Stock-Based Compensation and You!

By Markets Fool.com

Companies in the tech space are known for expensing their employees' salaries with stock-based compensation or restricted stock units.

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In this back-to-school episode of Industry Focus: Tech, Fool.com analyst Dylan Lewis and Supernova analyst David Kretzmann explain what investors need to know about stock-based compensation: what it means for companies and shareholders, how common the practice is, why companies do it, why shareholders tend not to look too kindly on it, and more. Also, the hosts give an example of one company that uses stock-based compensation terribly (and to less-than-winning results), and one company that's got the system down pat.

A full transcript follows the video.

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This podcast was recorded on Sept. 9, 2016.

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Dylan Lewis:This episode of Industry Focus is brought to you by Rocket Mortgage byQuicken Loans. Rocket Mortgagebrings the mortgage process into the 21st century with a fast, easy, and completely online process. Check out Rocket Mortgage today at quickenloans.com/fool.

Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It'sFriday, Sept. 9, and we are wrapping up back-to-school week with a discussion of stock-based compensation in tech. I'm your host, Dylan Lewis, and I'm joined in the studio by Motley Fool premium analyst David Kretzmann. David, how's it going?

David Kretzmann: It'sgood to be here, Dylan. Thanks for having me!

Lewis: So, back-to-school week, we're driving into some of these different concepts that are unique to each sector. I chose stock-based compensation in tech -- super relevant. But before we get into the show, David, because it's back-to-school week, any teachers growing up that really inspired you, helped you find your way, anything like that?

Kretzmann:It's hard to mention one. I'll go with Carol Parkhurst. She was my second grade teacher, one of the sweetest, kindest women who I ever knew. I don't know if I can point to a specific thing that I learned but in terms of being kind to others and enjoying life, the love of learning -- I think a lot of it stems from her, so I'll give her a shout-out.

Lewis: That's awesome, great lessons to learn early on. I'll give a little shout-out to Mary Florio,one of my high school English teachers, who pushed me to write for the school paper, then I ended up writing for my college paper and minoring in journalism, and now I'm here at the Fool! Financial media, look at that!

Kretzmann:Thank you, teachers!

Lewis: It's all thanks to Mary Florio. So, we will do our best toimitate our favorite teachers here on this show as we try to explain stock-based compensation today. Stock-based compensation takes a couple different forms. I think what you see most commonly is either stock options or restricted stock units. Stock options give the employees the right to buy shares of the company's stock at a predetermined price after a certain amount of time vested. Then, restricted stock units, thecompany distributes common shares directly to employees, again, after a vesting period.

We see this in all sectors of the market, but I think it's most relevant to tech. David?

Kretzmann:Yeah,absolutely. This really started, in large part in Silicon Valley, because paying employees in stock in one form or another is appealing when you're a young start-up and don't have cash. So, basically you're telling employees, "OK, we don't have cash on the books, but we can give you an equity portion of the company, or shares of the company, which theoretically should pay off even more than a cash salary, if the value of the company and the stock increases over time." So, it can be a very valuable proposition for employees. It can also be valuable for the company, because they don't have to spend precious cash on salaries, or, maybe they don't have to pay as much for salaries, if they can, instead, compensate employees with some form of stock.

Lewis: And because this has become such a staple of the tech world, I think this has become a hotly debated issuewhen it comes to company financials. If you go back to the '90s and even the early 2000s, this was kind of a big issue, and there was an open debate about, should technology firms have to expense their stock options, andshould it be something that's part of GAAP -- generally accepted accounting principles, the numbers that they report for public purposes?

The crux of the argument from the tech side is, "Stock option grants to employees are not cash expenses, so they shouldn't be recognized as an expense for GAAP reporting." The counterargument to that is, "Yes, they're not cash expenses,but share-basedcompensation is a type of compensation. If you're going to track salaries, you also need to track equity grants, and more importantly as it relates to investors, you're giving out equity in this business. Giving out shares means increasing the number of shares outstanding, which means diluting the existing shareholders."

