Xero Limited 2019 Annual Report From beautifully designed accounting software Wellington, NZ | John Scully, Product Manager (Mobile), with Anna Curzon, Chief Product Officer, Matt Barnett, General Manager Product and Para Muraleedharan, Product Manager Transactional Tax to beautiful accounting partnerships. London, UK | Gary Turner, Xero Managing Director, UK & EMEA, with accounting partners Stuart Airy, Sylwia Kotarba, and Riaz Kala from Accounts + Legal Singapore | Lim Wen Ling, The Mindful Company Co-founder, with Kevin Fitzgerald, Xero Regional Director, Asia, and Tessa Khoo, Marketing Director, Asia From growing our global presence San Francisco, US | Claire Hughes Johnson, Chief Operating Officer at Stripe, with Keri Gohman, Chief Platform Business Officer; Ryan Betka, Senior Vice President (USA) at Figured; Gabriella Horowitz, Marketing Leader at Expensify; Igor Khayet, Head of Business Development and Strategic Partnerships at Gusto to growing our platform connections. Highlights Subscribers 1,818,000 Total subscriber lifetime value $4.4 billion Annualised monthly recurring revenue $638,179,000 Operating revenue $552,819,000 Free cash flow Up 432,000 YOY Up 36%YOY Up 32%YOY Up 36%YOY Up $34,964,000 YOY $6,451,000 Gross margin percentage Up 2PP YOY 84% Melbourne, AU | The Xero crew in Australia get together for the year ahead at the annual kick-off meeting Chair’s review Pages 1–2 CEO’s review Pages 3–6 Bringing beautiful business to the world Pages 7–9 Harnessing the power of the Xero platform Pages 10–12 Xero’s social & environmental impact Pages 13–16 The Board of Directors Pages 17–18 Management commentary Pages 19–34 Auditor’s report Pages 36–39 Corporate governance statement Pages 77–89 Disclosures Pages 90–99 Financial statements Pages 40–43 Notes to the financial statements Pages 44–76 Contents 1 — Chair's review Chair's review — 2 Dear shareholder I am pleased to update you on another successful year for Xero. In the year ended 31 March 2019, Xero delivered against its financial and strategic objectives, and continued to expand our community of small business customers and partners around the world. Graham Smith Chair Notably, for the first time, this financial year, while delivering on revenue growth, the business achieved positive free cash flow excluding funds used for acquisitions. More broadly, we have improved our financial performance and operating metrics, while prioritising investment in growth. This year Xero made strong progress on building a beautiful, world-class platform for our customers and the communities we serve. We are focused on growing our global subscriber base, and our investment priorities will reflect this. Combined with our ongoing product and technology investments, Xero is well positioned to succeed both in times of global macroeconomic strength and potential volatility. The Board is pleased that the benefits we anticipated from consolidating Xero’s listing on the Australian Securities Exchange (ASX) have been realised. Liquidity in Xero’s stock has more than doubled since announcing the move to a sole ASX listing in November 2017. Combined with Xero’s inclusion in a range of equity market indices (including the S&P/ASX 100), the increase in liquidity has been accompanied by significantly higher investor and analyst interest, and a range of new investors have accumulated positions on our share register. Convertible notes issue builds financial flexibility Investor confidence in Xero was demonstrated by our successful US$300 million convertible notes issue, completed in October 2018. In parallel with the convertible notes issue, Xero entered a call spread arrangement that reduces the potential dilution to shareholders that could occur upon conversion. This structure has been used in other geographies, particularly the US, but was the first of its kind for an Australian or New Zealand company not listed in the US. The Xero Board | Bill Veghte, Graham Smith, Dale Murray, Lee Hatton, Rod Drury, Susan Peterson, Craig Winkler The funds raised will provide greater flexibility should we choose to execute acquisitions or investments with the aim of enhancing and extending Xero’s small business platform and ecosystem. We have a deeply experienced, highly qualified, international board of directors, and I’d like to thank and acknowledge the valuable contribution of my fellow directors during the year. We have implemented a capital allocation framework supporting the review and pursuit of future organic and inorganic investment opportunities. This is aligned with our strategic priorities, while satisfying our strong focus on financial discipline. Leadership at Xero Just over a year ago, we welcomed Steve Vamos as Xero’s new Chief Executive Officer, filling the shoes of founder Rod Drury, who moved to a non-executive director role on Xero’s Board. The Board is delighted with the progress in Steve’s first year and how well the leadership team is delivering on our strategy to achieve positive results. On behalf of the Board, I would like to thank the entire team of dedicated and talented people at Xero for their commitment and contributions to our business. To our valued partners and customers, and to Xero investors, thank you for the trust and confidence you place in us every day. Graham Smith Chair Chair’s review 3 — CEO's review CEO's review — 4 CEO’s review In the 2019 financial year: $2.8 trillion* Transactions through Xero $658.6 billion Invoices raised on Xero Dear shareholder It has been just over a year since I became Xero’s CEO and each day the extraordinary opportunities for our business are clear to see. Steve Vamos Chief Executive Officer I’d like to thank Xero’s founder Rod Drury for enabling a smooth and effective CEO transition and my induction into the business, and for his continued contribution to strategy and innovation. Thanks also to our Chair Graham Smith and our Board, Xero’s leadership team, our people, and our partners, customers and shareholders I’ve met around the world, for your support and for making me feel so welcome. Communities with purpose At the heart of Xero are deeply engaged, passionate and diverse global communities of people connected to Xero and to each other. These include small business owners and their customers, employees, accountants, bookkeepers, business advisors, banks and suppliers. * Incoming and outgoing transactions, 12-month period Together, we make planning, managing and running small businesses more seamless, simpler and smarter. Our purpose is to help make life better for people in small business, their advisors and communities around the world. The strength of our business is represented as much by the people in our extended communities as it is by the beautiful products we provide. Today, Xero is much more than a cloud accounting platform. Our customers are increasingly turning to Xero to help them run their businesses, not just manage their finances. The Xero platform connects customers with financial services, data insights, and more than 700 third-party apps. To illustrate the scale of activity the platform facilitates in our communities, in the 2019 financial year, $2.8 trillion* in transactions flowed through Xero and $658.6 billion in invoices were raised on the Xero platform. The platform also provides businesses with more than 200 connections to banks and financial service providers around the world. Financial and operating performance During the 2019 financial year (FY19) Xero delivered revenue growth of 36 percent while maintaining strong operational discipline. Notably, we achieved a significant milestone with our first positive free cash flow result in FY19. Particularly encouraging is our ongoing growth in subscribers across both established and emerging markets and our progress in entering, growing and scaling in new geographies. In FY19, we added 432,000 subscribers globally. Compare this to Xero’s total subscriber number of 475,000 just four years ago. Key financial highlights for the year were: – Operating revenue increased by 36 percent to $552.8 million For the first time, this year Xero’s International market subscriber additions of 239,000 collectively exceeded our home ANZ markets additions of 193,000. – Subscribers increased by 31 percent to 1.82 million – Free cash flow was positive for the first time at $6.5 million, an improvement of $35.0 million – The total lifetime value (LTV) of Xero subscribers was $4.4 billion, up 36 percent from the previous year – EBITDA, excluding impairments, increased by 84 percent to $91.8 million – Annualised monthly recurring revenue (AMRR) increased by 32 percent to $638.2 million A highlight of the year was Xero’s growth in the UK, where we achieved record subscriber additions for one country in a 12-month period. The UK business added 151,000 subscribers (up 48 percent) with revenues increasing by 50 percent (45 percent in constant currency). We remain well positioned to support small businesses and their advisors in the transition to HM Revenue & Customs' (HMRC) Making Tax Digital (MTD) policy initiative. At the same time as delivering these results, during the year we maintained a strong focus on the strategic initiatives and people and technology capabilities that are key to maximising our long-term opportunities. Detailed analysis of our 2019 financial performance can be found in the management commentary on pages 19–34. 