Think Value

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💼 Employee compensation tied to company capital is a widely used practice that sometimes significantly affects the organization’s Free Cash Flow and, consequently, its valuation.

📈 This refers to granting employees options or direct shares. Mistakes are easy to make because, in reported cash flow statements, this type of compensation often increases operating cash flow, creating an illusion of free cash.

📝 Example: Google’s summarized cash flow statement, 2014 (illustrated in the photo)

🔹 In such cases, this type of transaction should be considered as two separate operations:
1️⃣ Cash compensation to employees
2️⃣ Employees’ purchase of shares or options

⚠️ Otherwise, significant valuation errors can occur.

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💰 Employee capital-linked compensation affects cash flows in two ways:

• Tax effect: When options are granted, they are recorded as expenses and liabilities, creating a tax asset. If, later, the option generates income for the employee (i.e., the stock price exceeds the exercise price), the employee pays income tax, and the company’s taxable profit decreases.
• Dilution effect: To provide employee compensation under a capital-linked scheme, the company needs to repurchase its shares or issue new shares. This affects the cash flow statement, though the timing may not coincide with the compensation period.

📊 Three main methods are used to forecast the scale of such compensation:
1️⃣ Historical proportion relative to operating expenses (by department)
2️⃣ Value at the date of grant (for options, using their valuation at grant date)
3️⃣ Realized value at the exercise date (actual payout when the option is exercised)

💡 P.S. Valuing employee options differs from standard financial options; due to dilution effects, the formulas are more complex.

📚 Source: Corporate Valuation Theory, Evidence and Practice – Mark E. Zmijewski; Robert W. Holthausen, Second Edition

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