Understanding ESOPs (2): How Ocado magically palmed 63.6 mio GBP of Expenses


In one of our former blog posts we had a look at the accounting functioning of equity-settled stock option programs (HERE). Today we want to extend this framework for cash-settled programs – or more concretely: for programs that start out as equity-settled and become cash-settled on the way. It gets a bit more complex, though – but not less interesting.

Starting point is IFRS 2 Share Based Payments: This standard explains that for accounting purposes there is a big difference between equity-settled programs and cash-settled programs. While equity-settled programs, i.e. programs where the beneficiary receives shares of the company as a compensation, are fair-value-measured only once at the grant date – and then not remeasured – cash-settled programs are constantly remeasured until settlement. And there are good reasons for doing this.

Concretely, both equity-settled instruments (IFRS 2.14) as well as cash-settled instruments (IFRS 2.32-33) are initially measured at fair value at grant date. At this date there is no major difference between these two styles of settlement. But now, equity-settled programs leave the entity-sphere directly after granting. The entity owes a certain number of shares depending on certain conditions and perhaps for a certain fixed compensation (the strike). But this liability will not change anymore for equity-settled programs: it still stays the same number of shares – assuming a plain vanilla program. All economic changes to this promise – i.e. share price movements – take place outside of the entity’s sphere (at the capital market where the shares are traded). It might be that the company is covered (already owns the expected number of shares to give) or plans to go for a capital raising in the future or plans to buy-back shares from the market later. But the concrete way does not matter here, these are all transactions with the capital market, and hence they do not play a role in the entity-focused IFRS understanding.

Cash-settled instruments, in contrast, are not left at their grant date value until settlement. In the case of cash-settlement the entity has a cash-liability to pay – and the amount of payment might change over time, depending on the value of the underlying shares. This is a big difference to equity-settled instruments: While in the equity-settled case the company owes a fixed number of shares (plain vanilla case) that does not change over time, in the cash-settled case the company owes a variable amount of money, an amount that will change over time depending on stock price changes until settlement. And as – again – IFRS is an entity accounting system, the liability in the cash-settled case has to be remeasured constantly depending on market dynamics (IFRS 2.30). The following graph highlights the different treatment of equity- and cash-settled schemes according to IFRS 2.

Now one might ask: ‘Where is the difference in economic terms? Existing shareholders will end up with the same consequences in both cases – tax issues aside. Either the entity has to deliver the shares at a certain value at settlement or the cash-equivalent of this. This should not matter.’

And this is even correct! As seen from the shareholders’ position the consequences are the same. But – again and again – IFRS is not a shareholder perspective accounting system, it is an entity-focussed accounting system. And on the entity level things are quite different.

This is an important point to consider when e.g. valuing ownership positions in a company (e.g. when determining the fair value of shares): For equity-settled instruments it might be necessary to do certain adjustments to the accounting set of information simply because we cannot fully rely on an entity-based accounting system if we want to determine shareholder positions. And this is not due to a bias in reporting, it is just because we now take a different perspective than the reporting system does.

But let’s stick to IFRS accounting here. In terms of P&L impact over the full time-span between grant and settlement the equity-settled instrument obviously carries a higher total expense if the value of shares decreases over time, and it carries a lower total expense if the shares increase over time (this is admittedly a simplified view as time value effects of option pricing usually leads to slightly different break-even points). Of course, you never know before in which direction share prices develop. But for a company in a growth stage with a sound business model it at least seems to be the ex-ante smarter way to focus on equity-settled instruments – if management has the P&L expense in mind.

This brings us back to Ocado Group Plc. The company is a UK-based online grocer without any own stores. Founded in 2000 by three former investment bankers, it IPOd in July 2010. While already running several management incentive schemes, the company set up an additional incentive program in May 2014, the five-year (expiration on 8 May 2019) so called Growth Incentive Plan (GIP). This plan consisted of options with a zero strike and was subject to a single performance condition, the share price growth of Ocado relative to the growth of the FTSE 100 Share Index over that same period.