Insights

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” – Benjamin Graham

“Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of an option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside” – Warren Buffet, Berkshire Hathaway’s 1985 letter

There is a difference between the perspective of a business owner and that of a speculator. While the business owner is concerned with matters such as the competitive positioning of the business, the competitive intensity it faces, appropriate capital allocation actions, the business’s culture, etc., none of this concerns the speculator. The speculator is only concerned with the prospect of the stock price to increase.

As you think of that difference, consider the perspective of the C-suite corporate managers with disproportionately higher total compensations, especially true for American companies and the new economy businesses. The primary motivations seem to be to boost that compensation even further. Or that of most fund managers, active or passive, who are focused on keeping pace with their benchmarks. Or even those of the “investors” in these funds who are primarily concerned with the relative returns. Do they seem to be thinking like owners or speculators?

It is no surprise then that financial markets have been driven mainly by speculative frenzy as against investment merit.

In the current cycle, we find that an extreme excess has occurred in the so-called disruptor space—most of these businesses having been funded by the new funny money, aka VC funds. Consider the dissonance. The founders received progressively higher valuations, the higher the losses they incurred. Similarly, the providers of that funding, i.e., the VC managers, were rewarded for that behavior as higher valuations were being assigned to their investee companies as their losses expanded. Clearly, neither the founders nor those “investors” have been concerned with any such thing as an owner’s perspective.

One manifestation of this behavior we see is in the excessive issuances of Employee Stock Options (ESOs). While we think of ESOs as a true cost to as owners of our businesses, we haven’t seen much of a concern from other “investors” about the high level of owner dilution via ESOs. Managers and market participants have been quick to point out that ESOs align employee interest with that of the owners. However, it seems to us that one of the main reasons for such excessive issuances is that, when reporting non-GAAP numbers, managers could remove them from their costs. Further, as these issuances do not involve cash outlays, companies with such excessive issuances report much higher cash flows than they would if those expenses were paid in cash.

The table below shows the number of ESOs exercised as a percentage of the shares outstanding for a few high-growth companies for the latest financial year. This is a measure of the extent of dilution caused by ESOs to the existing owners. At 5% or more annually, the dilution experienced by the existing owner of the business is clearly excessive. Consider that at that continued rate of dilution, your ownership stake in the company will be reduced by as much as 20% over a five-year time. Indeed, for Snowflake and Palantir, that will be as much as a one-third reduction. Note that if the company buys back to set off that dilution, the existing owners aren’t any better off by that action. In such a case, the business’s cash flow is essentially redirected to the employees as against the owners.

Now, about that interest alignment idea. As against interest alignment, excessive reliance on ESOs add an additional risk to the business. Consider what happens when these businesses were to face economic slowdowns, business issues, or competitive issues that drove their stock prices lower. Or for that matter, an unwinding of the speculative excesses unrelated to business outcomes, not very different from what we have witnessed over the past few months. As their ESOs go deeply underwater, what are the motivations of such employees? In a strange manner, financial risk has been added to the business’s operational risk as the business suddenly finds itself with a prospect of higher employee attrition.