5 — CEO's review CEO's review — 6 Acquisitions While Xero delivered strong organic growth this financial year, we also enhanced our platform strategically through two targeted acquisitions. The acquisition of Hubdoc in August 2018 expands the Xero platform by providing a leading data-capture solution to help accountants, bookkeepers, and small businesses streamline administrative tasks. In December 2018 we acquired Instafile, a tax filing and accounts production solution that extends Xero’s existing connectivity to the UK’s HMRC and Companies House. This acquisition highlights our intent to continue to invest for growth in the UK and to provide the most compelling product experience to both small businesses and accounting professionals. Culture and human connections Xero’s culture is best illustrated by one of our five values, #human. This value represents our core belief that our business is all about connecting people with people, and caring about each other and those who we connect with. Technology is at the core of our business, but the human connections and collaboration we support are what underpin our culture. The ability of our people to form trusted relationships with small businesses, partners and advisors is a source of genuine competitive advantage. It is important to me that we provide our people with an environment where they feel safe to be themselves, are able to openly and honestly question and challenge each other and the way we do things, and are encouraged to think in new ways. Looking ahead We are in an exciting stage of Xero’s journey. We have the people, partnerships and platform to innovate and grow our business. We remain focused on the significant opportunities ahead for Xero while continuously improving what we do and how we do it. We will continue to prioritise investment in growing our subscriber base, improving our capability to deliver more services to our customers and partners, and expanding our presence in new markets such as Asia, Canada, and South Africa. We will remain focused on our highly valued relationships with our accounting and bookkeeping partners as the foundation of our go-to-market and customer engagement strategy. These advisors are helping to improve the productivity of, and provide insights to, small businesses in ways that were simply not possible before the onset of cloud computing. We will fuel strong organic growth while also pursuing strategic acquisitions and partnerships, which will benefit shareholders, small businesses, accounting and bookkeeping partners, and our ecosystem. I’m very proud of our team of Xero people around the world for the results they have delivered this year. Thanks to all of you! Steve Vamos Chief Executive Officer Melbourne, AU | Matt Jolley, Head of Customer Experience, AU, with Erin Jetter, People Experience Business Partner, Rachael Powell, Chief Customer, People and Marketing Officer, and Rob Goodwin, Commercial Director 7 — Bringing beautiful business to the world Bringing beautiful business to the world — 8 Bringing beautiful business to the world Xero made strong progress in FY19 towards our strategic priority of driving the adoption of cloud accounting. London, UK | Trent Innes, Managing Director, Australia and Asia, with Craig Hudson, Managing Director, New Zealand and Pacific Islands, and Gary Turner, Managing Director, UK and EMEA During the year, Xero’s total subscriber base grew by 432,000 (or 31 percent) to 1.82 million subscribers. It is encouraging to see this continued growth, but the opportunity for Xero from here remains immense. To provide some context around this opportunity, we estimate that less than 20 percent of small businesses currently use cloud accounting technologies, across the English-speaking countries in which we operate. In Xero’s home markets of New Zealand and Australia (ANZ), our small business customers and partners are leading the world in the adoption of cloud accounting technologies. We estimate that over 50 percent of small businesses in the region use cloud accounting, which is more than double the uptake within other markets such as North America and the UK. We work closely with our partners, advisors and government taxation authorities to help small businesses move to a digital environment and realise the benefits of adopting cloud technologies. Ultimately, the ability to access high-integrity information in real time, like cash flows, tax payments and payroll, benefits the economies in which we operate. Xero is balancing global focus with local market needs This is the first year Xero’s International markets have collectively added more subscribers than in our foundation markets of New Zealand and Australia. We anticipate this trend will continue, underscoring the increasing international composition of our business and its performance. UK A highlight for FY19 was the standout performance in the UK. Xero UK finished the year with 463,000 subscribers, adding 151,000 in the 12 months, a new record for any one country, and UK revenue was up by 50 percent. Xero is well positioned to continue to benefit from the opportunity provided by HMRC's MTD policy initiative and looking to FY20, we see MTD as a continuing growth catalyst for our UK business. ANZ During the second half of FY19, we announced total subscribers in ANZ had reached one million. We ended the year with 1.08 million subscribers, further cementing Xero as the region leader in cloud accounting. Xero’s revenue also increased strongly in the region by 30 percent from the previous year. Subscriber growth remained the primary driver for this increase in revenue. In New Zealand, where many small businesses already use cloud technologies, we’re increasing our presence in the market through the increased use of Xero product add-ons with associated incremental revenue from payroll, expenses, projects and other adjacent products (such as Hubdoc). An increase in prices, combined with a higher feature product mix, contributed to a 5 percent increase in ARPU in our foundation market. North America In North America, subscriber numbers reached 195,000 in the financial year and finished the period up 48 percent. Our US accountant and bookkeeper partner-led strategy continues to deliver positive results. Likewise, Canada is emerging as a key growth opportunity for Xero with an encouraging initial uptake in subscribers, further boosted by our acquisition of Hubdoc. Payday filing became mandatory in New Zealand from 1 April 2019, meaning most businesses are required to file payroll information with the Inland Revenue within two days of processing. Payday filing is easy with Xero. After a one-off connection is established with Inland Revenue, payday filing happens automatically each time a pay run is completed in Xero Payroll. Rest of World Xero’s Rest of World markets include South Africa, Singapore, Hong Kong, and others. Here, subscriber numbers increased by 43 percent to 83,000, with revenue up 55 percent as Xero continues to build brand recognition and distribution channels in these markets. The digitisation of small business accounting is also accelerating in Australia with the introduction by the Australian Taxation Office (ATO) of Single Touch Payroll, which will be mandatory for all Australian businesses from 1 July 2019. This legislation requires businesses of all sizes to file each pay run electronically with the ATO. This provides Xero with a substantial opportunity to support the changing small business compliance needs in the Australian market. 9 — Bringing beautiful business to the world Harnessing the power of the Xero platform — 10 Brisbane, AU | Xerocon Brisbane 2018 From New Zealand to the world Founded more than a decade ago in an apartment in Wellington, New Zealand, Xero was created as a cloud accounting platform designed to revolutionise how small businesses, accountants, and bookkeepers work together. As the needs of small business and their advisors have changed, Xero has expanded the breadth of our offerings to meet these needs building out to a business platform. Xero’s brand tagline changed during the year to reflect our strategic position as a business platform, moving from ‘beautiful accounting software’ to ‘beautiful business’. Combining the two words ‘beautiful’ and ‘business’ underscores the ongoing evolution of the business and highlights what our customers love about Xero – automated and easy, intelligent and connected, secure and reliable, creating a delightful and personalised user experience. Xero delivered a major customer support milestone with the launch in May 2018 of Xero Central – our customer support and community portal where customers engage with Xero and each other. Xero is delivering on its promise as a small business platform. The launch of Xero’s full-featured API for bank feeds in September 2018 is an example of this. The API enables banks, fintechs and other financial institutions of all sizes to connect with Xero, providing small business customers with a clearer view and faster access to their financial data. We have integrations with a range of financial institutions, including leading UK fintechs such as Tide, Starling, and TransferWise, as well as major global banks, including OCBC in Hong Kong and Singapore. We believe that the Xero brand comes to life with our communities at our signature Xerocon events. The events bring thousands of partners together to connect and learn. Now held in three geographies annually, in FY20 Xerocon will be held in San Diego, Brisbane and London. Xerocon has become part of Xero’s cultural fabric and illustrates the growing scale of the Xero communities. It is about building personal relationships, providing updates on new product developments and contemporary business practices, and working together to support small businesses. Xero’s purpose and people, the human element Xero’s continued expansion and future success depends on building and maintaining trust with our key customers, partners, and other