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Here's a thought experiment that helped me reason through SBC and GAAP. Scenario A: Company hires an engineer with a base salary of 100k/year, and 100k/year wo

by whack 6y ago

Here's a thought experiment that helped me reason through SBC and GAAP. Scenario A: Company hires an engineer with a base salary of 100k/year, and 100k/year worth of SBC. Scenario B: Company convinces an investor to invest 100k/year... and also hires him as an engineer with a base salary of 200k/year. From a business fundamentals and margins perspective, the two scenarios are identical. And yet, in scenario A, the company is spinning their non-GAAP annual expense as being 100k. Whereas in scenario B, the company wouldn't even try to spin their annual expense as being anything other than 200k. The above thought experiment becomes particularly powerful if the hypothetical company has no other expenses and an annual revenue of $150k. Using the non-GAAP estimates from scenario A can mislead investors into thinking that the company has a very healthy gross margin, and is a lucrative investment. Whereas the actual GAAP numbers from both scenarios A and B, make it clear that the business is not profitable at all.

wolco 6y ago
If you can convience employees to trade 100,000 cash for stock then is it really an expense or a risk shifted to the employee?
- hansvm 6y ago
  It read to me like they were intentionally ignoring details like the risk adjusted value of the SBC, not because they don't matter, but because they obscure the point being made that employee payment schemes can be used to sweep unprofitability under the rug.
- roenxi 6y ago
  If they are telling employees that the stock is worth $X and then accounting for it as costing $Y that sounds remarkably close to fraud.
repsilat 6y ago
Thanks, I think this is convincing (where most of the arguments in TFA, especially the Buffett quote) were pure equivocation. As an outside investor, if a company is not profitable accounting for stock compensation then the book value of your stake (or your share of the NPV of future profits, or whatever) is going down.
- otoburb 6y ago
  >>[...] especially the Buffett quote [...] were pure equivocation I interpreted TFA to cast the Buffet quote in a positive light, and not as an equivocation. >>As an outside investor, if a company is not profitable accounting for stock compensation then the book value of your stake (or your share of the NPV of future profits, or whatever) is going down. Sounds like you, Buffet and the FASB are completely aligned on this point -- all the more reason to use/weight the GAAP numbers more heavily than the non-GAAPs and adjust our decision models appropriately.
  - repsilat 6y ago
    Right -- I thought TFA's conclusion was correct, but the argument was unconvincing.
martinald 6y ago
Isn't there also Scenario C, where the investor invests $100k, employee gets a base salary of $100k and SBC of $100k? You've now got an extra $100k in the bank for other requirements. Effectively the SBC makes the employee an investor also, exchanging labour for equity (instead of just for cash). This seems to me to be different. Obviously there is some dilutive effect to the share allotments, but especially in earlier stage non public companies you probably always want to have more non cash vs cash expenses if you have the option?
- roenxi 6y ago
  That is identical to Scenario B - if the stock is actually worth 100k then they could have sold it for $100k and given the employee $200k as a base salary, while keeping the investor's money in the bank. Obviously there are some tax complexities in practice but in theory it balances out.
valuearb 6y ago
Those scenarios aren’t remotely identical. Consider the difference if the employee quits or is fired before vesting their options. Consider the difference if the company is sold for less than the strike price of the options.
- nostrademons 6y ago
  A lot of FAANGs are moving to using RSUs rather than options and eliminating the vesting cliff. They really are identical in that case. Then again, the companies that are doing so are generally the ones using GAAP earnings and including SBC. Companies still using options are often private, which means that Scenario B isn't even an option for the general public, and the only way for a non-accredited investor to own stock is to work for them.
manyhats 6y ago
Good explanation. I'll nudge it even more with a Scenario C to further illustrate that ignoring non-cash comp leads to an distorted picture. Scenario C: Company hires an engineer with zero base salary and $200k/year worth of stock that gets paid monthly with the correct number of shares to get $16.7k in value. The shares can immediately be sold back to the company for the full value. The engineer clearly receives $200k of economic value. Whether the stock is sold or not has no effect on the value transfer. Does this hypothetical company have 1) a 100% profit margin, or 2) is it losing money? If you picked 1), let's say the engineer quits and for whatever reason the company needs to pay the replacement $200k/year in cash. To do so, the company sells $16.7k of shares to an investor each month. Is it still a 100% margin company?
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gamblor956 6y ago
From a business fundamentals perspective, the two scenarios are completely different. In the second scenario, the investor turned employee has invested $100k cash. This is an actual liquid asset that does not exist in the first scenario.
- FullyFunctional 6y ago
  I don't see why it's not the same (Company gives $200k, issues shares, gets back $100k). 2nd point: GP said "invest 100k/year", thus he do make additional investments.
  - gamblor956 6y ago
    Because a liquid asset is different from a liability. And the transactions have different tax, legal, and accounting outcomes. At the simplest level, you can buy things and services with the $100k cash in Scenario 2 at the start of the year as soon as the investment is made. You don't have that cash in Scenario 1.
- jdxcode 6y ago
  Business fundamentals are concerned with cash flow (which the investment does not change because it’s not part of income/expenses). You’re talking about the balance statement, which it would benefit but unrelated to profit. In other words, yes they have more money, but no, it does not make them more profitable.
  - gamblor956 6y ago
    Business fundamentals are concerned with cash flow and the balance sheet. It's irrelevant to have positive cash flow if it can't service your debts (see, e.g., almost every company destroyed by a private equity firm, for example, Toys R Us). In other words, yes they have more money, but no, it does not make them more profitable. They're not profitable in either Scenario because they don't have any income in either. But in one scenario, they have $100k spendable cash, and in the other all they have is sweat equity that they claim is worth $200k compensation. With spendable cash, you have runway and the opportunity to acquire external products or services that they need for the business. With sweat equity, you have sweat and dreams of success.
zby 6y ago
I did not read the article - but that seems quite obvious - so the interesting thing would be the other side 'why SBC was not in GAAP expenses originally?'.
- ponker 6y ago
  When GAAP was developed stock-based compensation was not used nearly as widely as it is now, and was seen as more of a special item for a footnote.
- drc500free 6y ago
  I think because the GAAP metaphor is that revenues and expenses determine profits, which accumulate into equity, which is claimed by equity holders according to fully diluted shares. SBC was "supposed" to be accounted for by calculating dilution of the newly issued shares. The expense approach is basically a shortcut for analysts.
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by whack 6y ago

