Software Siphon — An Updated Look at Stock Comp in Software

Theme and Background

This chapter is the first part of Voss Capital's research report, focusing on how software industry stock-based compensation (SBC) erodes financial reality. The report points out that despite the significant decline in software stocks in 2022, SBC as a percentage of revenue remains at historically high levels, leading to a broad deterioration in the "true" Rule of 40 (adjusted EBITDA margin minus SBC margin plus expected NTM revenue growth). Revenue growth has slowed, and the rebound in profit margins is insufficient to close the gap. Small-cap companies (revenue below $1 billion) have experienced the most severe deterioration, while large-cap companies are less affected, which explains the recent outperformance of a few mega-cap software stocks.

Core Views

• SBC as a percentage of revenue remains at historically high levels: Despite the sharp decline in software stocks, SBC expenses have not fallen significantly, meaning companies are diluting existing shareholders at a faster rate.
• The "true" Rule of 40 has declined broadly: When SBC is included in the calculation, the median software stock's Rule of 40 is approaching the "Rule of 20," and the gap between adjusted EBITDA and "true EBITDA" (adjusted EBITDA minus SBC) is near an all-time high.
• Revenue growth is the main drag: Expected NTM revenue growth has fallen below the long-term average of 16%, dropping below 15%, while margin improvements (300–400 basis points) are insufficient to offset the slowdown.
• Valuations remain expensive: Despite the significant decline in 2022, software stock valuations are still above most historical periods. For companies with revenue above $1 billion, the EV/NTM EBITDA multiple remains 36x, compared to the historical range of 8–12x between 2008 and 2016.
• Counterintuitive judgment: The market widely believes that software stocks are "cheap" after the 2022 decline, but the report argues valuations are still at historically high levels. Small-cap companies are experiencing the worst fundamental deterioration, while the rise of large-cap companies (e.g., MSFT, ORCL) has fundamental support.

Key Arguments and Data

1. Historical trend of SBC as a percentage of revenue:

• During the 2000 tech bubble, SBC growth was mainly driven by rising stock prices; currently, RSUs account for a larger share, and stock price fluctuations have a smaller impact on SBC.
• Despite the sharp decline in software stocks in 2022, SBC as a percentage of revenue has not fallen, indicating accelerating dilution.

2. Changes in the Rule of 40:

• The Rule of 40 calculated using adjusted EBITDA is at the low end of its 15-year range; after adding SBC, the median software stock's Rule of 40 approaches 20.
• The gap between adjusted EBITDA and "true EBITDA" is near an all-time high.

3. Revenue growth and profit margins:

• Expected NTM revenue growth has fallen from over 20% in 2022 to below 15%, breaking below the long-term average of 16%.
• When growth rates exceed 15%, the median EV/NTM Sales multiple is 5x; below 15%, it is approximately 3x. The current median is 4.5x.
• Margin improvements of 300–400 basis points are expected but insufficient to offset the growth slowdown.

4. Scale divergence:

• Changes in "true EBITDA" margins by revenue group (from 2015 to present):

Revenue Scale	Change in True EBITDA Margin
>$10 billion	Improvement
$1–10 billion	Slight decline
<$1 billion	Significant deterioration

• Changes in "true Rule of 40" by revenue group:

Revenue Scale	True Rule of 40 (Current)	Trend
>$10 billion	55%	Near all-time high since 2015
$1–10 billion	Slight decline	Moderate
<$1 billion	Significant decline	Most severe

5. Valuation multiples:

• For companies with revenue above $1 billion, the EV/NTM EBITDA multiple remains 36x (with or without SBC).
• The historical range between 2008 and 2016 was 8–12x, and the current level is nearly three times the historical average.

Companies/Assets Involved

• Microsoft (MSFT) and Oracle (ORCL): As representatives of large-cap software companies, the report notes they have seen the largest YTD gains in 2023, partly supported by fundamentals (improvement in the true Rule of 40). Bullish.
• Small-cap software companies (revenue <$1 billion): True EBITDA margins have deteriorated significantly, the true Rule of 40 has dropped sharply, and valuations remain high. Bearish.

Investment Implications

• Avoid small-cap software stocks: Companies with revenue below $1 billion have the most severe fundamental deterioration and still hold high valuations, resulting in an unfavorable risk-reward profile.
• Focus on large-cap software stocks: Companies with revenue above $10 billion (e.g., MSFT, ORCL) show improved true Rule of 40 and relatively reasonable valuations, and are likely to continue outperforming.