stakeholders worldwide. At Xero our purpose is to 'make life better for people in small business, their advisors and communities around the world'. This purpose is at the heart of how we build our products and improve our platform, shape our values, build our workforce and keep our team of Xero people engaged. Over the past decade, our purpose and our people have become intrinsically linked. We believe if we build trust through a clear purpose and direction, and support and equip our people to do the best job of their lives, it has a positive ripple effect on customer loyalty and the long-term strength of our business. We hire people who are purpose-driven, customer- centric and passionate about small business and our industry. Our people also have a deep understanding of the accounting and needs of our customer base, particularly small business. As our business grows, our purpose and people will continue to be consciously connected to serve our growing communities of small businesses and their advisors. Harnessing the power of the Xero platform The Xero platform provides our 1.8 million subscribers with over 200 connections to banks and financial service providers, and more than 700 apps. Xero was founded as a cloud-based accounting offering with a revolutionary idea – a secure, real-time system of record on which small business could be conducted anywhere in the world. The power of our business platform is more than Xero as a company; it sustains a thriving ecosystem for others who build on the platform and contribute to driving success for our customers. Each day, people and small businesses rely on Xero’s ecosystem for seamless, real-time solutions and data, as well as connections to other people, to understand and run their businesses more effectively and efficiently. Xero’s platform delivers a human experience that harnesses the power and efficiencies of automation and machine learning technology. Today, the Xero platform truly embodies this idea, by extending well beyond financial record keeping, to providing a full spectrum of tools and services that can help small businesses succeed. The key pillars of the Xero platform are: – Security, privacy and scalability – Our vital network of partners within the accounting and bookkeeping industry – Connections with a wide range of financial institutions along with new global fintech companies and our vibrant community of connected apps in our ecosystem Scale of the platform this year – Over 200 connections with banks and financial service providers globally – $2.8 trillion in transactions flowed through Xero – $658.6 billion in invoices raised through the Xero platform – More than 50,000 users of Xero's API developer tools 11 — Harnessing the power of the Xero platform Harnessing the power of the Xero platform — 12 The Xero Platform Connected apps/ ecosystem 700+ linked apps >50,000 users of Xero's API developer tools Xero solutions Gusto (US Payroll) Xero products Bank Feeds Payroll Expenses Projects Hubdoc WorkflowMax le Led g g n i S r e ( System o f R e c o r d ) For small business Small businesses can manage their day-to-day finances with software that's smart and easy-to- use, having real-time access to their data and files For partners Accounting and bookkeeping partners can connect to their clients' data and work efficiently, bringing various work streams of their practice on to one platform in the cloud Connected apps/ ecosystem Partner specific tools and apps Xero partner products Compliance Workpapers Tax solutions HQ apps and explorer Practice Manager Reporting Partnerships at the heart of the Xero platform Xero’s platform continues to grow through our valuable partnerships with accountants and bookkeepers. We believe these special relationships and connections are what makes Xero unique. Having access to this information has transformed the way small businesses, accountants and bookkeepers work, enabling them to spend less time on manual data-entry tasks and access real-time information required to make critical business decisions. The platform allows accountants and bookkeepers to collaborate with their small business clients on one single, real-time general ledger. It also enables access to accounting tools, apps, financial institutions and a range of valuable and relevant data, in one place, available any time, on any device. Automation on the Xero platform is enabling additional efficiencies. For example, through the acquisition of Hubdoc, we can now auto-fetch financial documents from hundreds of utilities, telecom providers, and online vendors, freeing time for partners and small businesses and increasing the accuracy of their records. For accountants and bookkeepers, this means they can run their practices more efficiently and drive business growth. Xero is a global platform that seamlessly connects businesses, saves time, and enables success. Lune Croissanterie Melbourne, AU A marketplace and network for small business and financial solutions Xero has expanded out from its core accounting products to being a marketplace of ecosystem partners, comprising more than 700 third-party apps and more tightly integrated solutions and services. Xero’s open developer API allows data to flow seamlessly - with partners' and customers' consent - from Xero to third-party apps, enabling businesses of all sizes to build a toolkit that best suits them. To facilitate this integrated ecosystem, we work with more than 50,000 users of Xero's API developer tools who innovate and build according to small businesses’ needs. We have also established industry-leading partnerships with global financial institutions and fintechs to connect businesses with the financial information and services they need to run their businesses. Having a real-time view of cash flow, access to working capital when needed, and tools to get paid faster makes it easier for small businesses to operate. Customers using our payment gateways get paid substantially faster than other customers. Secure, scalable and efficient technology Xero’s platform is underpinned by robust and scalable infrastructure. Our technology has the capability to store petabytes of data, process millions of customer requests, and convert trillions of pieces of data into business insights to deliver a seamless, intuitive customer experience. Migration to the Amazon Web Services (AWS) platform in 2017 laid the foundations for Xero to deliver fast-paced innovation, leverage machine- learning technology, improve margins, and drive better business outcomes to help small businesses flourish. Since this migration, Xero has delivered more than 1.5 billion machine-learning recommendations, making it easier to quickly code and reconcile transactions. Data security and data protection are significant priorities. We are committed to protecting our customers' information, educating users about online-security best practice, and ensuring user- focussed guardrails are in place to safeguard data that flows through our platform. All data on Xero is encrypted and stored in several locations online so it’s safe, secure and available when our customers need it. Xero achieved a data security milestone in December 2018 when we gained ISO 27001 certification, the international standard for implementing, maintaining and continually improving information security management systems. We are continuously working to improve our data security, from two-step authentication on user accounts to data encryption and regular security audits. We believe that data is the currency of the modern economy. Our global platform leverages the collective power of millions of small businesses, accountants, bookkeepers, business advisors, and the many business activity data points and financial transactions they create. The next generation of innovative products and services we deliver will come from unlocking insights from this valuable data from our platform, and building new solutions to drive small business success. 13 — Xero’s social & environmental impact Xero’s social & environmental impact — 14 Xero’s social & environmental impact Xero is a young, fast-growing company, and we’re proud of what we’ve achieved so far. We are early in our journey to formalise our approach to corporate citizenship and believe we have the foundations to make positive contributions to the environment and sustainability. The role we play in society at large is also important and we intend to align our present and future efforts on social and environmental impact to our purpose. This is to ‘make life better for people in small business, their advisors and communities around the world’. We have appointed a Social and Environmental Impact Advisor who will steward our programmes to focus and report in the following areas: – Building on established efforts to deliver further environmental and sustainability initiatives that reflect Xero’s purpose, values and strategic direction – In alignment with our purpose, building out programmes that will engage and contribute to thriving communities around the world – Championing diversity and inclusion to cultivate our engaged global workforce The following are some of the initiatives we have undertaken so far. Environment and sustainability We are building on our environmental initiatives within Xero’s global office locations. We have taken steps to improve our waste, recycling and energy use to reduce our impact on the environment. A specific activity this year includes phasing out bottled water. In Auckland, New Zealand, the building we selected for our new office has been built to a 5* Green Star rating. In the US, our new Americas headquarters in Denver has a LEED Platinum rating and includes solar