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INTRODUCTION
Over the past several years there has been a significant increase in attention paid to equity usage across the technology sector. This focus has been particularly noticeable among software companies due to several factors, including:
In our 2024 “Software Sector Equity Report,” we analyzed equity usage among 129 public software companies with market capitalizations between $100M and $50B.[1]
KEY REPORT FINDING
Gross burn rate has long been a standard measure for evaluating the competitiveness of a company’s equity spend. It is a core feature of Institutional Shareholder Services’ (ISS) methodology to determine voting recommendations on new or amended equity plans. Gross burn rate is also a common metric presented to Compensation Committees to understand competitive positioning of a company’s equity budget.
However, stock-based compensation (SBC) expense, often expressed as a percentage of revenue, has recently emerged as a critical additional data point to evaluate equity spend, driven in part by increasing attention from Wall Street. The primary narrative accompanying this SBC trend is a view that equity compensation is an economic cost to the company and its shareholders that should be considered when evaluating the overall economics of the business and path to profitability. This viewpoint contrasts with a long-standing and widely adopted corporate practice of reporting adjusted earnings excluding the impact of stock-based compensation.
Aligning with this trend, our research highlighted both decreased burn rates and stock compensation expense in 2023. These decreases follow what we observed as significant increases in 2022, driven by a carryover of aggressive equity compensation from a competitive market in 2021 and low valuations during a downturn in 2022.
In addition to declines in medians, we also found a decrease in prevalence of companies above what have historically been on the high end of SBC/revenue and burn rate ranges.
For many companies, efforts to manage burn rate have been challenged by the combination of equity budgets denominated in dollars and continued share price volatility.
Unlike burn rate, addressing high SBC/revenue ratios can take time given that a significant portion of stock-based compensation expense reflects that amortization of grants from prior years. Declining revenue growth also makes it difficult to manage SBC/revenue over a short-term time horizon.
Segmenting the data based on market capitalization further highlights the challenge of maintaining a competitive equity program with relatively low valuation, with gross burn rates showing a notable inverse correlation with market capitalization. Evaluating equity budgets as a value in addition to burn rate can help distinguish the impact of compensation plan design and company performance and valuation when considering the competitive positioning of equity grant strategies.
We also found a meaningful positive correlation between SBC/revenue and revenue growth rates. Companies on a steeper growth curve are able to invest with an expectation that increasing revenue will absorb the expense over a three- to four-year vesting time horizon. However, this approach is challenging if growth decelerates. Reducing the dollar value of equity compensation budgets can be achieved primarily through reducing either headcount, the percentage of employees eligible for equity, and/or grant guidelines for eligible employees; all areas that can meaningfully impact employee retention and engagement.
Despite investors’ focus on managing equity usage, our research showed that the vast majority of executive compensation annual incentive plans do not use metrics that account for stock compensation expense. Among public companies with full disclosure of annual incentive plan performance measurement, 98% do not account for stock-based compensation. They measure either profitability metrics adjusted to exclude stock compensation or measure only growth and/or cash flow.
TAKEAWAYS AND NEXT STEPS
Against this backdrop, we encourage clients to evaluate their equity budgets looking at the current year and over time, accounting for projected equity budget in dollars, gross burn rate, and stock-based compensation expense. Net burn rate (gross burn rate with adjustment for cancellations) and/or actual dilution (the increase in shares outstanding attributable to RSU settlement and/or option exercise) can also be useful data points. A multi-year projection, similar to the simplified example below, can support meaningful discussion at the Compensation Committee level, with opportunities to evaluate equity budgets in the context of market data with sensitivity to inputs such as valuation and revenue growth.
Clearly articulating equity budgets in the context of both market data and over time acknowledges the perspective that equity is increasingly viewed as a scarce resource. Equity spend should also be evaluated in the context of the company’s profile relative to peers. Relevant factors may include growth, valuation, profitability, and business model.
For companies on the high end of market, rationalizing equity budgets could mean:
NEED ASSISTANCE?
Compensia has extensive experience in helping companies design equity programs aligned with the pay program objectives, market practices and shareholder expectations. If you would like assistance in reviewing your existing programs, or if you have any questions on the subjects addressed in this Thoughtful Pay Alert, please feel free to contact:
Greg Loehmann, Principal
408.907.4319
gloehmann@compensia.com
About Compensia
Compensia, Inc. is a management consulting firm that provides executive compensation advisory services to Compensation Committees and senior management.