In 2008, my burgeoning hobby of investing my college fund into a wide variety of public companies (oil & gas drillers, biotechs, banks, a shipwreck hunting operation) ran into its very first market downturn.
I was sixteen years old and excited. At last, I was experiencing the times I’d read about in investing books: fear, uncertainty, doubt, and with them an opportunity to prove that I was a “long-term investor”. I surveyed the ruins of my portfolio to find the company that I thought had the best prospects of a rapid recovery when things inevitably turned around- and, of course, settled on the one that was already down the most with the sophomoric logic that it would boomerang back. I set my sights on a Greek dry bulk shipping company with a stock down 80% from its highs as rental rates for the dry bulk vessels it owned had collapsed. I doubled down, selling some of my more resilient companies to add to my position.
That was a disastrous decision, and not just because asset-heavy cyclical businesses generally make for tough investing. I had failed to understand a basic financial concept- the company had been raising capital via dilutive equity raises. Though the stock was down 80%, the market cap was down much less thanks to the newly issued shares. The company ultimately did survive, but its price per share fell another 90% as it continued issuing stock to pay for ships it had ordered on hard-to-break contracts. I learned the hard way that in hard times, dilution can become enemy #1 for returns. The simple mental model which equates market cap with share price level returns doesn’t work if the share count increases dramatically along the way. I was so shaken by this experience that in my undergraduate computer science class I built a (now defunct) website to let investors chart market caps instead of share prices.
Unfortunately, this lesson is back to being top of mind given the state of SaaS valuations- and I expect investors, management teams, and employees might experience their own version of this lesson in the coming years. As everyone reading this probably knows, I believe deeply in the sector and want to see everyone involved succeed. Beating back the wall of skepticism it faces now to the benefit of all stakeholders will take disciplined execution and, above all, an ability to see the current situation with clear eyes and take it into account when planning for the future.
So: stock comp. As a result of the experience I relayed above, I’ve always been wary of dilution and have tended towards being academic when accounting for share-based compensation. It took me quite some time to get comfortable with it conceptually- I distinctly remember arguing with various sell-side analysts in my first job at Putnam. In the end, I settled into a four-part perspective that is/was fairly standard for other SaaS investors:
1. Stock-based compensation (SBC) is a real expense.
2. The equity participation culture/employee retention effect created by SBC with vesting is a good thing.
3. Given the prevailing valuation paradigm, SBC is unlikely to be a major drag on returns and is best accounted for as dilution.
4. There is a sort of triangular social contract between companies, shareholders, and employees that this compensation is more variable than cash compensation and is correlated with good times- in other words, SBC is high in part because stocks are up.
To expand on #3, let’s imagine a garden variety SaaS company. Say it generates $100m of ARR, with a 30% growth rate, 80% gross margins, 40% of revenue dedicated to S&M, 20% to R&D, and 10% to G&A for a 10% non-GAAP operating margin. SBC for a company like this would generally amount to another ~20% of revenue, taking GAAP margins down to -10%. A year ago, this company would trade at perhaps 15x ARR for a $1.5bn valuation. The cash value of SBC amounted to $20m (20% of $100m) or about 1.3% of the market cap per year. Not ideal, but not a huge detractor from returns either, especially for companies for which there was huge uncertainty about long-term revenue growth.
On #4, as valuations have fallen, instead of issuing employees the same number of shares at new, lower prices (thus effectively cutting total compensation), many firms have opted to “refresh” their SBC programs to provide employees the same approximate cash compensation they were receiving before. Instead of SBC being conceptualized as “employees participating in the upside with variable comp,” some companies seem to be treating SBC as if it were just another cash expense that needs to be maintained in $ terms year to year.
Given this, the math I used above to rationalize SBC as a modest drag on returns doesn’t hold in the current valuation paradigm for many companies. The hypothetical company I referenced above that used to trade at 15x ARR might trade for 3x ARR today. At 3x ARR, paying 20% of revenue in SBC requires issuing shares equal to ~7% of the company’s total shares outstanding per year. A company which might have been a decent ~14% IRR is instead an ~7% IRR post-dilution- and that makes a world of difference in a world where corporate bond yields are often high single digits. Of course, as many reading this know well, there are now some SaaS examples even more extreme than the 3x ARR case.
What’s fascinating about this situation is that unlike the dry-bulk shipper that burned me in my youth, many software companies are sitting on fortress balance sheets (not all, given converts, but that’s a separate post). Companies in distress often have no choice but to issue stock at painfully low prices in downturns to survive- but the average SaaS company is nowhere near that place. It is effectively issuing dilutive equity at its own discretion, using shares management would almost definitely argue are undervalued as a form of compensation that many employees seem to treat as a direct substitute for cash.
Though I know some are more cynical, I truly don’t believe that most management teams are consciously transferring wealth away from their existing shareholders (and, of course, themselves!) to their employees to an unprecedented degree. Instead, I suspect that they’re moving forward with the same deep-seated sense of long-term thinking and commitment to their employees that makes them visionary, successful founders in the first place- plus a dose of inertia, since this compensation/valuation paradigm has been the rule in Silicon Valley since most of their companies were founded. I, for one, certainly hope that valuations revert and this issue once again fades. Nonetheless, if current market conditions persist and the triangular contract between tech employees, their employers and their investors does not normalize back to a more balanced equilibrium, the industry will embark on a spree of dilution that has already depressed valuations today and will suppress returns over time.
Put another way- many smart generalist investors are now arguing that garden variety SaaS companies are structurally unprofitable, and their unserious treatment of SBC is a major driver behind that point of view. I don’t believe it myself, but management teams will likely have to acknowledge the situation soberly and head-on to change hearts and minds here.
Every situation is unique and deserves individual attention, but here are two ways companies might move toward a new equilibrium that could meliorate investor concerns:
The simplest solution with a minimum of changes to the status quo would be for companies to commit to buying back shares of stock issued to employees, such that dilution is capped at a certain % per year. This would effectively convert any SBC in excess of those levels to a quantifiable cash expense, without any change to the employee experience. It would, in turn, increase board/management focus on managing this expense like any other cash expense.
Unfortunately, that wouldn't fix the underlying issue that employees stand to be granted a very large share of companies over time if we stay on the current path. An alternative approach would be to change the compensation mix, increasing cash compensation and granting employees out-of-the-money call options that vest on the traditional schedule. That would preserve some key benefits of the current approach, while also reflecting the original concept that SBC is meant to help employees participate in the success of their companies and reward them for longevity with variable comp- not to be a direct substitute for cash.
Again, each company’s situation is unique and generalizations on blogs are dangerous- but either option above seems better than doing nothing, especially if the ongoing pace of dilution will be >5% per year and that fact is already reflected in a deeply discounted multiple. Much of the credit will come simply from acknowledging the seriousness and mathematical reality of SBC-related dilution. As the saying goes: "what gets measured gets improved."
I struggled writing this- it’s a hard time for SaaS companies, investors and employees alike, and the last thing I want to do is swoop in sanctimoniously on an issue that seems to only matter in darker times. As I said before, as an investor I'm of course rooting for multiples to expand. That said, I’m convinced that the benefits of addressing SBC are meaningful enough that this is a positive-sum game for all parties. For their part, investors will also need to understand that we are just a year removed from the “best of times,” and organizations change slowly, especially when it comes to foundational aspects of the social contract in an ecosystem. I have every confidence that should this regime persist, SaaS companies and employees will find a way to adapt to and thrive in the new equilibrium- and I know that they both stand to benefit over time from restoring broader investor confidence in the business model. I will keep doing whatever I can to bring that to fruition.