• Be wary of SBC dilution: SBC as a percentage of revenue has not declined in tandem with falling stock prices, meaning shareholder dilution is accelerating. SBC should be deducted in valuation models to reflect true profitability.
• Valuation risk persists: Even for companies with revenue above $1 billion, the EV/NTM EBITDA multiple of 36x is still far above the historical average (8–12x). If growth continues to slow, downside potential is significant.

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Theme and Background

This chapter delves further into the valuation issues of the software industry, with the core argument being that after accounting for stock-based compensation (SBC), the actual valuation of software companies is far more expensive than the surface data suggests. By comparing "adjusted EBITDA" multiples to "real EBITDA after including SBC" multiples, the author quantifies the hidden inflationary effect of SBC on valuations. The report also points out that although the overall fundamentals of the industry (e.g., quality of recurring revenue) have improved, growth expectations have dropped sharply, margin improvements have been modest, and combined with high interest rates and competitive risks from AI, the author maintains a cautious stance on the software sector as a whole.

Core Views

• The overall valuation of the software industry remains expensive in a historical context, especially after factoring in SBC. The author argues that even though the software industry should command valuations above historical averages due to higher-quality recurring revenue and greater recession resilience, the sharp decline in growth expectations and only modest margin improvements are insufficient to support current valuation levels.
• A counterintuitive judgment is: The author worries that the large number of competitors fueled by venture capital (VC) funding, along with cloud computing lowering customer switching costs, will make the "40%+ margins" assumed by many investors difficult to achieve (unless a company has the massive scale and true moat of Microsoft). Combined with higher interest rates, the median valuation of software stocks may fall back to approximately 3x sales.
• The impact of AI on the software industry is a double-edged sword: It could both improve margins by reducing demand for coders and accelerating innovation, and also lead to product commoditization, threatening specific areas such as low-code/no-code platforms, call centers, and related companies.

Key Arguments and Data

1. Hidden inflationary effect of SBC on valuations: Through charts (specific values are not provided in the text, but the methodology is described), the report shows how many times cheaper the EBITDA multiples of the median stock would appear for software companies with revenue exceeding $10 billion (currently 58 companies) if SBC costs were not included. This directly quantifies how SBC makes software companies "hiddenly" more expensive.

2. Assessment of industry fundamentals:

• Positive: The software industry has higher-quality recurring revenue and is more resilient to economic downturns.
• Negative: Growth expectations have "sharply declined," while margins have only "modestly improved," creating a mismatch.

3. Valuation and risk scenarios:

• The author believes that under a higher interest rate environment, the median valuation of software stocks could fall back to 3x sales. This judgment is based on a comprehensive consideration of intensified competition, margin pressure, and rising interest rates.

Companies/Assets Involved

Company/Asset	Role and Key Data	View
Microsoft	Mentioned as an industry benchmark with massive scale and a true moat.	Positive case. The author believes that only companies like Microsoft can achieve the assumed 40%+ margins.
Low-code/No-code platforms, Call centers	Mentioned as specific areas potentially threatened by AI.	Bearish. The author believes AI could lead to product commoditization in these areas, harming related companies.
Software industry as a whole (companies with revenue > $10 billion)	Object of analysis, totaling 58 companies.	Overall bearish. Valuations are expensive, and fundamental improvements are insufficient to support them, facing multiple risks from competition, interest rates, and AI.
Vertical niche SaaS stocks	Mentioned as an exception.	Bullish. The author states that they still find many attractive bottom-up investment opportunities with reasonable valuations in these areas.

Investment Implications

• Maintain caution on the software sector as a whole: Given high valuations, slowing growth, intensifying competition, and rising interest rates, investors should avoid broad, passive allocation to the software sector.
• Be wary of the distortion caused by SBC on valuations: When evaluating software companies, SBC must be treated as a real cost and metrics such as "real" EBITDA or free cash flow should be used; otherwise, profitability will be severely overestimated and valuation risks underestimated.
• Focus on giants with true moats and economies of scale: Such as Microsoft, which are more likely to achieve high margins and withstand competition and AI shocks.
• Bottom-up search in vertical niche SaaS: Against the backdrop of overall caution, the author believes that reasonably valued investment opportunities still exist in vertical niche SaaS. This suggests that investors should focus on specific sub-sectors and look for companies with unique competitive advantages and pricing power.
• Be alert to commoditization risks from AI: When investing in software companies in areas such as low-code/no-code and call centers, assess the risk that their products could be replaced or commoditized by AI.