In 2016, Microsoft made news when it suddenly purchased LinkedIn. Why did LinkedIn’s leadership decide to sell the company for more than $26 billion? Many speculated that LinkedIn’s reliance on stock-based compensation was a contributing factor.
As an investor or employee whose company offers this benefit, you’ve likely heard of stock-based compensation. Although it seems like a good practice on the surface, you might be wondering why more and more investors are becoming wary of companies that rely on it.
So, what exactly is stock-based compensation, and why has it become so pervasive in corporate settings?
What Is Stock-Based Compensation?
Stock-based compensation, sometimes known as equity or share-based compensation, is a practice in which companies supplement employees’ cash compensation (salary and bonuses) with shares of ownership in the business. It’s most commonly awarded to employees in the form of stock options or restricted stock.
Advantages of Stock-Based Compensation
One reason that companies offer stock-based compensation is to correct what’s called the “principal/agent problem.” Simply stated, a company’s employees (the “agents”) may not have the same incentives as the owners (the “principals”). If someone is both the owner and the manager of a business, they tend to be careful with expenses—they economize by flying coach instead of first class, for example, or they maintain a simple office instead of an expensively furnished one.
When the manager of a company is not also the owner, they have an incentive to make decisions that benefit themselves at the expense of the owners—they fly first class or maintain expensive offices. Giving employees stock-based compensation is an attempt to make them part-owners of the company and align their interests with the other owners.
Another reason, especially for small tech-based startups, is to avoid paying out cash. For many small companies, cash may be exceptionally tight, and paying employees in the form of stock offers payment tomorrow for work today. This can cut expenses for the company in the short-term and be exceptionally profitable for the employee in the long-term—think about stories of the Google janitor now worth millions, for example. If the company does poorly, this isn’t the case.
Disadvantages of Stock-Based Compensation
Although stock-based compensation has its benefits, it can come with drawbacks for investors, employees, and other key stakeholders.
Most notably, increasing the number of outstanding shares can dilute the ownership of existing shareholders. While this can be advantageous in terms of aligning interests with the company’s performance, it can also significantly reduce the value of those existing shares.
Additionally, if a company enters a period of falling stock prices, offering stock-based compensation is less likely to be seen as a worthwhile benefit when it comes to recruiting and retaining talent.
How a company reports stock-based compensation on their financial statements can also have a negative impact in some cases.
Accounting for Stock-Based Compensation
Issues with stock-based compensation can arise when it comes to accounting practices and the financial impact it can have on a company.
When stock-based compensation is offered, it dilutes the existing shares of stock and reduces their value. If the equity of a company is worth a set amount and doesn’t change depending on how many shares are outstanding, then issuing new shares must reduce the value of the existing shares by the exact amount given out in new shares.
In this way, stock-based compensation should hurt net income by the same amount as its listed value, just like an expense. In fact, under US GAAP, stock-based compensation should be recorded as a non-cash expense on an income statement. However, since it’s non-cash, many companies “adjust” their EBITDA to not include it.
Given that this dilution effect can be large, pressure has come from investors for companies to include it as an expense when reporting earnings. As noted by the New York Times, many companies, including Facebook and Microsoft, have done exactly that.
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This post was updated on October 6, 2020. It was originally published on June 16, 2016.
