‘OBSESSION’ WITH STOCK-BASED COMPENSATION

When LinkedIn announced that it sold to Microsoft for $26.2 billion, the New York Times unveiled the “unspoken reason” behind the deal:  LinkedIn’s “reliance--some might say overreliance--on stock-based compensation.”

In 2015, LinkedIn had $510 million stock-based compensation expense, which represents 17 percent of its net revenue.

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Not only LinkedIn, but also many other companies, mostly tech companies, are granting enormous amount of stock-based compensation to their employees. Twitter, for example, had stock compensation costs represent 31 percent of its net revenue last year. Yahoo and Alibaba are also among the tech companies that are highly dependent on stock to pay their employees. 

However, when companies’ stock price starts to go down, the value of compensation employees are getting will simply evaporate. 

Why Employees Take Stock Options.

Despite the risk of losing value, people are still willing to take stock options instead of cash, because of their belief that the company will do better in the future, and that a share will be worth more in the future than it is now. 

Another reason--tax mitigation. If a taxpayer is in the highest tax bracket, which is 39.6%, he or she only needs to pay 20% of his or her’s capital gain. For the same amount of compensation received, why not pay less taxes? 

Why Companies Prefer Issuing Stock-Based Compensation.

It wasn’t until December 2004 that the Financial Accounting Standards Board issued the Statement No. 123(R), Share-Based Payment, requiring companies to record the expense of stock-based compensation on the day they were granted. Before that, most of the companies thought it won’t cost them anything to pay employees with stock options. (Here is a podcast on the background of the topic from NPR) 

However, companies today still treat share-based payments as if they are “cost-free.” Companies like LinkedIn can “strip out” stock compensation expenses through reporting adjusted EBITDA--a non-GAAP financial measure. LinkedIn justifies the practice by saying that stock-based compensation “is noncash in nature,” and the exclusion of certain expenses in calculating adjusted EBITDA, according to the company, can provide a useful measure for period-to-period comparisons of the core business. I’m skeptical how useful the measure is, when the company was able to turn a $164 million loss to a $779 million gain after certain adjustments.

Plus, when companies offer stock options, they avoid paying out cash. For many companies, cash may be tight, and paying employees in the form of stock offers the promise of payment tomorrow for work today. 

Stock Buybacks.

However, the “downside” of giving out too many stock options is deteriorated earnings per share (EPS) and return on equity (ROE).  

EPS is calculated by dividing net income, after taking out preferred stock dividends paid, by the average number of common shares outstanding. It is an indicator of a company’s profitability and also considered to be the most important variable in determining a share’s price. 

When two companies have the same EPS number, but one could do so with less equity (investment), that’s when another indicator, ROE, comes into play. ROE calculates how many dollars of profit a company generates with each dollar of shareholders' equity. 

Many companies benefit by reducing share count outstanding through buybacks that enhance those performance ratios. If earnings stay the same but share count falls, then EPS and ROE rise. 

Apple Inc. announced its extended stock buyback program last year. Under the expanded program, the company will utilize a cumulative total of $200 billion of cash by the end of March 2017. With the interest rate this low, it will basically cost the company nothing to improve its ratios. 

It is not possible to regulate every activity companies do. Therefore, it is really up to investors to read between the lines of companies’ financials. 

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