wolco 6y ago

If you can convience employees to trade 100,000 cash for stock then is it really an expense or a risk shifted to the employee?

hansvm 6y ago
It read to me like they were intentionally ignoring details like the risk adjusted value of the SBC, not because they don't matter, but because they obscure the point being made that employee payment schemes can be used to sweep unprofitability under the rug.
roenxi 6y ago
If they are telling employees that the stock is worth $X and then accounting for it as costing $Y that sounds remarkably close to fraud.

repsilat 6y ago

Thanks, I think this is convincing (where most of the arguments in TFA, especially the Buffett quote) were pure equivocation. As an outside investor, if a company is not profitable accounting for stock compensation then the book value of your stake (or your share of the NPV of future profits, or whatever) is going down.

otoburb 6y ago
>>[...] especially the Buffett quote [...] were pure equivocation I interpreted TFA to cast the Buffet quote in a positive light, and not as an equivocation. >>As an outside investor, if a company is not profitable accounting for stock compensation then the book value of your stake (or your share of the NPV of future profits, or whatever) is going down. Sounds like you, Buffet and the FASB are completely aligned on this point -- all the more reason to use/weight the GAAP numbers more heavily than the non-GAAPs and adjust our decision models appropriately.
- repsilat 6y ago
  Right -- I thought TFA's conclusion was correct, but the argument was unconvincing.

