Stock-based compensation is an important part of many executive compensation packages. If employees and top management have a significant part of their own earnings and wealth tied to the company’s stock performance, their interests will be aligned well with shareholder interests.
On the other hand, stock compensation leads to “dilution” of other shareholders; as more and more shares are issued, existing stockholders come to own a smaller piece of the business. Up to a point, this is a reasonable sacrifice, and can be justified when highly motivated management and employees are creating lots of value for all shareholders. However, in some cases, a company’s management can become too generous with stock, so that the cost outweighs the benefit to shareholders.
The same is true for secondary share offerings and convertible debt. These tools can give a growing business access to low-cost capital. On the other hand, if the business is successful, its original shareholders will own a smaller piece of that success.
Netflix, Inc. (NASDAQ:NFLX) shareholders have experienced significant dilution of their holdings over the past two years from all of these factors, and this trend appears to be continuing. For now, shareholders are not complaining, because the stock has quadrupled since August. However, if the current run-up in Netflix, Inc. (NASDAQ:NFLX) stock turns out to be another bubble, shareholders may be dismayed to see that their ownership of Netflix has been diluted.
A stock bailout
Netflix had fewer than 53 million shares outstanding through most of 2010 and 2011 (roughly 54.4 million shares on a fully diluted basis), but the share count has been rising fairly quickly since then. The biggest factor was management’s decision to use stock to “bail out” the company after several strategic missteps in 2011 led to a rapid drop in Netflix, Inc. (NASDAQ:NFLX)‘s profitability.
First, Netflix offered 2.9 million shares in a secondary offering in late 2011 to raise $200 million of new capital. (Ironically, while the shares were offered at approximately $69 each, Netflix had spent $200 million buying back stock at an average price of $221.88 earlier in the year.) Netflix also issued $200 million of convertible debt in late 2011. In April 2013, the company forced the conversion of that debt to stock, which added another 2.3 million shares of Netflix, Inc. (NASDAQ:NFLX) stock.
These two transactions provided a much-needed capital infusion in late 2011. However, Netflix, Inc. (NASDAQ:NFLX) created more than 5.2 million new shares in the process, diluting existing shareholders by nearly 10%.
Netflix has also maintained a fairly generous stock-based compensation plan for its employees. According to the company’s most recent 10-K SEC filing, Netflix, Inc. (NASDAQ:NFLX) granted employees options for more than 1.8 million shares during 2012 at a weighted-average exercise price of $73.94. At Friday’s closing price of $220.22, those options are worth $264 million; in other words, if employees exercised those options and then immediately sold the stock on the open market, they would earn a $264 million profit.