One of the companies that we're going to get to in the second half of this show has a bad habit of doing that for some of their employees. But, if you look to the mid-2000s, theFinancial Accounting Standards Board decided that companies do need to include stock-based compensation as an expense when reporting GAAP numbers. Predictably, not all tech companies were thrilled about this. I think what we've seen in the time since then is a rise in the emphasis that companies put on their non-GAAP numbers. This is something you see in tons of conference calls, during earnings season. These are the numbers thatallow for adjustments outside of these generally accepted accounting principles, like I mentioned before.

On the second half of the show, we're going to dive a little bit into how different these numbers can look, and a few different companies, and how they approach stock-based compensation.

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So, David, we teased that we were going to be talking about a company that maybe dilutes shareholders a little bit with some of their stock-based compensation approaches.

Kretzmann:(laughs) Slightly.

Lewis: We're talking, of course, aboutTwitter(NYSE: TWTR). This isa company that has issued a ton of stock-based compensation in the last couple years. It has been over $150 million for each of the past five quarters, which is kind of crazy. Toput it into context, in the most recent quarter, stock-based compensation amounted up to 28% of revenue.

Kretzmann:Yeah, and comparing that to some other tech giants...looking over the past year in terms of stock-based compensation,for Twitter, it was about 26%. For LinkedIn, it's about 17%. ForFacebook, 15%. ForAlphabet, 7%. ForAmazon, 2%. So, Twitter really stands out in this department.

Stock-basedcompensation in and of itself isn't a bad thing, but it can be abused. I think in the case of Twitter, this is an example of a company that is between a rock and a hard place. They don't necessarily have the cash to pay employees their salaries or bonuses completely in cash. They promise their employees that they're going to play them lucrative salaries and bonuses, and stock-based compensation is a key piece of that. So, it's not an expense that's going to go away, unless they hire less-talented people. But, with stock-based compensation, it dilutes shareholders. When you have such an excessive level of stock-based compensation like you do at Twitter, their diluted share count, their diluted shares outstanding, is increasing each quarter by 1% to 2%. That basically means that any given year, thetotal number of shares outstanding for Twitter is going up about 10%. For the company to even tread water they need to grow sales and earnings at 10% a year.

So, stock-based compensation can be OK if a company is growing quickly, because theoretically, if you're a shareholder and you owned Twitter, you can say, "I'm OK with you diluting my ownership of the company if that'sgoing to help you maintain growth over time." But in the case of Twitter, you have a company that's really floundering in a lot of ways. They've had a lot of leadership changes and departures. Theirrevenue growth is decelerating. They're still not showing a GAAP profit. Their cash flow is still very questionable when you back out stock-based compensation. So, in the case of Twitter, it's a perfect storm where you have massive stock-based compensation, pretty rapid dilution, and at the same time the company's business and sales growth is decelerating.

Lewis: You mentioned backing stock-based compensation out of cash flow. We talked about how this plays with the financials a little bit.I think it's good to illustrate this to look at the reconciliation that Twitter does to get from their net loss number, which is a GAAP number, to their adjusted EBITDA. You look, their most recent quarter, Twitter posted a net loss of just over $100 million. Within thisreconciliation, there's this itemized table where they add back in certain costs. One of them is stock-based compensation,the other ones are depreciation, interests. That gets them to their earnings before interest, taxes, depreciation, and amortization number. $167 million of that is stock-based compensation. So, you see them swing from a net loss of over $100 million to an adjusted EBITDA of $175 million, and $167 million of that is stock-based compensation.

Kretzmann:Right,stock-based compensation in the case of Twitter and a lot of other companies that do this is the only reason a company shows an "adjusted" profit. And, it also carries over to the cash flow statement, because the companies will say, "We didn't actually pay out the stock-based compensation expense. That wasn't cash leaving our pockets. So, we're going to add it back and basically say that's cash the company kept." So, that contributes to operating cash flowand the free cash flow number.

Again, it can be good or bad. I think in the case like Twitter, I would argue it's probably being abused, because it's not very clear that that stock-based compensation expense iscontributing to shareholders is any way. The company and the stock have both performed pretty poorly over the past couple years, below expectations. But if stock-based compensation is the only thing that's leading to an adjusted profit or a decent-looking cash flow statement, I take that with a big grain of salt, because you don't want that to be the only driver of a company's profitability or cash flow generation.