panels to supplement the building’s energy consumption. End-of-trip facilities are also in place in both of these buildings to better support alternative modes of transport, and charging points for electric vehicles are available. This year, as part of our efforts to source sustainably, we made the switch to ethically sourced organic cotton t-shirts for our staff t-shirts. As a branded garment, they have become a point of pride and belonging for our Xero team. As a tech company, Xero has relatively low power consumption. Outside of our electricity usage in our global offices, a significant portion of energy consumption is through the data centres of AWS, our cloud services platform partner. It’s pleasing that AWS has a long-term commitment to 100 percent renewable energy use for its global infrastructure and in 2018, AWS exceeded 50 percent of its energy from renewables. We're working with AWS to determine how we can optimise infrastructure utilisation. Auckland, NZ | The Xero office Wellington, NZ | Xero employees Community initiatives We are committed to building thriving communities and deepening our partnerships with for-purpose organisations, including non-profits. Examples include: – Xero supports non-profits in communities through our global employee volunteer programme, Community Connect. The programme gives every Xero employee a paid day of leave each year to make a difference to non-profits in the communities in which they live and work. Xero employees have so far contributed more than 2,800 hours as part of the programme – Xero offers a lifetime discounted subscription for non-profit organisations globally on their Xero plan. We also have a sponsorship programme in each major region, providing funding to selected eligible organisations, events and charities – Xero champions mental health initiatives globally, including launching a pilot in March 2019 with 5,000 current Xero customers in New Zealand as part of the Xero Assistance Programme. The programme provides small businesses free access to the corporate quality Employee Assistance Programme support for them, their employees and their families – As part of our efforts to stimulate startup tech business growth, innovation and employment in New Zealand, we recently opened a new tech-focused community co-working space, ‘Rewired’ in Xero’s new Auckland office. The aim is to foster innovation and collaboration in a community environment 15 — Xero’s social & environmental impact Xero’s social & environmental impact — 16 Hunt & Gather Bee Co. Waikato, NZ Diversity & inclusion We believe that valuing diverse ideas leads to innovation, as well as inclusion. A diverse workforce reflects our global small business customer and partner communities and allows us to be relevant and well connected to both. Championing a diverse workforce helps us to attract and retain talent. We acknowledge that we all come to the table with different strengths and challenges, and at Xero we aspire to nurture these. Our efforts help us engage our communities with a greater purpose, and achieve employee satisfaction and increased productivity, which we believe enhances our overall performance. Looking inside Xero, we’ve promoted initiatives that have strengthened our own gender diversity. At 31 March 2019: – The Xero Board was 43 percent female – Xero’s leadership team was 50 percent female – 42 percent of Xero employees were female After appointing a Head of Diversity, Inclusion and Community in 2017, Xero has made great strides in this area, underpinned by our Diversity and Inclusion Policy and the objectives we use to measure our progress. As part of the International Women’s Day campaign in 2019, we celebrated what we’ve achieved so far. We also acknowledged what still needs to be done, to achieve gender balance both at work and more broadly in the communities in which we operate. Xero has joined a number of global organisations supporting and promoting LGBTI inclusion. These include Pride in Diversity in Australia and Stonewall in the UK. Xero has also achieved the Rainbow Tick certification in New Zealand in recognition of our inclusive workplace. There is more information about diversity and inclusion at Xero in the Corporate Governance Statement on page 79 to 81 of this Annual Report. For further information on Xero’s social and environmental impact initiatives, please visit xero.com/socialimpact. 17 — The Board of Directors The Board of Directors — 18 The Board of Directors Graham Smith CHAIR OF THE BOARD Independent Director since February 2015 and Chair since January 2017 Graham has more than 25 years of finance experience in the software and SaaS industry. He was Chief Financial Officer at Salesforce from 2008 to 2014. He has held executive positions at Advent Software, Vitria Technology, Nuance Communications, and Oracle. Graham is chair of Splunk, and serves on the boards of directors at Slack and BlackLine. He recently served on the Citrix and MINDBODY boards. Graham also gets involved in his local community, as evidenced by his Board membership of the Sonoma Valley Education Foundation. Nominations Committee (Chair) Audit and Risk Management Committee Rod Drury XERO FOUNDER / NON-EXECUTIVE DIRECTOR Director since July 2006 For more than a decade, Rod led Xero from humble beginnings with four employees working in a Wellington apartment to a global software business and S&P/ASX 100 company. Rod remains Xero’s largest shareholder. Rod started his career at Ernst & Young and went on to establish and lead a number of innovative technology businesses. Rod was an independent director on the NZX Board and the Trade Me Board. At the Deloitte Top 200 Awards in 2017, Rod was named Visionary Leader of the Year. He was named Ernst & Young New Zealand Entrepreneur of the Year in 2013, and is a member of the New Zealand Hi-Tech Hall of Fame. Lee Hatton NON-EXECUTIVE DIRECTOR Independent Director since April 2014 Lee has extensive commercial experience across New Zealand, Australia, the UK, and the US. After moving to Australia in 2012 to lead NAB’s Group Regulatory function, in 2015 Lee became the Chief Executive Officer of UBank where she is accountable for the business’s strategy and performance. Lee believes creating a growth culture, centred on customers, is the true disruptor of companies, and she has led large distribution teams throughout her career leveraging this philosophy. Recognised for her collaboration abilities and experience blending technology innovation and financial services, Lee is also an executive director of NAB Ventures and a non-executive director of BLD Group Pty Ltd. Lee is involved in the community and enjoys mentoring individuals, especially in relation to the future of work. Audit and Risk Management Committee (Chair) Susan Peterson NON-EXECUTIVE DIRECTOR Independent Director since February 2017 Susan is an experienced independent director on both ASX and NZX listed companies. She is currently an independent director of Trustpower, Vista Group, Property for Industry, and ASB Bank. Susan is a member of the New Zealand Markets Disciplinary Tribunal, was a past Ministerial Appointee to The National Advisory Council for the Employment of Women, and is a Board member of non-profit Global Women (NZ). Susan is founding co-chair and a shareholder in fast-growing health and wellness start-up company Organic Initiative Limited. People and Remuneration Committee Dale Murray, CBE NON-EXECUTIVE DIRECTOR Craig Winkler NON-EXECUTIVE DIRECTOR Independent Director since April 2018 Director since May 2009 Craig co-founded Australian small business accounting software provider MYOB in 1991. Craig built MYOB to be a popular business tool and brand which, in 2004, merged with Solution 6 to become Australia’s largest IT company. Craig joined the Xero Board in 2009. He now spends the majority of his time working in the philanthropic sector. People and Remuneration Committee Nominations Committee Dale is a technology entrepreneur and growth-company advisor. Dale co-founded mobile pioneer Omega Logic in 1999, which co-launched prepay top-ups in the UK. She led the growth of top-up transactions to £450m within five years, generating net revenue of £25 million. After selling the company in a trade sale, she turned to investing and advising start-ups and won the British Angel Investor of the Year award in 2011. Dale is currently a Europe Beachheads advisor for NZTE, a non-executive director at The Cranemere Group Ltd, and a board advisor to Seedrs. She was formerly a non- executive director and Trustee for the Peter Jones Foundation and a non-executive director at Sussex Place Ventures and the Department for Business, Innovation & Skills. She served on the Business Taskforce on EU Redtape for the British Prime Minister in 2013. Audit and Risk Management Committee Bill Veghte NON-EXECUTIVE DIRECTOR Independent Director since February 2014 Bill has spent 25 years in the IT industry building teams, businesses and technology. He spent 20 years at Microsoft where he served in a variety of engineering and leadership capacities, including running the Windows business and managing Microsoft’s North American business. He was the Chief Operating Officer of HP and served as Executive Vice President and General Manager of HP’s US$27 billion Enterprise Group. He was the CEO and director at SurveyMonkey. Bill is currently the Executive Chairman of Turbonomic, a market leader of IT workload automation. People and Remuneration Committee (Chair) Nominations Committee 19 — Management commentary Management commentary — 20 Management commentary You should read the following commentary with the consolidated financial statements and the related notes in this