A Fresh Look at SBC Data
We harvested and crunched thousands of lines of data from the past eight years for 117 public technology companies to answer the following questions:
- How has the level of SBC issuance changed over the past eight years?
- How has issuance behaviour shifted from options to Restricted Stock Units (RSUs)?
- How have companies issuing more SBC performed relative to those issuing less?
- What are the valuation implications of using SBC?
Above all else, the most interesting takeaway was that stock prices for those companies with higher SBC (measured by dilution) materially underperformed those with lower SBC. While intuitive, we had not seen data to support this idea.
In conducting our analysis, we focused on one key metric, being Net Dilution.
This is defined as Net RSU and options1 issued, divided by weighted average shares outstanding. We prefer this measure of SBC over the accounting-based measure because the accounting-based measure is:
1) a lagging metric (smoothed over multiple years), and
2) reliant on accounting-based valuations (which we are naturally sceptical about!).
How much SBC are public technology companies issuing?
Over the eight years for which we gathered data, we found the median level of Net Dilution was 2% p.a. In 2022, however, issuance spiked to 3%. This spike is most likely caused by the significant fall in technology company valuations and the need to issue more equity to maintain remuneration on a dollar basis.
The top quartile (highest dilution companies) saw Net Dilution rise to 4.9% in 2022. A more granular snapshot of all the companies can be seen below.
We calculated SBC-based dilution across the above companies from 2015 to 2022 and ranked the average net dilution over the last 1-5 years.
To our surprise, there was no clear relationship between company size and net dilution (we expected a negative correlation) and company revenue growth rate and net dilution (we expected a positive correlation). Among others, Atlassian, Shopify, HubSpot and Square have all consistently grown at 30% or more, and have kept their 3-5 year Net Dilution below 2% p.a. (see pages 13 and 15 of the full pack for more information).
Has the stock price performance differed between ‘high’ SBC issuers and ‘low’ SBC issuers?
We analysed the stock price performance of technology companies from 2018 to 2022 and compared these returns to levels of net dilution. Our conclusions are summarised in the following charts.
Above all else, we observe;
- An inverse correlation between a company level of SBC-based net dilution and its medium-term stock price performance.
- Companies with the lowest Net Dilution (<2% pa) recorded median stock price performance of +16.9% p.a. In contrast, those companies with the highest Net Dilution (>3% p.a.) recorded median stock price performance of negative 0.9% p.a.
- Growth technology companies that dilute greater than 3% p.a. from SBC on a net basis, are EXTREMELY UNLIKELY to outperform the market.
There are a number of possible conclusions to draw from this data. Most intuitively to us, it could be that companies with more disciplined SBC issuance behaviour are also more disciplined across other parts of their business (e.g. capital allocation, cost control, etc.) which, in turn, drives superior shareholder value creation. However, we acknowledge there could also be a ‘ chicken and egg’ problem – companies with strong stock price performance have an unfair advantage in being able to issue less SBC to reward their employees.
We have always been strong proponents of our portfolio companies diluting by no more than 3% per annum. It has seemed a reasonable rule of thumb that balances the ability to attract great talent, their alignment with all other owners of the business and shareholder value creation.
How has the mix of SBC changed – RSUs vs Options?
We have seen a distinctive trend away from options in favour of RSUs. In 2015, only 26% of companies relied wholly on RSUs as their method of paying SBC (with 71% using a combination of RSUs and options and only 3% using options only). In 2022, 56% of companies relied on RSUs only. Only one company in our data set granted no RSUs over the past eight years – Netflix!
The current reliance on RSUs has the advantage of simplicity, but fundamentally rewards employees differently – i.e. RSUs vest based on time rather than performance and are relatively more lucrative for employees if a stock price declines.
To further analyse the type of equity grants issued by US-listed growth tech companies over the last eight years, we split companies that IPO’d in 2019 or earlier into two groups based on their average SBC-based dilution over the last 3-5 years – less than and greater than 2% p.a. dilution.
We found that the less dilutive half of the cohort had a much higher proportion of equity plans that had a mix of options & RSUs, suggesting that there are potential advantages of including options in a company’s equity policy as it relates to dilution.
How much does the SBC decision matter to valuation?
In very simple terms…a lot.
A company diluting its share count by 4% p.a. compared to a company diluting its share count at 2% p.a. over a 20-year period will have a c20% lower valuation on a per-share basis. The impact could be much higher if you assume dilution continues in perpetuity.
Another way to think about it; what is the 5-year market capitalisation growth required simply to offset share dilution? That is, for the stock price to simply stay constant given the stock-based compensation levels. At 3% dilution, the market capitalisation needs to grow by c16% over five years, and at 5% dilution, this jumps to over 27%!
Where to from here? The TDM view
Despite a growing awareness of the huge value transfer (from companies to employees) occurring via SBC, the topic has historically had insufficient attention from investors and companies alike. However, this is changing and in the current market we have seen exponential growth in focus on this area.
We fundamentally believe in the power of SBC, when used in the right way. We would love to see public growth technology businesses gravitate towards some key principles:
- Limit SBC net dilution to 3% p.a. In an ideal world, it is 2% p.a. or lower
- Retain some use of options or performance-based RSUs rather than exclusively using time-based RSUs
- Provide medium-term guidance on the level of net dilution
We believe this will set companies up with a more sustainable financial model, and will help investors properly value those companies.
We would love to hear from any growth companies or investors with different perspectives on this topic. We’ve enjoyed getting stuck into this new data set and hope it helps others interested in the topic.
If you are interested in conducting your own analysis via the Excel data book, feel free to email email@example.com.
-  we assume 1 RSU is equivalent to 3 options as an estimation of the fair value of an option relative to the price of the company’s common stock. This was necessary to get to a common numerator.
-  We also recently saw these calculations presented by Thomas Reiner – https://www.platformaeronaut.com/p/tech-company-dilution-finding-ground