Stock-Based Compensations and Adjustments on EBITDA

Ramkumar Raja Chidambaram
6 min readSep 23, 2022


Stock-Based Compensations and Adjustments on EBITDA

Stock-Based Compensations and Adjustments on EBITDA

This week, Oyo drafted an addendum to its earlier red herring prospectus to SEBI, where the firm had arrived at an adjusted EBITDA of Rs.10.6 crores communicating to its investors that it has become profitable. So has OYO become a cash-generating entity? Instead, when we look at their income statement, OYO reported a loss of Rs.413 crores.

Mohandas Pai even claimed this exercise of adjusting EBITDA to show that the firm is making profits was fake accounting by saying, “There is nothing like an adjusted EBITDA”.

In this post, i provide my insights on how the disclosure process, especially the IPO, has lost its relevance, with accounting standards becoming subjective and not factual/accurate. I substantiate my case by taking Stock-based compensation as an example and how firms add these expenses to arrive at the adjusted EBITDA. I end this post by surmising that Accounting isn’t about facts but has become management’s subjective judgement, estimates and projections.

From Earnings to Adjusted EBITDA

To get from their reported losses to Adjusted EBITDA, Oyo made the following adjustments:

From a reported Rs. 413 crore loss, Oyo showed a positive EBITDA of 10 crores by adding non-cash and non-operating expenses. The most significant component is the add-back of stock-based payment expenses of Rs.259.5 crores. While the accountants have agreed to these adjustments, let us understand if this action makes any logic and if these adjustments convey additional value to investors.

  1. Accountants have treated employee option expense as a non-cash experience. This assumption is fallacious as Share-based compensation is not a non-cash expense like depreciation/amortization, which gets added to determine the cash flows. Even if i take the accountant’s logic and assume that these are non-cash expenses, we cannot add them back to EBITDA because it is an accounting earnings number and not a cash flow.
  2. Are stock-based compensation expenses extraordinary? When firms have extraordinary expenses, we can add them back because it does not reflect the actual operations of the business. So if i assume that Accountants add back expenses because they assume the expenses are extraordinary, then it is flawed logic. However, we know firms regularly issue shares to employees to align them with the shareholder’s interests. Thus, they are not extraordinary but recurring expenses.
  3. Accountants justify adding back stock compensation expenses by claiming they will add these issued shares to the share count to arrive at the diluted EPS. Unfortunately, this consistency argument is a sloppy way of dealing with stock-based compensation, and i will explain to them why this logic is sloppy in the later part of this post.

Why Companies Give ESOPs

Whenever firms cannot pay employees with cash but need to attract talent, they issue equity-based compensation. Thus, we see start-ups issuing ESOPs compared to matured firms. For leadership/C-level executives, firms grant ESOPs to limit executive compensation and align them to the shareholders’ interests so that their decisions increase shareholder value.

While firms grant options to attract talent, the accounting standards (GAAP/IFRS) mandate firms to value these options when granted to employees and expense them at the time. Thus, we saw Oyo include share-based expenses in its income statement. In addition, many firms, especially US companies, have moved from ESOPs to restricted stock units because option expenses reduce earnings. Thus, stock-based compensation is expenses similar to salaries that employees receive and should get deducted from earnings. Therefore, employers should recognize these expenses when they grant employees stock options.

Is ESOPs a non-cash expense?

Accountants think stock options are non-cash expenses and treat them like depreciation and amortization. In my view, stock options are not non-cash expenses but must get treated as employee salaries.

To give an analogy, i own a business that generates 100 million in revenues and 10 million in earnings. I hire a manager for a salary of 1 million. However, i pay the manager with my equity rather than cash. Thus, the manager receives 1% of my firm’s revenues as equity compensation. If i treat the manager’s compensation as a non-cash expense, i effectively tell my investors that the manager is working for free. Thus my earnings have no impact and continue to generate 10 million.

Is this argument rational? Are they free lunches in the corporate world?

The moment i grant 1% of my revenues as equity makes my share in equity lesser because i give a part of it to the manager. So, to extrapolate, firms granting ESOPs reduce the value of equity holders because of share dilution, and more the firms granting ESOP, the shareholder value of equity investors reduces because they have to share the profits with the employees.

We can also think of ESOPs as a barter system to evade the cash flow effects.For instance, i issue shares to the public and use the amount from share issuances to pay compensation to employees. Here, i treat the salaries as expenses because i pay employees in cash. Alternatively, suppose i issue ESOPs to employees as compensation. What i am doing is that i am not going to capital markets to issue shares and raise capital but paying the equivalent compensation as ESOPs instead of cash.

So, firms must treat these ESOPs as expenses and cannot refrain from that by arguing that because employees receive ESOPs, we treat that as a non-cash expenses and will add them back to determine the adjusted earnings. By doing that, the firm effectively communicates to investors that ESOPs are free lunches. As a result, firms can grant ESOPs generously and add them back to arrive at adjusted earnings numbers that do not accurately represent the firm’s intrinsic value. Further, by adding ESOPs to the share count, accountants effectively dilute the equity holder’s stake in the firm, thereby reducing their value.

Thus firms cannot treat ESOPs as non-cash expenses similar to depreciation and amortization but treat them as employee salaries. So, they cannot add back ESOPs to arrive at adjusted earnings.

How To Treat ESOPs In Valuation Exercise

For analysts looking to value OYO or any business that grants ESOPs, how do they incorporate the effect of ESOPs in DCF valuation?

I treat ESOPs in two parts.

  1. Firms have issued ESOPs but do not intend to issue them in the future. In this scenario, if the options are alive, there is an additional claim on equity value, and the analyst must deduct the value of ESOPs from the equity value to arrive at the value of the common stock. Thus, i do not increase the share count, and I deduct the options’ value from the equity value. On the other hand, in the case of restricted stock units, because employees are not allowed to trade them for a definite period in the exchange, i add the RSU to the existing share count and then divide them by equity value to arrive at the value per share.
  2. For companies that intend to issue ESOPs in the future, the projected earnings and cash flows are lower than those of the firm that has not issued ESOPs. As a result, these lower cash flows reduce the firm’s intrinsic value.

Thus, when i value OYO, i do not add back stock option expenses and forecast cash flows accordingly. Thus, the value of OYO’s operating assets must incorporate lower cash flows due to ESOPs. For the ESOPs already in place, i value them using the Black Scholes model from their exercise price, the expiry period of the option and then subtract this value from the equity value to arrive at the value per share.

My Final Thoughts

Accountants manipulate earnings by adding back stock option expenses and treating them as non-cash expenses. In finance, there are no free lunches. So if a company decides to pay 1 million to an employee, that will affect the equity value, whether the payment is cash or equity. Companies pay an employee equity or cash based on its cash flows, potential to attract talent, and align management’s incentives with shareholder value. However, these decisions should not reflect on adjustments that companies make to earnings to arrive at a value per share.



Ramkumar Raja Chidambaram

Experienced M&A, Corporate Development Professional with extensive VC/PE experience