report. Some parts of this commentary include information regarding the plans and strategy for the business, and include forward-looking statements that involve risks and uncertainties. Actual results and the timing of certain events may differ materially from future results expressed or implied by the forward-looking statements contained in the following commentary. All amounts are presented in New Zealand dollars (NZD) except where indicated. References to FY19 are to the year ended 31 March 2019. References to the comparative period or FY18 are to the year ended 31 March 2018. Non-GAAP measures have been included, as we believe they provide useful information for readers to assist in understanding Xero’s financial performance. Non-GAAP financial measures should not be viewed in isolation nor considered as substitutes for measures reported in accordance with NZ IFRS. Effective from 1 April 2018, Xero has adopted NZ IFRS 9: Financial Instruments, NZ IFRS 15: Revenue from Contracts with Customers and NZ IFRS: 16 Leases. Prior year comparatives including key SaaS metrics have been restated to reflect these new standards. See note 2 to the financial statements for more information on the impact of these standards on the financial performance and position of the Group. Sukhjinder Pannu, Accounts + Legal, with Rishi Ruparelia, Xero Partner Success Manager, and Megan Hall, Accounts + Legal, London 21 — Management commentary Business results Year ended 31 March Subscription revenue Other operating revenue Total operating revenue Cost of revenue Gross profit Gross margin percentage Total operating expenses Percentage of operating revenue Other income and expenses Operating profit/(loss) before asset impairments Asset impairments Operating loss Percentage of operating revenue Net finance expense Income tax expense Net loss Percentage of operating revenue *pp stands for percentage points **NM stands for not meaningful 2019 ($000s) 538,384 14,435 552,819 (90,915) 461,904 83.6% 2018 ($000s) 397,772 8,887 406,659 (75,349) 331,310 81.5% (451,881) (352,245) 81.7% (96) 9,927 (18,604) (8,677) -1.6% (14,459) (4,007) (27,143) -4.9% 86.6% 364 (20,571) (1,550) (22,121) -5.4% (1,750) (1,043) (24,914) -6.1% change 35% 62% 36% 21% 39% 2.1pp* 28% -4.9pp -126% NM** NM -61% 3.8pp NM 284% 9% 1.2pp During the 2019 financial year (FY19), Xero continued to deliver strong operating revenue growth of 36% alongside further demonstration of operational discipline. This was reflected in achieving Xero’s first positive free cash flow result of $6.5 million for the year, an improvement of $35.0 million over the comparative year. The second half of the year resulted in Xero’s first net profit after tax of $1.4 million, compared to a $5.3 million loss for the second half of the comparative period. Operating revenue growth was primarily driven by subscriber growth in all markets. Cost of revenue decreased as a proportion of operating revenue due to continued efficiencies in the costs of hosting Xero’s cloud services and further productivity gains from investment in the customer service platform. Total operating expenses increased year-on-year as Xero continued to invest in scaling its global business, new products, and quality subscriber growth. Total operating revenue increased by 36% while operating expenses grew proportionately less at 28%, driven by efficiencies and financial discipline. The operating loss reduced by 61%, despite the adverse impact of a $16.3 million impairment. This impairment related to the decision to discontinue the US payroll product and move to a full service solution in the US, provided by our partner Gusto, a US cloud-based payroll service provider. Without the impact of this impairment, operating profit would have been $7.6 million. The statutory net loss increased by $2.2 million over the comparative period, with FY19 being adversely impacted by the impairment mentioned above. Management commentary — 22 Earnings Before Interest, Tax, Depreciation, and Amortisation (EBITDA) EBITDA disclosures (which are non-GAAP financial measures) have been included, as we believe they provide useful information for readers in understanding Xero’s financial performance. EBITDA is calculated by adding back depreciation, amortisation, net finance expense, and income tax expense to net losses. EBITDA excluding the impact of non-cash share-based payments and impairments (a non-GAAP financial measure) is also provided as we believe it provides useful information to analyse trends in cash-based expenses. Year ended 31 March Net loss Add back: net finance expense Add back: depreciation and amortisation Add back: income tax expense EBITDA EBITDA margin 2019 ($000s) (27,143) 14,459 81,848 4,007 73,171 13.2% 2018 ($000s) (24,914) 1,750 70,318 1,043 48,197 11.9% change 9% NM 16% 284% 52% 1.3pp EBITDA increased by 52% for FY19 against the comparative period. This was impacted by non-cash asset impairments, including a $16.3 million write off of the US payroll product and attributable goodwill relating to the decision to discontinue the US payroll product, and $7.9 million of transaction costs and operating losses from the acquisition of Hubdoc. EBITDA was positively impacted by $1.4 million resulting from an increase in capitalisation rates from 42.3% in the comparative period to 43.1% in FY19. Year ended 31 March EBITDA Add back: non-cash share-based payments Add back: non-cash impairments EBITDA excluding non-cash share-based payments and impairments Percentage of operating revenue 2019 ($000s) 73,171 28,946 18,604 120,721 21.8% 2018 ($000s) 48,197 17,004 1,550 66,751 16.4% change 52% 70% NM 81% 5.4pp EBITDA excluding non-cash share-based payments and non-cash impairments improved by $54.0 million or 81% over the comparative period. This increase was due to operating revenue growth of 36% and expenses growing to a lesser extent over the comparative period. EBITDA excluding non-cash share-based payments and non-cash impairments for the second half of the year was $71.4 million, representing 24% of operating revenue. This was a 74% improvement over the second half of the comparative period. 23 — Management commentary Cash flows Free cash flow is a non-GAAP financial measure that has been included to show readers net cash generated by and invested into the business. We define free cash flow as cash flows from operating activities less cash flows used for investing activities, excluding cash used for acquisitions of, and investments into, businesses and strategic assets. Year ended 31 March Receipts from customers Other operating cash flows Total cash flows from operating activities Investing activities Add back: acquisitions Free cash flows 2019 ($000s) 552,256 2018 ($000s) 410,470 (438,030) (349,274) 114,226 (140,471) 32,696 6,451 61,196 (89,709) - (28,513) change 35% 25% 87% 57% NM NM Free cash flows for FY19 are positive for the first year in Xero’s history, with a $6.5 million inflow when excluding the cash cost of acquiring Hubdoc and Instafile from investing cash flows. Receipts from customers increased by 35% or $141.8 million to $552.3 million which is closely aligned with revenue growth. Other operating cash outflows increased by 25% or $88.8 million to $438.0 million, in line with headcount growth of 25% and operating expenses growth of 28%. Net cash flows from operating activities increased by $53.0 million to $114.2 million as receipts from customers increased by 35%, while payments to suppliers increased by 24% compared to the previous year. Cash outflows from investing activities, excluding acquisitions, increased by 20% or $18.1 million. The increase is largely driven by an increase in cash outflows for capitalised development costs of $15.9 million (excluding Instafile), as well as $2.0 million more capitalised sales commissions. Free cash flows $25m $0 ($25m) ($50m) ($75m) ($100m) FY16 FY17 FY18 FY19 Management commentary — 24 Operating revenue Subscription revenue comprises recurring monthly fees from subscribers to Xero’s online software. Within a subscription, customers also receive support services and product updates. Operating revenue also includes revenue from other related services, including attendance fees for conferences and events such as Xerocon, revenue share agreements with other financial web service providers, and the implementation of online accounting software services. Subscription revenue comprises 97% of operating revenue in FY19. Year ended 31 March Subscription revenue Other operating revenue Total operating revenue 2019 ($000s) 538,384 14,435 2018 ($000s) 397,772 8,887 552,819 406,659 change 35% 62% 36% change in constant currency 34% 62% 34% The 35% increase in subscription revenue during the year was primarily driven by year-on-year subscriber growth of 31%, adding 432,000 subscribers in the year. It is also due to an increase in uptake in the Xero payroll, projects and expenses modules now being sold as add ons in most markets, as well as the acquisition of Hubdoc in August 2018. Excluding Hubdoc revenue from FY19, subscription revenue would have grown by 34% compared to FY18. Other operating revenue increased by 62%. A significant component of other operating revenue is the monetisation of financial web partners where Xero works with providers to offer online financial solutions, such as payments and lending referrals, to subscribers resulting in an associated share of revenue. A further component of the increase in other operating revenue is due to the revenue from Xerocon events. Conference income increased as a result of one additional Xerocon being held during FY19, as well as an increase in the number of attendees and exhibitors attending Xerocon events. Constant currency operating revenue (a non-GAAP financial measure) is provided to assist readers in understanding and assessing Xero’s financial performance during the year, excluding the impact of foreign currency fluctuations. Constant currency operating revenue is calculated by translating operating revenue for FY19 at the effective exchange rates for FY18. As 82% of Xero’s operating revenue is denominated in foreign currencies, the comparatively weaker NZD against Great British pound (GBP) and United States dollar (USD) during FY19 compared to FY18 had a positive impact on reported revenue. Constant currency operating revenue for the Group for FY19 was $4.0 million lower than reported operating revenue. Year-on-year constant currency operating revenue growth of 34% was lower than reported revenue growth at 36%. 