based compensation, readers can develop a comprehensive understanding of its role in modern business practices and its impact on both companies and their stakeholders.

Source: Morgan Stanley

Share-based compensation refers to the practice of awarding employees with company shares or stock options instead of or in addition to traditional cash compensation. It attempts to aligns employee and shareholder interests by linking the value of employees’ compensation to the performance of the company’s stock.

Here are two common types of share-based compensation:

  • Restricted stock units (RSUs): RSUs grant employees the right to receive company shares after a predetermined vesting period. Until the vesting period is complete, the employee does not own the shares and is subject to certain restrictions, such as continued employment or achieving performance targets.
  • Stock options: Stock options provide employees with the opportunity to purchase company shares at a predetermined price (the strike price) within a specific timeframe. The options typically have a vesting period, after which they can be exercised.

 Why share-based compensation has become popular?

Alignment of interests: Share-based compensation has gained popularity due to its ability to align the interests of employees and shareholders. When employees are granted shares or stock options, they develop a vested interest in the company’s success and the increase in shareholder value. This alignment is crucial as it ensures that employees are motivated to work towards the company’s growth and profitability, as their own compensation is directly linked to the performance of the stock price.

Retaining talent: Share-based compensation serves as a powerful tool for attracting and retaining top talent within organizations. By providing employees with a stake in the company’s future through shares or stock options that vest over time, it instills a sense of ownership, loyalty, and commitment. This aligns employees’ interests with shareholders and motivates them to contribute to the company’s growth and profitability. It acts as a recognition and reward system, enhancing employee satisfaction and engagement. By fostering a loyal and committed workforce, share-based compensation helps organizations retain valuable talent and drive long-term success.

Performance-driven culture: Share-based compensation programs help to establish a performance-driven culture within organizations. By tying compensation to specific performance metrics, such as stock price targets or financial goals, companies can incentivize employees to strive for excellence and achieve objectives that benefit both the organization and its investors. This performance-driven culture encourages employees to go above and beyond, promotes accountability, and enhances overall organizational performance.

How does share-based compensation affect investors?

Potential dilution and financial impact: Share-based compensation programs can lead to the dilution of existing shareholders’ ownership stakes. As employees exercise stock options or RSUs vest, additional shares are issued, potentially reducing the proportionate ownership of existing shareholders. This dilution can have a significant financial impact on investors.

Financial reporting quality: The increased popularity of share-based compensation has led many companies to report adjusted EBITDA figures by excluding share compensation as a non-cash expense. While this adjustment intends to offer a clearer perspective on a company’s operational performance, it can potentially mislead investors who rely on these figures as a key metric. By excluding the cost of share-based compensation from performance metrics, it can distort the perception of a company’s profitability and its capacity to generate sustainable earnings, leaving investors without a comprehensive understanding of the company’s true financial position.

Capital allocation: Share-based compensation also ties into the broader issue of capital allocation decisions made by companies. Some companies choose to use share buybacks as a means to offset dilution caused by share-based compensation. Although buybacks can offer temporary relief by reducing the number of outstanding shares, it is essential for investors to assess whether this represents the most efficient use of capital. Investors should consider whether alternative capital allocation strategies, such as dividends or investment in growth initiatives, would better serve their long-term interests.

Principle-agent problem: Companies executives have the potential to misuse share-based compensation as a means to enrich themselves. A notable example is the case of Snap Inc.’s CEO, who received a US$638 million bonus in 2017, making it the third largest CEO payout on record. This substantial bonus was accompanied by the possibility of an additional three percent of the company’s outstanding shares, intended as a motivational incentive to drive business growth and improve financial performance. However, for investors, this raises concerns about a corporate culture that may prioritize short-term gains or reward executives regardless of their actual performance. Excessive or misaligned share-based compensation can lead to the dilution of shareholder value and divert resources from other investment opportunities or returning capital to shareholders through dividends or share buybacks.

The fifth perspective

When evaluating an investment, investors should give careful consideration to the potential dilutive effects of share-based compensation programs on future earnings. This includes taking into account diluted per share financial metrics such as earnings per share and free cash flow per share. It is of utmost importance for investors to exercise vigilance and closely monitor the transparency and appropriateness of share-based compensation programs.

Vital information regarding these programs can be found in the company’s proxy statement, which offers valuable insights into the company’s compensation practices and policies. By actively engaging with this information and safeguarding their interests, investors can ensure that executives prioritize the long-term success of the company over personal gain. Maintaining a watchful eye on share-based compensation practices is essential for shareholders to make well-informed investment decisions and foster sustainable growth within their investment portfolios.

Choon Leo Wang

Choon Leo is a growth-focused investor with an interest in innovative platform businesses that connect users and fix market inefficiencies. He believes that companies with the most competitive business models will compound in value over the long term. He currently holds CFA Level I qualifications.

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