The greatest ever wealth transfer from shareholders to employees

Stock-based compensation (SBC) might be the greatest transfer of wealth from shareholders to employees that the world has even seen. Let’s look at how it works by examining the FAANG stocks. In this article FAANG refers to Facebook, Adobe, Amazon, Nvidia and Google. 

I know this is not the usual FAANG list. I removed Apple and Netflix and replaced them with Adobe and Nvidia. The reason I removed Apple is because it is such a behemoth that it skews the analysis positively, while up-and-comer, Netflix, skews the analysis negatively. 

What is stock-based compensation?

Stock-based compensation is way for corporations to pay employees, using stocks or stock-options, instead of using cash.

The stock given to an employee might have restrictions, such as, it cannot be sold and the awards of stock will happen over number of years.

A stock option is the right to buy stock in the future, at a price agreed upon today. For instance, if you are given an option to buy stock for $100 and in future the stock goes up to $300, you only pay $100 for the stock. You would make an instant profit of $200. On the other hand if the stock goes down to $50, your option is worthless because you are not going to purchase $50 stock for $100.

Why do corporations pay with SBC?

Start-up companies are usually short of cash. So to get employees to join, they offer low pay in cash but give the employees shares in the company, which could become valuable in future.

This makes sense, the company preserves its precious cash resources and the employees take the risk of joining because it could pay well in future.

A good example is Steve Ballmer. In 1980, he was employee number 30 at an unknown company called Microsoft. He was given shares and today he has a net worth of $111 billion. Clearly, it was worth it.

What’s the problem?

Over the past few decades, SBC has become commonplace and is now awarded in mature companies, up and down the organisation. The rationale being to align employees to shareholders. This is where the problems begin.

Besides creating “alignment”, SBC also makes the company’s financial statements look better. Accounting rules require the company to treat SBC like an expense, but management argues that these are not cash costs, so they often present adjusted profit numbers where the SBC has been removed.

In addition to that, SBC would never be included in free cash flow because it is not a cash flow. That means free cash flow is higher when SBC is used and higher cash flow always looks good to investors.

Hiding the effects with buybacks

SBC sounds good so far, except for one thing. That is, if you issue shares to employees, you end up diluting the existing shareholders.

For instance, if a company has 100 shares outstanding and you own all the shares. Then you own 100% of the company. But if 5 new shares are given to employees, then you own 100/105 = 95.2% of the company. Your ownership has been diluted by 4.8%.

Of course this does not look good, so companies that issue SBC also usually buy back their own shares on the open market. If you issued 5 shares to employees but bought back 5 shares in the market, there is no dilution. In our example, employees would own 5% (5 shares) of the company and you would own 95% (95 shares). You have not been diluted because you sold 5 shares in the market, so you expect to own 95%, not 100%.

Buybacks is big topic, so we will talk about it in detail at another time. But in the world of cheap money and rising stock prices, it is easy for companies to convince shareholders that buybacks are a good investment. A convenient side-effect is that it helps to mitigate the effect of the shares issued as SBC.

Hidden Wealth transfer

In effect, if you give an employee a share and then buy it back at a higher price, you have transferred wealth to the employee.

Who is paying for that wealth transfer? The existing shareholders. The profits of the company belong to the shareholders and if it is used to fund buybacks, then the shareholders are paying for it.

Here is the part that makes it a hidden wealth transfer. When SBC is issued to an employee, it is valued on the day of the grant. For instance, an employee is given $100 of stock at today’s price, he holds it for a few years and then sells it for $300. He effectively receives $200 more than the cost recorded by the company. He was awarded $100 of stock but received $300 of value.

This $200 is the hidden cost, because neither the company, nor the shareholders see it. But in aggregate if you add up all proceeds received by all the employees for their SBC and then subtract the cost at the date it was awarded, you would come up with a large number. And that number is the wealth that shareholders have transferred to employees without knowing it.

How much SBC is handed out?

Let’s look at our FAANG stocks since 2013. That includes 10 full fiscal years and about three-quarter of the current year. The table below shows the free cash flows generated by the respective companies and the value of SBC awarded in a given year. It also shows the percentage of SBC to free cash flow.

Over the past decade, our FAANG companies have generated $760 billion in free cash flow. But they have also awarded $291 billion in SBC to employees. That is equivalent to 38% of free cash flow. In other words, if the employees had been paid in cash, free cash flow would be 38% lower, in aggregate, for these companies.

Some companies like Amazon have awarded more SBC ($89 billion) than free cash flow ($76 billion) that they generated. So if they had paid employees in cash, they would have negative free cash flows.

Remember when I said that the hidden wealth transfer was not the recorded cost of the SBC, but is in the gain when the stock is sold. Well, here’s how much each stock is up in the past 10 years:

• Facebook up 607%

• Adobe up 974%

• Amazon up 649%

• Nvidia up 12081% (that’s not a typo)

• Google up 392% (since 2014)

So how much did the SBC really cost shareholders? I’m not sure, but you can bet it was a lot more than the accounting numbers reported in the financial statements.

How could this all end?

Over the past decade, share prices have been rising due to cheap money and a tech boom. That situation made it very attractive to accept SBC.

What happens when the boom ends? Earnings growth will slow down. That will lead to lower growth in stock prices or no growth in stock prices while the earnings catch up.

In that scenario, SBC will not be as lucrative. Some people might ask for more SBC to make up for the fact that they will not see massive growth. Other people might prefer cash. If stock prices drop, no one will want SBC.

SBC might slow down going forward, but we are not there yet. Last year was bad for stocks, but this year has been good. For instance, Nvidia is up 176% in the past year – great if you got SBC a year ago.

What does this mean for extraordinary companies?

I would like to leave you with a warm feeling that it will all be okay, but I am going to leave you with mixed feelings.

The SBC problem is worse for extraordinary companies than for other companies because extraordinary companies compound a higher rate. That means the hidden cost of SBC can be much higher than the accounting cost recorded on the financial statements.

For this reason, it is important to assess the proportion of SBC being awarded in each company and decide if it is excessive or not.

While SBC is huge in tech companies, it is at more reasonable levels in non-tech companies. That leaves lots of extraordinary companies where this is not such a big issue.

In the long run, I think we will be okay. But we have to do our analyses carefully, remembering that SBC causes inflated cash flows, ownership dilution and it encourages buybacks - which may be value destructive (a topic for another day).

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