What is stock-based compensation? Investing Explained

In this series, we break down the jargon and explain a popular investment term or theme. Here it is stock-based compensation.

What is this?

SBC stands for Share-Based Compensation (also known as Share-Based Compensation). Companies that want to win the loyalty of managers or employees will grant them stock options that can later be exchanged for stock.

SBC has been at the center of controversy amid heightened scrutiny of executive pay following the collapse of lender Silicon Valley Bank, which sparked a global banking panic.

Some technology companies issued options at a time when their stocks were soaring. Subsequently, however, their shares fell, making SBC options worth much less. That was the case, for example, with payment group Stripe, which last month raised money to address the problem.

Meanwhile, some other companies have granted employees their option packages at the original much higher value.

How does that work?

Let’s say the employees were each entitled to 5,000 shares at $40 each. Instead, they will receive 20,000 shares at the current price of $10. This increase in the number of outstanding shares results in dilution for other shareholders as their share of profits and dividends is reduced.

Which companies prefer SBC?

In Silicon Valley, limited supply unit packages (RSUs), which require beneficiaries to meet certain goals, have been key to attracting talent. Often, employees are drawn to the promise that their options will pay off when the company makes its IPO. But SBC is not only popular with American technology companies. More established European and UK companies seeking to hire and retain the best people are setting up programmes.

Why not pay higher salaries?

The argument is that SBC aligns the interests of employees and managers with those of shareholders. If bosses and employees have an interest in the value of the company’s stock, they will put even more effort into driving sales and profits. SBC also helps companies save money as their labor costs are much lower. Employees may be eligible for bumper rewards in the future. But until that point arrives, it could be argued that they are subsidizing their tight employer.

Other problems with SBC?

There is much ado about the fact that some companies do not disclose SBC in their earnings or earnings reports. As a form of compensation, it should be considered a business expense, although some companies, such as the software giant Salesforce, do not see it that way.

Leading fund managers are not impressed. Berkshire Hathaway’s Warren Buffett argues, “If options aren’t a form of compensation, then what are they?” If compensation is not a cost, what is? And if the costs are not allowed to be included in the calculation of the income, where in the world should they go?’

Does anyone else cross this?

Fundsmith manager Terry Smith has criticized Intuit, the accounting software group, for excluding SBC from its profits, saying the practice makes it difficult to compare companies in the same field and is therefore misleading.

Microsoft is not ruling out SBC, which is why Smith continues to hold shares in this tech titan and sells out Intuit.

Private investors who also favor transparency in accounting will almost certainly take the same view.