Reference no: EM133342256

Tech Shares Are Crashing, So Kiss Your Bonus Goodbye

Chris Bryant

May 10, 2022

 

The plunge in technology shares is providing investors with a harsh lesson in the reflexivity of stock-based compensation, which acts as a tailwind for companies while stock prices are increasing but can hamper employee retention and threaten cash flow when share prices collapse.

Loss-making mobile-games company Skillz Inc., for example, in September promised chief executive Andrew Paradise a bonus worth roughly $175 million if he could reverse a steep decline in the share price and quintuple the market value within seven years. (1)

However, the rout continued - the shares have declined 96% since last year's peak - and in March, Paradise agreed to cancel his compensation plan so the San Francisco-based company could top up equity awards for the rest of the workforce instead. Skillz is also boosting salaries by 15% to discourage employees from quitting. The added wage expense will, though, make reaching positive free cash flow even harder.

Its predicament is one shared by scores of neophyte technology companies that are suddenly under pressure to generate profits, rather than just rapid revenue growth. Pandemic winners such as Peloton Interactive Inc. and Robinhood Markets Inc. are slashing jobs, and the morale of those who remain has been bruised by the shrinking value of employee stock awards.

For younger tech employees, their first experience of a really vicious bear market comes as an unpleasant shock. For the past decade, tech companies seemed only to shower them with wealth. By accepting stock in lieu of cash, however, staffers were effectively providing cheap financing to their employers, a decision that now doesn't look as smart. When stock prices crater, workers "discover that they've been earning much less than they thought," Alliance Bernstein analysts explained in a prescient note last year.

It's a shock, too, for employers and investors. Paying staff with shares allowed tech firms to report seemingly good "adjusted earnings" and cash flows, because stock compensation is excluded from those calculations. Shareholders still suffered dilution from increasing share counts, but gave it little thought because the market values of firms were rapidly increasing.

Now the tech compensation ratchet has swung the other way. Companies are having to offer higher cash salaries to reduce their employees' exposure to stock-market volatility and help them cope with a cost-of-living squeeze. Amazon.com Inc. has more than doubled its maximum base salary to $350,000 to aid hiring and retention, while rival e-commerce giant Shopify Inc. has given employees more flexibility to choose between cash- and stock-based pay. Cisco Systems Inc. is making cash a higher proportion of total compensation.

Boosting pay packets won't pose a problem for cash-rich FAANG stocks, but it might be trickier for smaller cash-burning upstarts. In December, Skillz added to its coffers via a $300 million high-yield bond, but was forced to pay an eye-watering 10.25% coupon.

As Snap Inc. (which paid $1.1 billion in stock compensation last year) reminded investors recently, dilution from employee stock awards also "tends to move inversely" with equity values. Put another way, as stock prices fall, companies may have to offer employees even more shares to achieve the same compensation levels. DoorDash Inc. has offered recent hires top-up equity grants to offset the losses they've incurred since joining, Business Insider reported. Meanwhile, Nikola Corp. is asking shareholders at its June annual meeting for permission to increase its share count by one-third, in part to aid the "attraction and retention of employees" through additional equity grants.

The big unknown these firms face is this: Will their employees walk? Stock options, like the ones Netflix Inc. offers, can lose their entire retention value if the stock drifts far enough below the exercise price. Not surprisingly, its staff are now pressing for additional grants, according to The Information.

However, restricted stock units, essentially free awards of stock that typically vest over a four-year period, are far more common these days and will retain at least some value (unless the company goes bust).

A low stock price isn't necessarily a disaster for recruitment: If a company can convince new hires its shares are undervalued, it may still be able to attract talent who'd profit handsomely from a rebound. Given the worsening tech jobs market - Meta Platforms has reportedly instituted a hiring freeze through the end of the year - the pressure to increase cash salaries may soon start to abate and employees may decide to stay put. Moreover, money also isn't the only consideration: Corporate culture, "mission," and career advancement matter to employees too.

While shareholders will understand the need to retain top engineering talent, they're unlikely to show the same tolerance if companies rebase executive compensation so top managers still make bank. Amid the last year's market euphoria, several tech firms offered senior executives pay plans potentially worth nine or ten-digits in return for reaching ambitious share price goals. Like at Skillz, those targets now look unrealistic because stocks have cratered: Robinhood executives, for example, will need to increase the company's market capitalization by around 30 times to achieve all of their bonuses.

But those who stood to profit most from rising markets can't really complain when the pendulum swings the other way. Tech's newfound need for financial discipline should also apply to executive pay.

Part 1

How is stock-based compensation used as management control device? How does it impact agency risk?

Part 2

Why is stock-based compensation particularly useful in start-up companies? 

Part 3

With stock prices falling, employees may demand increased monetary compensation. If this holds true, what is the expected impact on labour rate efficiency and price?

Part 4

Do you think this issue is as prevalent in an industry such as banking?