How Companies Play Accounting Games w/ SBC

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1. How Companies Play Accounting Games w/ SBC

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How Companies Play Accounting Games w/ SBC

SBC - or stock based compensation is a topic that gets debated a lot in accounting / finance

While it sounds boring and unimportant, it’s very important when it comes to public companies reporting profits

A few key other terms to delineate between prior to reading further

EBITDA - Earnings before interest taxes depreciation and amortization: a proxy for core operating CASH flow

EBIT - Earnings before interest and taxes: a proxy for core operating PROFIT (not cash flow). Includes depreciation and amortization because those are core expenses that impact profit, but since they’re non-cash expenses included in this metric, this isn’t a proxy for cash flow like EBITDA

Adjusted EBITDA - Adding back / backing out non-recurring or one-time expenses to show a higher EBITDA

Most private deals in M&A the investment bankers representing the seller show an adjusted EBITDA that buyers will bid on (because its higher than regular EBITDA)

The buyers and sellers will debate over some of the adjustments that are boosting the EBITDA by backing them out / adding them back

Example:

$5m EBITDA business selling for 5x is worth $25m

A $7m adjusted EBITDA business at the same multiple is worth $35m

$2m of adjustments with a multiple of 5 goes a long way

SBC is straight forward, issuing stock to employees rather than playing them in cash

SBC at its core makes a lot of sense for both early stage companies/startups and employees for multiple reasons

1. Early stage startups typically don’t have the cash to pay market based compensation

2. Early employees at startups are taking a risk to join this company, and should share in the upside that they can get with equity as the company scales

As mentioned above, SBC is a non-cash expense

There isn’t a true cash expense paid out like the salary, you are issuing them stock

Just like how depreciation is a non-cash expense, you don’t pay anyone depreciation, it’s just a non-cash expense booked lowering the value of a long-term asset

The accounting games start coming into play when these startups go public and continue to issue SBC

Let’s look at an example

A big tech company wants to hire a machine learning engineer and pay them $1m

Rather than paying him/her $1m over the year in salary (cash), they pay him $500k, and issue him/her $500k worth of stock

Now that stock can vest in the current year, over multiple years, but for this example let’s say it all vests this year

So when that $500k stock vests this year the employee can sell it on the public markets, and they did make $1m in compensation all things being equal

Awhile back, stock based compensation did not have to be included GAAP EBITDA (Generally Accepted Accounting Principles that public companies abide by) when companies reported their earnings

Therefore, companies could issue SBC in lieu of salaries and bonuses and their numbers would be inflated

This has since changed, and companies now have to include SBC in their GAAP EBITDA, lowering their numbers

HOWEVER

This does not stop companies from adding it back / backing it out to get their adjusted EBITDA

As you can see in the picture below from Lyft

They are showing a net loss in Q1’2022 of $197 million

After they add back depreciation, interest, stock based comp, and other items, they show an adjusted EBITDA of POSITIVE $55m

They added back $153.7 million in SBC

This is how public companies play games with their accounting

They continue to underpay new employees in cash and issue stock to them instead

The downside for investors is issuing more and more stock can be dilutive to shareholders, lowering their ownership percentage

The positive is they can throw all of this into stock based compensation, and add it back when showing their adjusted EBITDA

Truthfully, adding back SBC to your adjusted EBITDA is a crock of shit

You are compensating an employee - that is a real business cost whether its paid in cash or stock

If you would have paid them in all cash, you’re EBITDA and profit would be much lower

But you issued them stock so you can say it’s a non-cash expense and add it back to EBITDA, which shouldn’t be the case

SBC is just accounting games as it’s compensating someone market value but with cash and stock, but it’s a real business expense

Coinbase reported in the recent quarter that SBC is approximately 70% of revenue

70% of their TOPLINE REVENUE in stock based compensation

But they’ll add that back to get a higher adjusted EBITDA, and talk about adjusted EBITDA on the earnings call as if that’s not a real expense of the business

It is

So that adjusted EBITDA Coinbase tells you is as useful as a poopy flavored lollipop

I am all for companies aligning employees with the long-term goals of the company by issuing stock

I think it’s important especially for early employees

But the concept has gotten out of hand with these tech companies going public and continuing to use SBC to inflate their adjusted EBITDA

When you look at a public companies financials, 2 of the most important sections to read are the financial footnotes and the Management Discussion & Analysis

The financial footnotes will discuss what is being added back to get to adjusted EBITDA and provide greater detail on various items

The MD&A section will management’s view of the business, where its going, how its doing, risks, etc

When I see a company discuss their adjusted EBITDA with massive SBC that is continuing to grow, I want to yell

There was positive progress made towards this accounting crap when GAAP made SBC be included in GAAP reported numbers

But companies then just decided to say ok fine, here’s my GAAP EBITDA of $10m, and here’s my adjusted EBITDA adding back SBC of $60m, and that’s our true EBITDA

Hoopla

Play stupid games, win stupid prizes

This game can come to an end when employees that are getting issued these shares start to push back because they think the company is overvalued or has an inflated valuation

If you get issued stock at a $4b valuation of one of these tech companies during the 0% int rate environment and now that company is worth $2b and you haven’t vested or had a chance to sell that stock, you’re not feeling great about being compensated in stock because the value has halved before you had a chance to sell

SBC is highly debated in the finance world and Twitter world (me), but all it is is accounting games, it’s a real expenses and nobody can tell you otherwise so they can take their adjusted EBITDA and shove it up their ass

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.