Why Pro Forma-ing Stock-Based Compensation Out of Your Financials Is a Bad Idea

After seeing the buzz around pro forma financials in the tech industry, I felt compelled to discuss why removing stock-based compensation (SBC) from your financial statements is a risky move. We'll start with what pro forma financials entail, delve into the drawbacks of excluding SBC, and finally, explore better alternatives.

What are pro forma financials?

Pro forma financials are adjusted statements that reflect the impact of specific events or transactions, whether past or anticipated. Adjusted EBITDA, for example, is a common pro forma metric that can exclude this non-cash expense to show a company’s earnings without the impact of SBC.

Such statements are particularly useful for companies undergoing significant changes like acquisitions or restructuring, or those wanting to underscore certain financial aspects not obvious from standard GAAP statements.

Why pro forma-ing SBC out of your financials is a bad idea

Stock-based compensation is a non-cash expense linked to granting equity options or other equity forms as employee compensation. It's a staple in the tech sector, helping attract and retain talent as well as aligning employee interests with those of the company.

Excluding SBC from your financials is problematic for several reasons:

  1. It Misrepresents Financial Health: SBC, though not a cash expense, still reflects a real cost. Omitting it paints an incomplete and potentially misleading picture of your financial health, complicating investor assessments of your company’s profitability.

  2. It sets a dangerous precedent: If you start excluding SBC out of your financials, what’s to stop you from adjusting other expenses as well? This can lead to a slippery slope where companies are able to manipulate their financial statements to make themselves look more profitable than they really are.

  3. It undermines the credibility of your financial statements: Investors rely on your financial statements to make informed investment decisions. If they see that you’re excluding SBC out of your financials, they may question the integrity of your financial reporting and be less likely to trust the information you provide.

Consider Snapchat's experience with excluding SBC, which has been criticized for enriching executives at the expense of shareholders, highlighting the potential consequences of such practices.

The only alternative: show SBC in your financial statements

So, what's the alternative, you ask? Simply put, just don't do it. Instead, consider what showing SBC in your financial statements can do for your company. It gives a sobering view of your financial health, helps investors make informed decisions, and builds trust in your financial reporting. It's a strategy that benefits all parties involved.

Excluding SBC can mislead, create dangerous precedents, and erode trust. By presenting SBC transparently in your financials, you ensure a more accurate and reliable portrayal of your company’s financial wellbeing, attracting investors and establishing your reporting's credibility.

I hope this insight is valuable. For questions or further discussion on this topic, don't hesitate to reach out.