25 — Management commentary Operating revenue by geography Year ended 31 March Australia New Zealand Australia and New Zealand (ANZ) total United Kingdom (UK) North America Rest of World International total Total operating revenue 2019 ($000s) 261,468 97,639 359,107 119,521 44,270 29,921 193,712 552,819 2018 ($000s) 197,094 78,807 275,901 79,611 31,873 19,274 130,758 406,659 change 33% 24% 30% 50% 39% 55% 48% 36% change in constant currency 33% 24% 31% 45% 33% 48% 43% 34% Operating revenue grew in all of Xero’s geographies, with growth of 30% in the established ANZ markets largely due to the increased subscriber base. The two countries combined added 193,000 subscribers in FY19. Constant currency operating revenue growth for the ANZ markets was higher at 31% with a stronger average NZD against AUD compared to FY18. This growth is higher than subscriber growth of 22% largely due to a 3.7% increase in average revenue per user. International markets continue to exhibit strong growth, particularly in the UK market, which achieved an operating revenue increase of 50% (45% in constant currency) from FY18. The Rest of World markets revenue grew by 55% (48% in constant currency) with strong performances in South Africa and Asia. Total Group operating revenue by geography* $600m $400m $200m * represents each region's contribution to total Group operating revenue for the respective period 0 FY16 Rest of World North America United Kingdom New Zealand Australia FY17 FY18 FY19 Management commentary — 26 Subscriber numbers Xero has refined its methodology regarding how it defines a subscriber. Now, subscribers to multiple Xero owned but independently billed products (for example Xero and Hubdoc, or Xero and WorkflowMax) are counted as a single subscriber to the Xero platform. The comparative period has not been adjusted as the change in methodology did not have a significant impact on that period’s subscriber balance. The revised definition of ‘Subscriber’ is: Each unique subscription to a Xero-offered product that is purchased by a user (eg small business or accounting partner) and which is, or is available to be, deployed. Subscribers that have multiple subscriptions to integrated products on the Xero platform are counted as a single subscriber. At 31 March Australia New Zealand Australia and New Zealand (ANZ) total United Kingdom North America Rest of World International total Total paying subscribers 2019 726,000 351,000 1,077,000 463,000 195,000 83,000 741,000 2018 583,000 301,000 884,000 312,000 132,000 58,000 502,000 1,818,000 1,386,000 change 25% 17% 22% 48% 48% 43% 48% 31% Subscribers grew by 432,000 during the year, or 31%, bringing total subscribers to 1,818,000 at 31 March 2019. North American subscribers at 31 March 2019 includes 19,000 subscribers acquired through the acquisition of Hubdoc. Excluding acquired Hubdoc subscribers, North American subscribers grew by 44,000 or 33%, and total Group subscribers grew by 413,000 or 30%. ANZ surpassed one million subscribers in FY19, adding 193,000 subscribers or 22% in the year as Xero continues to strengthen its presence in these established markets. For the first time, International markets added more subscribers than the ANZ markets, increasing by 239,000 or 48% (220,000 or 44% excluding acquired Hubdoc subscribers) in FY19. The UK was of particular note, adding 151,000 subscribers in FY19, with 108,000 of those added in the second half of the year. Both the FY19 and second half FY19 UK subscriber additions are new records for any one country. Net subscriber additions FY19 FY18 Australia New Zealand United Kingdom North America Rest of World 34.9% 33.1% 28.5% 39.0% 432k 14.6% 11.6% 5.8% 351k 11.4% 5.4% 15.7% Regional subscribers at 31 March 2019* Australia 726,000 2018 // 583,000 New Zealand 351,000 2018 // 301,000 United Kingdom 463,000 2018 // 312,000 North America 195,000 2018 // 132,000 * Rest of World subscribers at 31 March 2019 83,000 (31 March 2018: 58,000) 27 — Management commentary Annualised monthly recurring revenue Annualised monthly recurring revenue (AMRR) is a non-GAAP financial measure, which represents monthly recurring revenue at 31 March multiplied by 12. It provides a 12-month forward view of revenue, assuming any promotions have ended and other factors such as subscriber numbers, transaction volumes, pricing, and foreign exchange remain unchanged during the year. Constant currency AMRR (also a non-GAAP financial measure) is calculated by translating AMRR at 31 March 2019 at the foreign exchange rates from 31 March 2018, and is provided to assist in understanding and assessing year-on-year growth rates, excluding the impact of foreign currency fluctuations. At 31 March ANZ International Total 2019 ($000s) 396,233 241,946 638,179 2018 ($000s) 314,496 169,925 484,421 change 26% 42% 32% change in constant currency 28% 40% 32% The growth in AMRR was driven by both subscriber and average revenue per user (ARPU) growth. ARPU increases were due to increased revenue from non-accounting services, such as financial web revenue, that grew at a faster rate than subscription revenue as well as price increases in Australia and New Zealand. Xero added $153.8 million of AMRR in FY19. The weaker NZD exchange rate against USD at 31 March 2019 compared to 31 March 2018 has had a favourable impact on the reported AMRR growth for the International segment, with constant currency AMRR growth of 40% two percentage points lower than reported growth of 42%. In constant currency, total AMRR has grown by 32%, one percentage point higher than subscriber growth, led by higher ARPU in the ANZ segment. For the first time, more AMRR was added in the second half of the year in the International markets than the ANZ markets in both actual and constant currency terms. Management commentary — 28 Gross profit Gross profit represents operating revenue less cost of revenue. Cost of revenue consists of expenses directly associated with securely hosting Xero’s services, sourcing relevant data from financial institutions, and providing support to subscribers. The costs include hosting and content distribution costs, bank feed costs, personnel and related expenses (including salaries, benefits, bonuses, and share-based payments) directly associated with cloud infrastructure and subscriber support, contracted third-party vendor costs, related depreciation and amortisation, and allocated overheads. Year ended 31 March Operating revenue Cost of revenue Gross profit Gross margin percentage 2019 ($000s) 552,819 (90,915) 461,904 83.6% 2018 ($000s) 406,659 (75,349) 331,310 81.5% change 36% 21% 39% 2.1pp Cost of revenue for FY19 grew by $15.6 million to $90.9 million, representing a 21% increase when compared to the comparative period. The primary reasons for the change were increases in personnel costs required by Xero’s customer support teams to support more subscribers, and increased cloud hosting costs against the comparative period. Operating revenue growth of 36% resulted in gross profit increasing by $130.6 million, or 39%, to $461.9 million. Cost of revenue decreased as a percentage of operating revenue compared to FY18 due to efficiencies in hosting costs and in the customer support platform. Customer support became more efficient with the release of Xero Central during FY19. Xero Central utilises machine learning to suggest and refine answers to customers' questions as they are asking them. Gross margin for the year of 83.6% is an improvement of 2.1 percentage points compared to FY18. Gross margin percentage 85.0% 80.0% * affected by AWS migration 75.0% FY16* FY17* FY18 FY19 29 — Management commentary Sales and marketing Sales and marketing expenses consist of personnel and related expenses (including salaries, benefits, bonuses, the amortisation of deferred commission costs and share-based payments) directly associated with the sales and marketing teams, and the cost of educating and onboarding both partners and small business customers. Costs also include relationship management costs incurred to support the existing subscriber base. Other costs included are external advertising costs, marketing costs and promotional events, as well as allocated overheads. Year ended 31 March Sales and marketing expenses Percentage of operating revenue 2019 ($000s) 248,014 44.9% 2018 ($000s) 189,203 46.5% change 31% -1.6pp Sales and marketing costs increased by $58.8 million, or 31%, to $248.0 million for the year, compared to operating revenue growth of 36% and subscriber growth of 31%. The majority of sales and marketing costs are incurred in acquiring new subscribers and are expensed in the period, in contrast to the associated revenue from those subscribers which is recognised over the life of the subscriber (currently around seven and a half years on average). Note that sales commission costs are now capitalised and amortised to sales and