This was bound to happen – it was just a question of when...
As long as stocks rise, everybody is willing to take some of their pay in stock. At least they were in Silicon Valley, where stock-based compensation ("stock-based comp") had become a way of life.
Stories about regular employees striking it rich are commonplace in tech. As far back as 2007, the New York Times ran a story headlined, "Google Options Make Masseuse a Multimillionaire." It was referring to the company's in-house masseuse.
Obviously, some of those riches are on paper. But some are real, and it has been a great way to get paid...
That is, at least, until tech stocks started falling and employees suddenly realized they weren't as rich as they thought they were.
Which gets us to where we are today...
To keep disgruntled employees from leaving, companies have started reacting...
Last week, Business Insider ran a story about how a leaked memo from DoorDash (DASH), the popular meal delivery service, said it would start to "top up" its stock grants to offset the 50% plunge in its stock since November 2021.
The article went on to say...
The downturn in many tech stocks has set off similar complaints across the industry and forced companies with particularly weak stock prices to react.
Indeed, the nifty new due diligence site DuDil, run by former investigative television journalist Nick Winkler, noted similar changes at Zoom (ZM), among others.
In a post headlined, "Zoom risks diluting shareholders in bid to keep employees," Winkler pointed to this new disclosure from Zoom's 10-K...
In October 2021, we added a feature to new and existing stock awards that provides employees with additional awards based on certain stock price criteria.
Shopify (SHOP) is doing something similar, with a twist...
Canadian newspaper the Globe and Mail reported that the company, whose software is used widely by small businesses for online transactions, allows its employees to choose between cash and stock. As the newspaper explained...
Previously, employees were provided restricted stock units in addition to base salaries at an allocation set by management. Now, there will no longer be a fixed amount, so employees will receive a single total compensation number and have the choice to determine how much is cash versus stock.
Of course, the good news for employees is that they'll either receive more stock or cash. That's important for morale, especially if stock prices rebound while they're still employed – and assuming they're vested.
It's a different story for investors...
If more stock is doled out the way it usually is, as a restricted stock unit ("RSU"), there's a risk an investor's stake in the company will be diluted as those units are vested. And that dilution can occur regardless of whether the share prices rise or fall, which means that shareholders may suffer a double blow from both a declining share price and dilution... sort of what's happening now.
Meanwhile, if companies do what Shopify is doing – and add more cash to the equation – margins and cash flow could take a hit. As The Information reported...
The shift in the balance of compensation toward cash will make the impact of headcount expenses more apparent on the bottom line.
And it will have a double-whammy impact as a wide array of tech companies – from Meta Platforms (FB) to Shopify to Pinterest (PINS) – are looking to hire more people. There's little doubt the adjusted profit margins that some investors focus on are likely to erode at some companies this year.
Likewise, as Nick Winkler of DuDil points out...
In some high-flying tech stocks, positive operating cash flow would turn negative.
The below chart, which he put together, tells that story.
Winkler adds that while Shopify's more than $7 billion in cash gives it plenty of cushion, its decision could ripple through the entire tech sector...
If choosing between cash and equity lures talented engineers and competitors are forced to follow Shopify's lead, even a relatively modest percentage of employees choosing cash over equity would negatively impact cash flows and, ultimately, valuations.
But there's one other problem...
In an environment where profits arguably matter more than ever, some of the newest public companies – those theoretically with the most stock-based compensation – may find themselves in a vise.
"Unfortunately," Renaissance Capital CEO Bill Smith wrote over the weekend in a note to his subscribers, "The largest [initial public offerings] in recent years have been money losers. Last year 55% of IPOs in the largest decile had negative [earnings before interest, taxes, depreciation, and amortization]."
Smith goes on to write...
It will take time for Silicon Valley to self-correct. Many execs at pre-IPO companies haven't had to make the tough calls that come with operating in the black. And employees paid in stock options may find their 'golden handcuffs' are made of pyrite.
In other words, worthless.
Meanwhile, from the shameless self-promotion department...
Quick update on my newsletter, Investment Opportunities, including a hint at the portfolio:
HGIO, as we call it, launched initially in late March with seven names. An eighth was added in the April edition.
Working alongside veteran analyst Gabe Marshank, who has decades of experience researching stocks for major hedge funds, I'm looking for generally overlooked good companies that should outperform the market over two to five years. If they pay a dividend, all the better.
The product is continuing to evolve.
Next in the queue, we're working on launching a quantitative/qualitative scoring system to help us with our stock selection and avoid significant earnings and accounting quality issues.
As for the current main portfolio, I can't give the names, but here's a tease of how we're thinking and what they are. In the current main "Sleep at Night" portfolio:
- The Steph Curry of its industry. Just looking at a very long-term chart of this company versus its peers is itself a great story.
- A case of mistaken identity. Mention this company's name, and everybody knows them for only one thing. Yet, over the years, it has evolved into something completely different.
- What a real Uber (UBER) looks like. Most people don't think of this company as fractional ownership, but we do – and it's better than most. Proof – it's not just the leader in its industry but triple the size of its closest competitor.
- Boring business, exciting cash flow. This spinoff of a spinoff converts all the net income into one thing shareholders really want – free cash flow.
- Left for dead, but very much alive. While in bankruptcy, this company quietly revitalized itself.
- This irreplaceable asset is hiding in plain sight. Every now and then, you stumble on one of these – controls 70% of its end market and has a runway of years with committed revenue.
The newsletter also has a "backdoor" portfolio, with just two companies – one, a broken special purpose acquisition company ("SPAC"), and the other an IPO.
- The wrong IPO at the wrong time could be the right stock. This is a classic example of Wall Street not fully understanding how this company's ownership structure has changed.
- This broken SPAC is a possible disrupter in health care. This company is still priced below what the private investment in public equity ("PIPE") investors paid – the "backdoor" – and unlike many SPACs, it has increased its guidance. Unless the model proves somehow unsustainable or management fails to execute, I can't see how this company won't ultimately be part of something else. Without question, this is the riskiest name in our portfolio. That said... As solid as our main portfolio is, we also wanted some sizzle, and this is without question the riskiest of our ideas.
For subscription info, click here.
As always, feel free to reach out via e-mail by clicking here. And if you're on Twitter, feel free to follow me there at @herbgreenberg. My DMs are open. I look forward to hearing from you.
Regards,
Herb Greenberg
April 12, 2022
