Tech kept talent happy doling out stock during the boom. It's screwing investors in the bust.
- Stock-based compensation has been a popular way to attract and keep talent in the tech industry.
- As tech stock prices plunge, firms are granting new stocks to staff to keep compensation high.
Investors are getting antsy as rising stock-based compensation expenses against falling stock prices threaten their returns.
The competitive landscape for talent over the past two years led tech companies to dole out equity in place of cash to make compensation packages as enticing as possible. As long as the stock price went up, investors had very little to say because it was part of the company's growth strategy, said Aalap Shah, managing director at advisory firm Pearl Meyer.
But as stock values tumble in the second half of 2022, investors are looking at the increase in stock-based compensation (SBC) as an issue.
The more shares a company issues, the less value an investor's stake is. And tech companies have been issuing a lot of shares to not only attract new employees but hang on to their existing ones.
Zoom, considered a pandemic darling stock, lost over 60% of its value this year and its net income fell over 85% to $48 million. At the same time, its SBC expenses rose from $256 million to $305 million in the third quarter.
Another pandemic darling that rose to fame in 2020, Peloton, has fallen 68% year to date while its SBC has more than doubled, growing from $75 million to $182 million in the previous quarter.
When employee stocks began to lose value in mid-2022, some companies issued new shares at a lower price to keep monetary incentives within reach. Other companies, like Zoom, offered to make up the difference in value.
Zoom was eager to ensure there was no risk of workers "feeling that they're being undervalued," said Kelly Steckelberg, Zoom's CFO and treasurer, at Bank of America's 2022 Global Technology Conference in June.
Over its last three quarters, Zoom granted 17.7 million restricted stock units, according to a regulatory filing. That's about 14 million RSUs more than it issued in its previous fiscal year.
Peloton granted more than 4 million stock options and 1.7 million RSUs in its fiscal year that ended in June 2021. The following fiscal year, those numbers climbed to 19 million and 10 million, respectively. In the last quarter ending in September, the company issued more than 836,000 stock options and 13 million RSUs.
In a period where investors are focused on profitability over growth, such retention and hiring efforts begin to look costly. Shareholders are still paying for the existing stock grants and now they're going to pay for new grants, too, said Shah.
"The drop in the stock price makes the expense, for lack of a better way to phrase it, a lot more expensive," he added.
Jim Chanos took to Twitter to air his astonishment at how high SBC has risen at Zoom, tweeting, "$ZM SBC insanity continues, lol. $305M in the 3Q, up from $256M in 2Q, and $119M in 3Q last year. SBC is 94% of "Adjusted Net Income" this quarter. Unreal."
—Diogenes (@WallStCynic) November 21, 2022
SBC is on the rise among small and mid-sized firms, as well, according to analysts Mark Shmulik and Nikhil Devnani at Bernstein. It puts management in a "catch-22," they wrote. Making short-term decisions to juice your share price can lead to long-term disaster. But ignore your stock price, and you have trouble retaining talent since their equity is worth less. "Using stock at lower share prices to compensate employees further exacerbates the dilution effect of SBC," they write.
Morgan Stanley analysts Meta Marshal and Keith Weiss penned in November that top-up grants will help with employee retention, but the competition for talent is causing employee stock offerings to be "outsized" and subsequently, SBC expenses will remain high in the short term.
Sid Rajeev, head of research at Fundamental Research Group in Vancouver, expects tech companies to continue with this trend because they need the talent and cash alone is no longer a top selling point when all the other tech companies offer equity.
If we're in a sustained contraction, SBC's expense is going to be a bit more top of mind. Whether investors keep SBC top of mind is dependent on how long the global economic contraction continues, Shah told Insider. If the market takes a turn for the better, the topic of stock-based compensation expenses will fall by the wayside again and growth will be at the forefront, he said.
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