As you've likely heard by now, Microsoft purchased LinkedIn. So why did LinkedIn's leadership decide to sell the company? Many have started to speculate that Linkedin's reliance on stock-based compensation could be a contributing factor.
So what exactly is stock-based compensation and why has it become so pervasive in corporate settings?
One unspoken reason behind the LinkedIn sale https://t.co/tl5APXXdFb— The New York Times (@nytimes) June 14, 2016
One reason that companies started offering stock-based compensation was to correct what is called the “principle/agent problem.” Simply stated, the employees of a company (the “agents”) may not have the same incentives that the owners of a company (the “principles”) may have. If someone is both the owner and the manager of a business, they tend to be very careful with expenses – they economize by flying coach instead of 1st class, for example, or they maintain a simple office instead of an expensively furnished one.
When the manager of a company is not also the owner, they have an incentive to make decisions that benefit themselves at the expense of the owners – they fly first class or maintain expensive offices. Giving employees stock-based compensation is an attempt to make them also part-owners of the company, and align their interests with the other owners.
Another reason, especially for small tech-based startups, is to avoid paying out cash. For many small companies, cash may be exceptionally tight, and paying employees in the form of stock offers payment tomorrow for work today. This can cut expenses for the company in the short-term and can be exceptionally profitable for the employee in the long-term – think about stories of the Google janitor now being worth millions, for example. Obviously, if the company does poorly, this isn’t the case.
So why all the concern? Well, when stock-based compensation is offered, it dilutes the existing shares of stock and reduces their value. If we imagine that the equity of a company is worth a set amount and doesn’t change depending on how many shares are outstanding, then issuing new shares must reduce the value of the existing shares – by exactly the amount given out in new shares.
In this way, stock-based compensation should hurt Net Income by exactly the same amount as its listed value, just like an expense. But since it’s non-cash, many companies “adjust” their EBITDA to not include it. However, as this dilution effect can be very large, pressure has come from investors for companies to include this as an expense when reporting earnings.
As you can see in this New York Times article, many companies, including Facebook and Microsoft, have started doing exactly that.
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About the Author
Brian is a member of the HBX Course Delivery Team and is currently working to design a Finance course for the HBX platform. He is a veteran of the United States submarine force and has a background in the insurance industry. He holds an MBA from McGill University in Montreal.