On a recent weekend, I was playing with my new puppy when my phone rang. On the other end was the CEO of a major public software company with a warning: the industry was headed for painful financial reset.
I can’t say who this is because he doesn’t want to be identified, talking about sensitive topics — and he wanted to speak honestly, without the usual restrictions of his company’s public relations department. These are the times you really listen!
The topic was broadly about how AI is disrupting software and impacting the business models of companies that offer software as a service, or SaaS. I’ve covered this deeply for about a year, so this wasn’t a surprise. But one of his main messages was unexpected — and is already proving prescient.
This CEO said stock-based compensation, or SBC, is too high for SaaS companies now. Future revenue growth may not be as strong anymore, so SBC has to come down, and the financial discipline of the software industry has to improve. This year, SaaS companies will have to cut a lot of employees to adjust, he predicted.
I’ll explain this more in a second, but this reality is already beginning to play out. On Wednesday, a prominent software provider called Atlassian said it’s cutting 10% of its workforce. That followed Block’s 40% job cuts.
Both companies attributed some of these layoffs to the impact of generative AI. However, they both said they’re still hiring engineers.
“Five years from now, we’ll have more engineers working for our company than we do today,” Atlassian CEO Mike Cannon-Brooks said in October, adding, “They will be more efficient.”
So what’s really happening here? Let’s go back to the weekend call I got from that other software CEO.
The rise of cheaper software
One broad message he shared is that generative AI is making it much easier to create software. This means the supply of software is skyrocketing, so according to the law of supply and demand, the value of software is falling.
This won’t mean the death of SaaS. In fact, cheaper and more prevalent software will be a huge boon to the tech industry because more people will use it. And smart software engineers will be needed to check that all this software is still working — and to understand deeply why it’s working or not.
“Engineering is changing, and great engineers are more important than ever,” said Boris Cherny, the head of Anthropic’s Claude Code, one of the main drivers of AI software disruption.
So, what’s likely happening is that generative AI is changing how software is made and maintained, and upending how software companies charge for their offerings.
For now, this could mean slower revenue growth for software providers. And this is what brings us back to the need for more financial discipline in the sector — and to the issue of stock-based compensation, or SBC.
Engineers and other tech talent are wooed by software companies with generous chunks of equity, known as restricted stock units, or RSUs. The awards are often valued based on the market price on the day they’re granted.
That works well when stocks are rising. But software stocks have taken a beating in recent months on concern about slowing growth and the potential impact of AI.
To keep the same level of stock compensation with the same size workforce, software companies will soon have to issue millions of extra shares. That will dilute existing shareholders and cut deeply into future earnings per share, one of the main measures of any company’s financial health.
“SBC (stock-based compensation) is coming up a lot more in our investor conversations,” Raimo Lenshow, a software analyst at Barclays, wrote in a recent research note.
He assessed software company valuations after the recent SaaS swoon in the market. Stocks looked more compelling, until he included SBC in the analysis.
“Adjusting for the large levels of stock-based compensation, the situation looks less rosy,” he warned.
So what can software companies do to address investor concerns about this? One solution is to cut jobs. That immediately reduces stock-based compensation costs, because companies don’t need to issue more new stock to those folks being let go (and future vesting ends for these people, too). This improves earnings, based on old-school GAAP measures — which is where investors like to go during times of stress in the tech industry.
This was a big driver of Atlassian’s job cuts this week, according to William Blair analysts.
“For Atlassian, it is important to moderate SBC lower as it has one of the highest levels of stock comp in the industry,” they wrote in a research note. “This has recently become a louder conversation as tech investors look for more profits from scaled businesses.”
This happened in 2022 as well, and Business Insider covered it a lot. Back then, the tech industry was coming down hard from a pandemic-era hiring binge. Growth was slowing and SBC looked completely unsustainable. Brutal financial discipline ensued and thousands of tech workers lost their jobs.
We’re in a similar moment now, according to that CEO who called me on the weekend. Before he got off the phone, he said financial discipline has to improve.
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