Equity-based Compensation and Long-term Value Creation

Most investors prefer companies run by management teams who have significant share ownership and therefore ‘skin in the game’. Naturally, though, not all executives can be founders and so over time, equity-based compensation has gained popularity to incentivise newer talent and key employees to think and act like owner-managers. While the theory is sound, Fairlight’s experience has been that not all equity-compensation schemes are well-crafted and often fail to drive long-term value creation for shareholders.

Cosy Alignment or Red Flag?

In 2004, IFRS introduced a new rule requiring entities to recognise equity or stock-based compensation (SBC) transactions in their financial statements. Following this regulation, from 2005 to 2024, the median ratio of share-based payments to sales in the US grew sevenfold, from 0.15% to approximately 1.1%. This growth in SBC has not been limited to the US; it has also been observed globally, in countries like the UK, Australia, France, and Germany, although to a lesser extent (Figure 1).

Figure 1.

While 1% of sales may not seem substantial, sector-specific data in the US reveals a clear upward trend in share-based payment expenses requiring investors to pay more attention to these costs.

The upward trend is particularly prevalent across IT due to the large number of firms in this sector being speculative and unprofitable tech businesses (Figure 2). There are two lenses in which we can view the use of SBC to incentivise executive teams within this industry. The first is a measure of alignment and enticement for an executive to take a risk on working for a more speculative enterprise, the second is potentially waving a red flag to indicate a business may be underfunded with a requirement to conserve cash.

Our July 2022 post discussed the latter lens, specifically, how the accounting of equity-based compensation costs can improve the appearance of the profit and loss and cash flow statements of a business. We do not think it is a coincidence that unprofitable technology companies find SBC particularly appealing.

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Figure 2.

The Fairlight strategy doesn’t invest in unprofitable businesses, so we mainly focus on assessing the quality of equity-compensation structures.

Optimal Incentive Structures

Striking the right balance between creating long-term shareholder value and retaining high-performing executives is paramount when evaluating these structures. Below is our opinion of best practice:

1. Avoid share price-based metrics: Incentives based on share prices can encourage management teams to become overly promotional of their businesses to attempt to drive short-term share price appreciation rather than focusing on making decisions which prioritise long-term value creation.

2. Prefer returns on capital: Fairlight has a preference for compensation plans skewed towards return on capital metrics versus earnings metrics like EPS growth which can be boosted artificially with rushed and poor-quality acquisitions.

3. Maintain a long-term focus: While it is important to remunerate talent for outstanding performance in any given year with cash-based bonuses, we prefer plans where the majority of remuneration is skewed towards long-term equity awards.

The Fairlight View

Fairlight views equity-based compensation as an important mechanism to foster an owner-manager mentality. We are particularly supportive of incentives that link executive compensation to returns on capital over the long-term, rather than share price outcomes. At the same time we recognise that equity-based compensation is a real cost for businesses and thus should be presented clearly as such and not added back to ‘adjusted earnings’, a practice that has become common amongst most listed companies.

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