marketing costs over a five-year period. Sales and marketing costs in the International markets increased by 34%, compared to operating revenue growth of 48% as Xero looks to benefit from the opportunity MTD offers in the UK market. Sales and marketing costs in the ANZ markets increased by 26% compared to operating revenue growth of 30%. The average cost of acquiring each subscriber has increased to $397 per gross subscriber added in FY19 compared to $376 in FY18. The increase is largely due to segment mix effects with the strong growth in International subscriber numbers as well as additional investment in the more established ANZ markets. Group customer acquisition metrics remain strong and the associated spend continues to power increased levels of subscriber and AMRR growth. As a percentage of operating revenue, sales and marketing costs decreased from 46.5% in FY18 to 44.9% for FY19. Management commentary — 30 Product design and development Product design and development costs consist primarily of personnel and related expenses (including salaries, benefits, bonuses, and share-based payments) directly associated with product design and development employees, as well as allocated overheads. The proportion of product design and development expenses that creates a benefit in future years and meets certain requirements under IFRS is capitalisable as an intangible asset and is then amortised to the Income Statement over the estimated life of the asset created. The amount amortised relating to the Xero product and platform is included as a product design and development expense. Year ended 31 March Total product design and development costs (including amounts capitalised)1 Percentage of operating revenue Less capitalised development costs Product design and development expense (excluding amortisation of amounts capitalised) Less government grants Add amortisation of capitalised development costs Product design and development expenses Percentage of operating revenue 1 excludes impairments 2019 ($000s) 170,946 30.9% (73,598) 97,348 (5,219) 45,666 137,795 24.9% 2018 ($000s) 140,513 34.6% (59,374) 81,139 (4,517) 39,683 116,305 28.6% change 22% -3.7pp 24% 20% 16% 15% 18% -3.7pp Xero continues to invest in its global product and platform, developing a significant range of new features during FY19, including: – Xero Central, a one-stop shop for our users to manage their relationship with Xero – Making Tax Digital functionality, allows users to manage UK VAT compliance digitally through integrated HMRC and Xero workflows – Profit and Loss at a glance on mobile, gives users a quick view of their profit and loss, and a breakdown of income and spending, from their Android or iOS dashboard – A global API, allows any bank or other financial institution to sync their bank feeds directly to the Xero platform – Single Touch Payroll functionality, allows Australian employers to comply with new Australian Taxation Office payroll reporting requirements – Payday Filing functionality, allows New Zealand employers to comply with new Inland Revenue payroll reporting requirements – New Navigation, intuitive navigation experience that makes it quicker and easier for Xero businesses and advisors to discover new features and seamlessly navigate to those they most frequently use Total product design and development costs were $170.9 million in FY19, $30.4 million or 22%, higher than in the previous period. Of this, $73.6 million was capitalised, with the balance of $97.3 million included as an expense in the Income Statement. The amount capitalised represents a capitalisation rate of 43.1% of total product design and development costs for FY19, which is 0.8 percentage points higher than the comparative period. As a proportion of operating revenue, total product design and development costs for FY19 (including amounts capitalised) decreased by 3.7 percentage points to 30.9%, compared to 34.6% for the comparative period, as revenue grew at a faster rate than product design and development costs. The amortisation of previously capitalised product design and development expenditure of $45.7 million was included as a non-cash expense in the Income Statement, giving total net expenses (after the netting of government grants) for the period of $137.8 million. Amortisation of previously capitalised development costs increased due to higher intangibles balances than in the comparative period. Product design and development expenses increased by 18% on the comparative period as Xero continued to increase investment in product and innovation. As a proportion of operating revenue, product design and development expenses decreased to 24.9% in FY19 from 28.6% in the comparative period. 31 — Management commentary General and administration General and administration expenses consist of personnel and related expenses (including salaries, benefits, bonuses, and share-based payments) for executive, finance, billing, legal, human resources, and administrative employees, and the Xero Board. It also includes legal, accounting and other professional services fees, insurance premiums, other corporate expenses, and allocated overheads. Year ended 31 March General and administration expenses Percentage of operating revenue 2019 ($000s) 66,072 12.0% 2018 ($000s) 46,737 11.5% change 41% 0.5pp General and administration costs were $66.1 million for FY19, $19.3 million or 41% higher than in FY18. The current period includes $1.3 million of costs relating to the acquisition of Hubdoc, as well as a $5.0 million increase in non-cash share-based compensation. General and administration costs as a proportion of operating revenue remained relatively consistent with FY18, increasing 0.5 percentage points from 11.5% in FY18 to 12.0% in FY19. Employees At 31 March Total Group 2019 2,531 2018 2,021 change 25% Full-time equivalent (FTE) employees increased by 510 or 25% in FY19, taking the total FTEs to 2,531, compared to a 31% increase in subscribers and 36% increase in operating revenue. The increase includes 83 FTEs who joined Xero as part of the acquisition of Hubdoc. The slower growth compared to revenue and subscribers reflects the benefits of economies of scale and operating efficiencies. Net finance expense Year ended 31 March Interest income on deposits Total finance income Interest on convertible notes Bank standby facility costs Finance lease interest Other finance expense Total finance expense Net finance expense 2019 ($000s) 8,035 8,035 (12,753) (1,847) (4,987) (2,907) (22,494) (14,459) 2018 ($000s) 2,440 2,440 - (775) (3,100) (315) (4,190) (1,750) change 229% 229% NM NM 61% 823% NM NM Finance income in FY19 was $8.0 million, an increase of $5.6 million or 229% from the previous year due to increased cash and short- term deposit balances from the issue of convertible notes in October 2018. Proceeds from the convertible notes issue are held on deposit until required. This increase to finance expense was driven by interest on the convertible notes and on term debt used for the acquisition of Hubdoc, combined with fees relating to an undrawn committed standby facility. Finance lease interest increased by $1.9 million due to leases for office space entered into during the year, particularly the Auckland building lease which has a 12 year term. Management commentary — 32 Segment contribution Operating revenue is allocated to a segment depending on where the subscriber resides. Expenses include cost of revenue, sales and marketing costs incurred directly in-region, and an allocation of centrally managed costs and overheads, such as hosting and user support costs. Year ended 31 March 2019 Operating revenue Expenses Other income Segment contribution Contribution margin percentage Year ended 31 March 2018 Operating revenue Expenses Other income Segment contribution Contribution margin percentage ANZ ($000s) International ($000s) 359,107 (140,175) 69 219,001 61.0% 275,901 (118,683) 16 157,234 57.0% 193,712 (198,754) 331 (4,711) -2.4% 130,758 (145,869) 1,071 (14,040) -10.7% Total ($000s) 552,819 (338,929) 400 214,290 38.8% 406,659 (264,552) 1,087 143,194 35.2% ANZ Operating revenue for FY19 grew by 30% compared to the comparative period, further reinforcing Xero’s market leading position in the region. Revenue growth tracked ahead of subscriber growth of 22%, largely due to improvements in ARPU. This, along with cost efficiencies, resulted in a segment contribution for the year of $219.0 million, which improved as a percentage of operating revenue from 57.0% to 61.0%. Across ANZ 193,000 subscribers were added in FY19 to finish with 1,077,000 subscribers. International Operating revenue for FY19 grew by 48% due to subscriber growth of 48% as well as an additional Xerocon being held in the year. International’s contribution loss decreased to $4.7 million in FY19, compared to $14.0 million in FY18. The contribution margin improved from -10.7% to -2.4% due to scaling and efficiencies, particularly in the UK, while maintaining strong revenue growth. The contribution margin was comparatively lower than that of ANZ, reflecting the investment in subscriber growth in the UK, North America, and Asia, as Xero continues to build brand recognition and distribution channels in these markets. 