Stock-based compensation can be a good way to retain employees and to ensure their interests are aligned with those of shareholders. But it's not a free lunch despite the deceptive non-GAAP figures touted by many companies. Stock-based compensation is not a cash cost, but it is a real cost.
For one, stock-based compensation dilutes shareholders by increasing the share count. Some companies hand out stock options like candy on Halloween, then turn around and buy back their own shares to prevent this dilution. All this does is turn a non-cash expense into a cash expense, although the accounting doesn't capture that reality.
Another issue is that stock-based compensation can create bad incentives for management. If the mission is to maximize free cash flow, for example, one way to do that is to shift as much compensation as possible to equity.
Twilio (TWLO 1.08%) is the poster child for excessive stock-based compensation. The company took a charge of nearly $800 million related to stock-based compensation in 2022, equivalent to more than 20% of revenue. Twilio's share count jumped 3.5% year over year in the fourth quarter. That may not seem like much, but if you compound that level of dilution for 10 years, a shareholder would see their stake in the company dwindle by around 30% in that time.
Taming the beast
Under generally accepted accounting principles (GAAP) accounting, which treats stock-based compensation as a real expense, Twilio posted a net loss of $229 million in Q4 on $1.02 billion of revenue. For the full year, Twilio lost $1.26 billion on $3.83 billion of revenue. Twilio did eke out a non-GAAP net profit in Q4 of $41 million, but that metric involves adding back nearly $200 million in stock-based compensation, along with some other items.
Twilio is doing two things to rein in costs and specifically, stock-based compensation costs. First, the company is laying off a substantial percentage of its workforce as growth slows down. Following an 11% workforce reduction last September, Twilio is now laying off an additional 17% of its workforce. These layoffs will lower cash costs immediately, although it will take more time for the benefits to flow through to stock-based compensation.
Second, Twilio is making changes to its compensation structure. The company is shifting from stock-based to cash-based compensation, with the goal of bringing down stock-based compensation as a percentage of revenue to a range of 10% to 12% by 2027. That target will take nearly five years to reach because of the way new hires are compensated. It's not until year 5 that the stock-based compensation for a new hire begins to decline, and Twilio did a lot of hiring since 2020.
Slowing growth
Twilio is cutting costs and reining in stock-based compensation because it has little choice. The company's dollar-based net expansion rate, a measure of the pace at which existing customers are ramping up spending, tumbled to 110% in Q4. That's down from 122% in Q3 and down from 139% in Q4 2020. Customers are pulling back in a big way.
On top of the layoffs, Twilio is breaking its business into two units. The mature communications unit will focus on efficiency, while the faster-growing applications unit will aim to accelerate growth. Data and applications accounted for just 12% of revenue in Q4, and it grew only slightly faster than the company as a whole.
With growth slowing and the stock in the doghouse, Twilio can no longer rack up gigantic losses and dole out excessive stock-based compensation. The company needs to prove to investors that it can transform itself into a sustainable, profitable business. The company's restructuring and its shift away from stock-based compensation are good steps in that direction.