Lewis: Right,especially because it is, in a certain sense, coming out of the everyday investor's pocket. Even if it's being used well, with a high-growing company, I think it's very important for folks to check in and see thisreconciliation going from net loss to adjusted EBITDA, or take a look at a cash flow statement, and get a sense of how big of a chunk is coming out with stock-based compensation,because it's just a good thing to monitor.

Kretzmann:Absolutely. The other piece of stock-based compensation that we can get into is, I think one of the better ways you can use stock-based compensation with your company is to align the interests of management and the wider employee base with shareholders. I think, at its best, stock-based compensation can help align an executive team and the employees of the business to think in terms of, "How can we grow the business sustainably over a three- to five-year period, and rewardemployees and executives accordingly?" That's stock-based compensation at its best. At its worst, it's just a way to compensate employees and executives in the short term, maybe give some warped incentives, at the expense of common shareholders like you and me.

Lewis: Do you have a couple companies in mind that do it particularly well? Twitter, it sounds like, is kind of a dog in your eyes, with this.

Kretzmann:There are some bright spots, likeJack Dorsey, he's the co-founder who returned as CEO last year. He's elected to receive no compensation, including stock grants or stock options, this year. He alsodonated a good chunk of his ownership in Twitter to the equity pool at Twitter. So, some of his shares will basically be distributed across the entire company. So, there are some good things. But Twitter, for the most part, a lot of their compensation is in stock-based compensation, when you're looking at the executive level. But it's just based on operating metrics over one year, so there's not much of a hurdle for management to jump to get that stock-based compensation.

Lewis: We talked about the idea of vesting periods before, and what you'll commonly see is shares vest over --they'reusually denominated in years, one year, two years, and then every year following that. If your hurdle rate is one or two years, that's going to impact your thinking a little bit, whether you realize it or not.

Kretzmann: Exactly. And,by the way, you can find these numbers in the SEC filings for each company and the DEF 14A, or what we call commonly the proxy statement. It's worth taking a look at. Also,you don't only want to look at what executives are being compensated with and how, you also want to look at the board of directors. In the case of Twitter, the board members are paid $12,500 in cash every quarter just for showing up, and they're also given a stock award of $225,000 that vests quarterly until the next board meeting. So, basically, they get a quarter of a million in stock that's vested within a year. To me, that's not a very compelling incentive for long-term performance.

Lewis: Yeah,that doesn't push you toward long-term thinking.

Kretzmann:Exactly. They're getting rewarded no matter what within a year, no matter how the company performs. One example, more in the tech space, that I think is a better example -- it's not perfect, but it's a step in the right direction. It's Wayfair(NYSE: W), the online furniture retailer. The co-founders are still at the company, they actually still own almost 40% of the company.

Lewis: Which is something we always love to see as Fools.

Kretzmann:Right. So, that's a great starting point. The two co-founders reduced their cash salary to $80,000 -- a reasonable base salary. The bulk of executive pay is paid out in restricted stock units that vest over a period of five years. Right there, that shows you, the executives have to think in terms of the long term. Ideally, this would be tied to business performance. Ideally, they wouldn't even get rewarded if the business didn't meet certain operating metrics. But, still, that's certainly an improvement over Twitter, where you're getting rewarded no matter what within a year. At Wayfair, you have to wait five years. And the board of directors, they don't get paid any cash. Instead, they're paid inrestricted stock units that vest over three years. So, even at the board of directors level, they're not just getting paid cash and stock to show up every quarter. They also have to think as long-term owners of the business, since their stock will vest over a three-year period. So, that's a bit of an improvement, I think, over what you see at Twitter.

Lewis: Andit's something that can dramatically shape the overall strategy for a business, and the direction that management wants to take it.

Kretzmann:Exactly. And, of course, you don't want to put any one metric or factor in a vacuum as an investor. You want to evaluatemanagement incentives and compensation along with all the other factors. So, I wouldn't buy or sell a stock based solely on this. Twitter might end up being a multibagger from here, it might be a great investment, and Wayfair might be a dud. But, obviously, all else being equal, I want to know that the management team at a company I'm investing in is thinking of and incentivized to think about the long-term sustainability and growth of a business.

