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Overhang and Its Importance for Investors

Overhang is a key metric that investors need to understand when evaluating companies, especially those with significant employee equity compensation programs. Overhang represents the total number of outstanding equity awards such as stock options and restricted stock units (RSUs) that have been granted but not yet exercised or vested. These outstanding equity awards create a "overhang" of potential future dilution to existing shareholders if and when the awards are ultimately exercised or vested. The higher the overhang, the greater the potential dilution risk down the road.

Calculating Overhang

The formula for calculating overhang is:

Overhang = (Outstanding Equity Awards) / (Outstanding Shares + Outstanding Equity Awards)

For example, let's look at a hypothetical company with the following equity structure:

  • Outstanding Shares: 100 million

  • Outstanding Stock Options: 10 million

  • Outstanding RSUs: 5 million

To calculate overhang:

  • Outstanding Equity Awards = 10M options + 5M RSUs = 15M

  • Overhang = 15M / (100M + 15M) = 0.13 or 13%

In this example, the company has an overhang of 13%, meaning the outstanding equity awards represent potential future dilution of 13% if all are exercised/vested.

Why Overhang Matters

High overhang isn't necessarily bad, but it does increase future dilution risk for investors. Mature companies will often have higher controlled overhang as they use equity awards to attract and retain talented employees. However, excessive overhang can be a red flag if it seems disproportionate to the company's needs. For high-growth companies, overhang is especially important to monitor. These companies tend to compensate employees heavily with equity. As they grow rapidly, they also issue new equity awards frequently to new hires. This can lead to overhang ballooning if not kept in check. Investors should analyze overhang in the context of the company's equity use practices and future equity needs. An overhang of 15% may be reasonable for a mature company, but potentially excessive for a startup that will need to continue issuing awards aggressively.

Implications for Investors

Overhang represents a future dilution risk that investors need to understand. All else equal, higher overhang makes a company less attractive on a price/share basis due to the dilution hanging over existing shareholders. However, overhang is just one part of the analysis. Investors need to evaluate whether a company's overhang level is justified by their talent needs and equity comp philosophy. Unsustainable overhang that continues growing could negatively impact future returns. But reasonable, controlled overhang may be a smart investment in attracting talent that drives company growth.

Overhang Burn Rate

In addition to looking at the overall overhang percentage, investors should also analyze the overhang burn rate. This metric shows how quickly a company is depleting its overhang by granting new equity awards. A high burn rate indicates the company is issuing awards at an accelerated pace, which could lead to continued increases in overhang if not offset by stock buybacks or other mechanisms. Conversely, a low burn rate suggests better control over potential future dilution.

Valuation Impact

All else being equal, higher overhang should theoretically translate to a lower valuation for a company. This is because the potential future dilution reduces the equity value accruing to existing shareholders.

However, valuation is an inexact science. The market may not fully price in overhang, especially at high-growth companies where investors focus more on future potential than current dilution. But astute investors will scrutinize overhang as one factor impacting intrinsic value calculations.

Equity Plan Resources

Companies with high overhang need to reserve a larger pool of outstanding shares to accommodate future equity grants. This means less flexibility for other actions like buybacks that could create shareholder value. Investors should ensure companies have sufficient remaining shares reserved in their equity plans to handle expected future grants. Running out could force repeated equity plan increases and accelerated dilution.

Executive Compensation

While overhang covers equity awards granted company-wide, investors should also analyze executive-level equity grants separately. Excessive awards to the executive team despite high overhang could be a red flag about corporate governance practices.

Sector Context

Investor expectations around reasonable overhang levels can vary across sectors. For example, technology companies often have higher overhang due to greater equity compensation. Whereas asset-heavy industries like manufacturing tend to have lower levels. Investors should benchmark a company's overhang against sector norms and peers to gauge if they are an outlier above or below accepted practices for their industry.

By fully understanding a company's overhang trajectory, grant practices, and equity compensation philosophy, investors can better assess whether the potential future dilution is a reasonable investment in attracting talent and driving growth. Monitoring this closely is essential for preserving shareholder value.

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