martinald 6y ago

Isn't there also Scenario C, where the investor invests $100k, employee gets a base salary of $100k and SBC of $100k? You've now got an extra $100k in the bank for other requirements. Effectively the SBC makes the employee an investor also, exchanging labour for equity (instead of just for cash). This seems to me to be different. Obviously there is some dilutive effect to the share allotments, but especially in earlier stage non public companies you probably always want to have more non cash vs cash expenses if you have the option?

roenxi 6y ago
That is identical to Scenario B - if the stock is actually worth 100k then they could have sold it for $100k and given the employee $200k as a base salary, while keeping the investor's money in the bank. Obviously there are some tax complexities in practice but in theory it balances out.

valuearb 6y ago

Those scenarios aren’t remotely identical. Consider the difference if the employee quits or is fired before vesting their options. Consider the difference if the company is sold for less than the strike price of the options.

nostrademons 6y ago
A lot of FAANGs are moving to using RSUs rather than options and eliminating the vesting cliff. They really are identical in that case. Then again, the companies that are doing so are generally the ones using GAAP earnings and including SBC. Companies still using options are often private, which means that Scenario B isn't even an option for the general public, and the only way for a non-accredited investor to own stock is to work for them.

manyhats 6y ago

Good explanation. I'll nudge it even more with a Scenario C to further illustrate that ignoring non-cash comp leads to an distorted picture. Scenario C: Company hires an engineer with zero base salary and $200k/year worth of stock that gets paid monthly with the correct number of shares to get $16.7k in value. The shares can immediately be sold back to the company for the full value. The engineer clearly receives $200k of economic value. Whether the stock is sold or not has no effect on the value transfer. Does this hypothetical company have 1) a 100% profit margin, or 2) is it losing money? If you picked 1), let's say the engineer quits and for whatever reason the company needs to pay the replacement $200k/year in cash. To do so, the company sells $16.7k of shares to an investor each month. Is it still a 100% margin company?

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gamblor956 6y ago

From a business fundamentals perspective, the two scenarios are completely different. In the second scenario, the investor turned employee has invested $100k cash. This is an actual liquid asset that does not exist in the first scenario.

FullyFunctional 6y ago
I don't see why it's not the same (Company gives $200k, issues shares, gets back $100k). 2nd point: GP said "invest 100k/year", thus he do make additional investments.
- gamblor956 6y ago
  Because a liquid asset is different from a liability. And the transactions have different tax, legal, and accounting outcomes. At the simplest level, you can buy things and services with the $100k cash in Scenario 2 at the start of the year as soon as the investment is made. You don't have that cash in Scenario 1.
jdxcode 6y ago
Business fundamentals are concerned with cash flow (which the investment does not change because it’s not part of income/expenses). You’re talking about the balance statement, which it would benefit but unrelated to profit. In other words, yes they have more money, but no, it does not make them more profitable.
- gamblor956 6y ago
  Business fundamentals are concerned with cash flow and the balance sheet. It's irrelevant to have positive cash flow if it can't service your debts (see, e.g., almost every company destroyed by a private equity firm, for example, Toys R Us). In other words, yes they have more money, but no, it does not make them more profitable. They're not profitable in either Scenario because they don't have any income in either. But in one scenario, they have $100k spendable cash, and in the other all they have is sweat equity that they claim is worth $200k compensation. With spendable cash, you have runway and the opportunity to acquire external products or services that they need for the business. With sweat equity, you have sweat and dreams of success.

zby 6y ago

I did not read the article - but that seems quite obvious - so the interesting thing would be the other side 'why SBC was not in GAAP expenses originally?'.

ponker 6y ago
When GAAP was developed stock-based compensation was not used nearly as widely as it is now, and was seen as more of a special item for a footnote.
drc500free 6y ago
I think because the GAAP metaphor is that revenues and expenses determine profits, which accumulate into equity, which is claimed by equity holders according to fully diluted shares. SBC was "supposed" to be accounted for by calculating dilution of the newly issued shares. The expense approach is basically a shortcut for analysts.

deleted 6y ago

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