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As you know, the sale of stock is a capital account operation, so just giving the money to an employee appears to be a current expense with no offsetting curren

by rsj_hn 5y ago

As you know, the sale of stock is a capital account operation, so just giving the money to an employee appears to be a current expense with no offsetting current revenue. It would be like selling off a share of your future profits to make current payroll (which is what it is). But what you are missing is that many modern companies, and especially software companies (2/3 of labor expenses are R&D), have capital that is basically IP created by their employees, and so just as it's a good idea to sell equity to buy some metal stamping machine, and this does not dilute the equity of the firm or cheat any shareholders, so it's also a good idea to sell equity to hire the person to write your application, or create a vaccine, or design a new engine, and this also does not dilute equity or hurt the company. In fact many times when key employees leave the share price of a company falls and the shareholders are more than happy to vote for boards that give stock grants to key employees that cause the company to earn more long term profits. And ultimately this is something that GAAP just can't handle due to its antiquated distinction between labor and capital investment -- under GAAP you can't expense a labor R&D expense over a period of time. You have to take the charge all in the same year. So this gives you misleading accounting results, and this is also why savvy investors look at the non-GAAP results and then they have to use their judgement to determine whether the IP that the company's employees are creating will generate the expected long term returns. Moreover if you are such a company, it makes excellent sense to finance R&D by selling stock, and for most companies R&D is almost entirely labor compensation. So ultimately GAAP is just out of touch with what capital investment means in the modern world - capital investment happens by paying people a lot of money to create IP for you, and not by purchasing tractors. Similarly stock analysts who view labor as purely a current expense and not an investment are also out of touch with many industries. That wont work in Biotech or Software or SpaceX or really any firm that does a lot of R&D. So let the stock market decide whether those equity sales are funding compensation that will generate the return or whether they will merely dilute -- the investors are the ones who need to price this, it can't be mechanically determined via GAAP rules designed to track the balance sheet of a 19th century coal plant.

fshbbdssbbgdd 5y ago
> But what you are missing is that many modern companies, and especially software companies (2/3 of labor expenses are R&D), have capital that is basically IP created by their employees, and so just as it's a good idea to sell equity to buy some metal stamping machine, and this does not dilute the equity of the firm or cheat any shareholders, so it's also a good idea to sell equity to hire the person to write your application, or create a vaccine, or design a new engine, and this also does not dilute equity or hurt the company. This is a useful way to think about R&D expenses, but it’s not a justification for different treatment of cash and stock comp for employees. It’s more like an argument that R&D investment should be capitalized - and it sometimes is. But whether you capitalize R&D shouldn’t depend on what portion of the expense is stock vs cash.
- rsj_hn 5y ago
  > but it’s not a justification for different treatment of cash and stock comp for employees. It is, because the firm will give stock comp -- which is a share of future profits, in proportion to the capital provided by employees -- if it doesn't the shareholders can police that as it will be seen via lower long term P/E ratios. Therefore you really only need the P/E ratios to guide you, you don't need anything else. There is simply no need for GAAP to insist that employee comp is always a current expense and is never a capital investment. That's the issue. > It’s more like an argument that R&D investment should be capitalized - and it sometimes is Tech firms can't expense worker comp as capital investment under GAAP. But worker comp accounts for most R&D. Thus tech can't really expense R&D under GAAP properly. That's the problem. That's why these software firms have to show huge GAAP losses when really they are making investments and show non-GAAP profits. It would be the same thing as if capital equipment purchase cost had to be on the income statement and could not be depreciated -- you'd also see huge losses in the first few years followed by absurd earnings. This is exactly the situation tech firms are in, and it explains why both investors and firms focus on non-GAAP earnings in this sector. What we need is the concept of capital expenditures funded by employee compensation, because the reality of how modern firms work. That's all that's going on here when software firms give stock options to key employees that develop the applications they sell. Instead, GAAP is biased towards the purchase of things like computers and equipment, which is actually a much less useful measure of the true capital that a tech firm has.
  - fshbbdssbbgdd 5y ago
    At Uber, a large portion of compensation for engineers is in stock. At Netflix, it’s almost entirely cash. Why should non-GAAP earnings privilege Uber’s approach over Netflix’s approach? Wouldn’t it be better to make your non-GAAP earnings capitalize R&D expenses? Even at a company like Uber, plenty of stock goes to non-R&D employees, and plenty of cash does go to R&D, so it’s not even measuring what you want it to measure. Also, capitalizing R&D would mean that companies could also write down failed R&D investment, which is obviously necessary for accurate reporting if you never charged that investment as an expense.

by rsj_hn 5y ago

fshbbdssbbgdd 5y ago

> But what you are missing is that many modern companies, and especially software companies (2/3 of labor expenses are R&D), have capital that is basically IP created by their employees, and so just as it's a good idea to sell equity to buy some metal stamping machine, and this does not dilute the equity of the firm or cheat any shareholders, so it's also a good idea to sell equity to hire the person to write your application, or create a vaccine, or design a new engine, and this also does not dilute equity or hurt the company. This is a useful way to think about R&D expenses, but it’s not a justification for different treatment of cash and stock comp for employees. It’s more like an argument that R&D investment should be capitalized - and it sometimes is. But whether you capitalize R&D shouldn’t depend on what portion of the expense is stock vs cash.

rsj_hn 5y ago
> but it’s not a justification for different treatment of cash and stock comp for employees. It is, because the firm will give stock comp -- which is a share of future profits, in proportion to the capital provided by employees -- if it doesn't the shareholders can police that as it will be seen via lower long term P/E ratios. Therefore you really only need the P/E ratios to guide you, you don't need anything else. There is simply no need for GAAP to insist that employee comp is always a current expense and is never a capital investment. That's the issue. > It’s more like an argument that R&D investment should be capitalized - and it sometimes is Tech firms can't expense worker comp as capital investment under GAAP. But worker comp accounts for most R&D. Thus tech can't really expense R&D under GAAP properly. That's the problem. That's why these software firms have to show huge GAAP losses when really they are making investments and show non-GAAP profits. It would be the same thing as if capital equipment purchase cost had to be on the income statement and could not be depreciated -- you'd also see huge losses in the first few years followed by absurd earnings. This is exactly the situation tech firms are in, and it explains why both investors and firms focus on non-GAAP earnings in this sector. What we need is the concept of capital expenditures funded by employee compensation, because the reality of how modern firms work. That's all that's going on here when software firms give stock options to key employees that develop the applications they sell. Instead, GAAP is biased towards the purchase of things like computers and equipment, which is actually a much less useful measure of the true capital that a tech firm has.
- fshbbdssbbgdd 5y ago
  At Uber, a large portion of compensation for engineers is in stock. At Netflix, it’s almost entirely cash. Why should non-GAAP earnings privilege Uber’s approach over Netflix’s approach? Wouldn’t it be better to make your non-GAAP earnings capitalize R&D expenses? Even at a company like Uber, plenty of stock goes to non-R&D employees, and plenty of cash does go to R&D, so it’s not even measuring what you want it to measure. Also, capitalizing R&D would mean that companies could also write down failed R&D investment, which is obviously necessary for accurate reporting if you never charged that investment as an expense.