One company that's not, strictly speaking, a tech company --

Lewis: That's all right, we can talk non-tech. I'm allowed to talk non-tech.

Kretzmann:I'm on the Rule Breakers service, so I want to break the rules of this podcast.

Lewis: Yeah, there it is.

Kretzmann:I think, one companythat has one of the best compensation incentive programs out there is Home Depot(NYSE: HD). Starting with the board of directors, the annual compensationgiven to directors, at least two-thirds of that has to be in stock. The shares of stocks must continue to be held by the director until he or she leaves the board, and the bulk of compensation is in deferred shares. So basically, as long as you're on the board at Home Depot, you are getting deferred stock, but you can't sell it until you leave. So, that incentivizes you to think of the long term of Home Depot as long as you want to be a director.

Lewis: Right,it's a very different timetable for decision making.

Kretzmann:Right. So, that's a good start. Then, looking at the executive level, you basically have five different variables or components that contribute to total compensation for executives. You have the base salary. That's the only fixed component ofexecutive salary at Home Depot. It's a flat amount of cash. It's not a low amount, but it's still a flat amount of cash. That makes up about 20% of their total compensation,if you're an executive at Home Depot. Then you have a variable portion of cash salary that's tied to operating income, and some business metrics like operating income, inventory turnover, return on invested capital.

The variable cash portion of that salary is tied to very important operating metrics for the health of the business for that year. Then you have performance-based restricted stock. That's looking at otheroperating metrics like operating profit. The executives will only get shares if they meet their hurdles for operating profit. Then you have stock options. Again, those are tied to other metrics,I won't go into them right now. Then, performance shares, which are based on three-year averages for operating profit, return on invested capital, inventory turnover.

Lewis: And when you have that three-year average,you don't have people squeezing at the end of a quarter to try to make something look good. It's something you have to sustain for performance.

Kretzmann:Exactly. Some companies will tie their stock-based compensation to things like EPS or net income, things that can be tweaked much more easily in the short term than something that'slooking at a three-year average for something like inventory turnover or return on invested capital. Incentives arevery important, and this is something that we try to focus on here at the Fool. You want to make sure that management is incentivized to do things that will contribute to the long-term health and sustainability of the business. In the case of Home Depot, it's kind of complex having the five segments that go into an executive's compensation. But, when you look at each of thosesegments and combine those, I'm pretty confident that the executives at Home Depot are thinking of and rewarded by long-term performance of those key operating metrics at the company.

Lewis: Awesome, that's a great example. For listeners that are interested in getting a little bit more on this, or just want to see it written out rather than hearing about it on a podcast -- I know sometimes we throw a lot of numbers and definitions at you here -- there's an article on fool.com, "Stock-Based Compensation and Tech Stocks: What You Need To Know,"written by one of our contributors, Timothy Green. If you can't find it throughGoogle or anything like that,feel free to just shoot us an email, and we're happy to send it along to you.

Anything else before I let you go, David?

Kretzmann:No, I think that's it. Like I said,incentives are really important. Stock-based compensation is a key component of how management is rewarded and incentivized. I encourage people out there, if you're researching a company, add the proxy statement to something you look at. It's not the most entertaining evening reading you'll have, butit's important to see just how much the management of the company is aligned with you as a long-term shareholder, and the proxy statement is a great step to figuring that out one way or another.

Lewis: That's sound advice. I think your teacher would be proud.

Kretzmann:Oh, I appreciate it, Dylan. Likewise.

Lewis: Well,listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email. Like I said, if you want to get a copy of that article, we're happy to send it along. Just reach out at industryfocus@fool.com. You can always tweet us @MFIndustryFocus. If you'relooking for more of our stuff, subscribe at iTunes or check out the Fool's family of shows at fool.com/podcasts. As always, people on the program may have own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For David Kretzmann, I'm Dylan Lewis, thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. David Kretzmann owns shares of Amazon.com, Facebook, Home Depot, LinkedIn, Twitter, and Wayfair. Dylan Lewis owns shares of Alphabet (A shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon.com, Facebook, Twitter, and Wayfair. The Motley Fool owns shares of LinkedIn. The Motley Fool recommends Home Depot. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.