Accounting for share-based compensation to employees has been a subject of great interest to investors, academics, and other stakeholders. While this has always been a hot topic given the substantial value it creates for employees, share-based compensation has recently garnered a lot of attention given the many billion dollar ecommerce valuations.
Many public and private businesses supplement cash compensation of employees by granting them shares of the business or the right to buy shares of the business. This type of compensation is commonly referred to as equity compensation or share-based compensation.
With the current spurt in ecommerce, there are many newly created companies, especially from the technology sector, whose businesses are yet to generate adequate cash flows. These companies use the tool of share based compensation to attract and retain quality talent because apart from the basic pay, insurance and other allowances, employees also get the opportunity to reap the benefits of the companys success going forward. Thus for start-up companies that are yet to establish a market presence, the share-based compensation expenses can be quite substantial as compared to their overall revenues.
As a rule, companies show all cash payments made to employees as expenses in the income statement. But with stock compensation, things are a bit different. Companies may decide to pay its employees either by using restricted stocks or stock options. And since this is permitted by accounting rules, companies treat share based compensation as a non-cash expense.
Many financial experts, notably, Professor Aswath Damodaran, Professor of Finance at NYU, Stern, where he teaches corporate finance and equity valuation, have taken issue with this categorization. Professor Damodaran argues that share based compensation is a real expense and hence should not be added back when calculating operating cash flow.
Leveraging the tool of stock participation with employees works really well especially in the early growth stage when the company is increasing its value at a rapid pace. However, as growth slows and / or market valuation slips, the attractiveness of this tool diminishes for employees in general and key employees in particular. They won't be able to use shares as an income confirmation when applying for a loan, for example. The market could even start negatively discounting the high share-based compensation as and when company fundamentals slip or positive sentiment towards the stock or the industry dissipates. In many people-driven industries such as technology, drop in market value could impact leadership retention which in turn leads to a further drop in market value.
Currently treated as a non-cash expense, share-based compensation can have a huge impact on the balance sheet cash flow calculations if treated as a cash expense. To understand how significant the financial impact of share-based compensation could be to companies, we studied 14 technology firms, 11 of which are in the S&P 500 list with our CleanData application (CleanData is a cloud-based global repository of financial information that enables you to search and analyze business and financial data of companies across industries and geographies).
In the table below, we look at share-based compensation of these 14 companies as a percentage of revenues for these firms.
Three companies in the above list, Salesforce, Twitter and Workday, have a significantly higher percentage of share-based compensation expense in relation to their revenues.
However, since some of the companies in this list enjoy comparatively large revenues, it would be interesting to see how the share-based expense stacks up against the operating expense and income of each company. The 2 tables below study share-based compensation in relation to these two parameters.
The table below shows share-based compensation of these 14 companies as a percentage of operating expenses for these firms.
Here again, Twitter and Workday continue to have a higher share-based compensation expense to operating expense ratio. Verisign, Salesforce, Akamai, Adobe and Groupon too have share-based compensation expense greater than 10% of their operating expense.
The table below shows share-based compensation of these 14 companies as a percentage of operating income for these firms.
Here, we see that four companies Groupon, Salesforce, Twitter and Workday have losses at the operating level itself and are impacted by significant share-based compensation as well.
Finally, we calculate the free cash flow for these companies for FY15 but we also exclude share-based compensation expense from the calculations by treating it as a cash expense (as suggested by Professor Aswath Damodaran).
This analysis shows that the two companies, Twitter and Workday, have negative free cash flow and the corresponding figures for Groupon and Salesforce are not that impressive either.
· Twitter and Workday have a very high share-based compensation expense to revenues ratio (30% +).
· Twitter and Workday also have a very high share-based compensation expense to operating expense ratio (30% +).
· Four companies (Twitter, Workday, Salesforce and Groupon) are making losses at the operating level.
· Workday has a negative free cash flow even if one excludes share-based compensation expense from the calculations. Twitters free cash flow turns negative if share-based compensation expense is excluded from the calculations.
· Twitters stock price is hovering quite close to its all-time low since it started trading in November 2013. Workdays stock price is placed in the middle of its 4 year price range since it listed in October 2012.
Therefore, two companies, Workday and Twitter, especially Twitter, may find it increasingly difficult to attract/retain talent using equity-based compensation incentives if there is no major upswing at the operating level.