33 — Management commentary Key SAAS metrics SaaS companies like Xero operate on many of the same performance metrics as traditional companies, such as revenue, cash flow, and customer numbers. However, understanding the performance of SaaS companies, and being able to benchmark them requires an understanding of SaaS-specific metrics. Below are some of the headline metrics we utilise to manage and drive Xero’s performance. Average revenue per user (ARPU) is calculated as AMRR (see definition on page 27) at 31 March divided by subscribers at that time (and divided by 12 to get a monthly view). CAC months are months of ARPU to recover the cost of acquiring each new subscriber. With the adoption of NZ IFRS 15 and the resulting spreading of contract acquisition costs, Xero has changed the calculation of CAC months to adjust for the deferral and amortisation of contract acquisition costs. The revised calculation is sales and marketing costs for the year excluding the deferral and amortisation of contract acquisition costs, less conference revenue (such as Xerocon), divided by gross new subscribers added during the same period, divided by ARPU. The revised calculation of the cost of acquiring each new subscriber is consistent with that used in prior years, as the deferral and amortisation of contract acquisition costs was not required prior to the implementation of NZ IFRS 15. MRR churn is the value of monthly recurring revenue (MRR) from subscribers who leave Xero in a month as a percentage of the total MRR at the start of that month. The percentage provided is the average of the monthly churn for the previous 12 months. Lifetime value (LTV) is the gross margin expected from a subscriber over the lifetime of that subscriber. This is calculated by taking the average subscriber lifetime (one divided by MRR churn), multiplied by ARPU, multiplied by the gross margin percentage. Group LTV is calculated as the sum of the individual segment LTVs, multiplied by their respective segment subscribers, divided by total Group subscribers. LTV/CAC is the ratio between the LTV and the cost to acquire that subscriber, eg. the LTV derived from a subscriber in ANZ is currently on average 10.7 times the cost of acquiring that subscriber. We strive to maximise total lifetime value whilst maintaining the optimal level of investment to maintain a desirable LTV/CAC ratio. We improve total lifetime value in multiple ways, such as increasing subscriber numbers, enhancing products and services for existing subscribers thereby increasing ARPU, improving gross margin through cost efficiencies, and investing in retaining customers. The table below outlines key metrics across Xero’s segments: At 31 March 2019 ARPU ($) CAC months MRR churn LTV per subscriber ($) LTV/CAC At 31 March 2018 ARPU ($) CAC months MRR churn LTV per subscriber ($) LTV/CAC ANZ 30.66 9.4 0.85% 3,075 10.7 ANZ 29.65 8.3 0.86% 2,841 11.5 International 27.21 18.3 1.55% 1,413 2.8 International 28.21 18.6 1.62% 1,402 2.7 Total 29.25 13.6 1.10% 2,398 6.0 Total 29.13 12.9 1.10% 2,320 6.2 Management commentary — 34 ANZ – ARPU increased by 3.4% driven by the higher value product mix and pricing in both Australia and New Zealand, as Xero focuses on being a small business platform and sees increased use of Xero add-ons such as payroll, expenses, and projects as well as adjacent products. In constant currency terms ARPU increased by 4.8%. CAC months at 31 March 2019 was higher when compared to 31 March 2018 as Xero continues to invest in small business platform, ecosystem, and finweb strategies that target existing customers, as well as investing to drive growth to further increase market share in the ANZ segment. Improved ARPU, gross margin and lower churn led to an 8% improvement in LTV per subscriber (10% in constant currency). Total subscriber LTV increased by 32% to $3.3 billion at 31 March 2019 compared to the comparative period. International – ARPU across the International segment decreased by 3.5% (4.8% in constant currency) over FY19 due to a focus on the lower ARPU partner channel in the UK and US markets. Despite a lower ARPU, lower churn and higher gross margin led to a 1% improvement in LTV per subscriber at 31 March 2019 compared to the comparative period (flat in constant currency). Total LTV for the International segment increased by 49% to $1.0 billion at 31 March 2019 due to subscriber growth, particularly in the UK market, and improvements in gross margin. Total Group – ARPU increased slightly by 0.4% (0.8% increase in constant currency) due to product mix and pricing in ANZ being offset by a shift towards the more efficient but lower ARPU partner channel, particularly in the International segment. LTV increased 3% from the same time last year to $2,398 per subscriber, due to the improvements in ARPU and gross margin. Group constant currency LTV per subscriber at 31 March 2019 was 4% higher than at 31 March 2018. Total LTV at 31 March 2019 was $4.4 billion, an improvement of $1.1 billion compared to 31 March 2018. CAC months increased 5% to 13.6 months when compared to 31 March 2018 due to the International markets contributing a larger component to the Group as well as continued investment in the ANZ markets. Total lifetime value ANZ International $5b $4b $3b $2b $1b $0 2016 2017 2018 2019 At 31 March 35 — Financial Statements Financial Statements contents Auditor's report Financial statements Income Statement Statement of Financial Position Statement of Changes in Equity Statement of Cash Flows Notes to financial statements General information 1. Reporting entity and statutory base 2. Basis of accounting Performance 3. Segment information 4. Revenue 5. Expenses 6. Finance income and expense 7. Earnings per share Operating assets and liabilities 8. Trade and other receivables 9. Property, plant and equipment 10. Intangible assets 11. Trade and other payables 12. Other current liabilities 13. Lease liabilities Funding and risk 14. Term debt 15. Financial instruments, capital and financial risk management 16. Derivatives and hedge accounting 17. Share capital Group structure 18. Business combinations 19. Group entities Other information 20. Current and deferred income tax 21. Reconciliation of operating cash flows 22. Changes in financial assets and liabilities arising from financing activities 23. Share-based payments 24. Key management personnel and related parties 25. Commitments and contingencies 26. Events after balance sheet date Directors' responsibility statement 36 40 40 41 42 43 44 44 44 48 49 50 51 52 52 53 54 57 57 57 58 59 65 66 67 68 69 71 72 72 74 75 75 76 Independent Auditor's report — 36 Independent auditor’s report to the Shareholders of Xero Limited responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. Ernst & Young has provided a SOC 2 assurance report pertaining to Xero’s technology control environment, R&D tax credit advice, and other assurance services related to the issuance of convertible notes and the Group’s preparation for compliance with ISO 27001. We have no other relationship with, or interest in, Xero Limited or any of its subsidiaries. Partners and employees of our firm may deal with the group on normal terms within the ordinary course of trading activities of the business of the group. Key audit matters Key audit matters are those matters that, in our professional judgment, were of most significance in our audit of the consolidated financial statements of the current year. These matters were addressed in the context of our audit of the consolidated financial statements as a whole, and in forming our opinion thereon, but we do not provide a separate opinion on these matters. For each matter below, our description of how our audit addressed the matter is provided in that context. We have fulfilled the responsibilities described in the Auditor’s responsibilities for the audit of the financial statements section of the audit report, including in relation to these matters. Accordingly, our audit included the performance of procedures designed to respond to our assessment of the risks of material misstatement of the financial statements. The results of our audit procedures, including the procedures performed to address the matters below, provide the basis for our audit opinion on the accompanying consolidated financial statements. Opinion We have audited the financial statements of Xero Limited (“the company”) and its subsidiaries (together “the Group”) on pages 40 to 75, which comprise the consolidated statement of financial position of the group as at 31 March 2019, and the consolidated income statement, consolidated statement of comprehensive income, consolidated statement of changes in equity and consolidated statement of cash flows for the year then ended of the Group, and the notes to the consolidated financial statements including a summary of significant accounting policies. In our opinion, the consolidated financial statements on pages 40 to 75 present fairly, in all material respects, the consolidated financial position of the group as at 31 March 2019 and its consolidated financial performance and cash flows for the year then ended in accordance with New Zealand equivalents to International Financial Reporting Standards and International Financial Reporting Standards. This report is made solely to the company's shareholders, as a body. Our audit has been undertaken so that we might state to the company's shareholders those matters we are required to state to them in an auditor's report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company's shareholders, as a body, for our audit work, for this report, or for the opinions we have formed. Basis for opinion We conducted our audit in accordance with International Standards on Auditing (New Zealand). Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the Financial Statements section of our report. We are independent of the group in accordance with Professional and Ethical Standard 1 (revised) Code of Ethics for Assurance Practitioners issued by the New Zealand Auditing and Assurance Standards Board, and we have fulfilled our other ethical 37 — Independent Auditor's report Convertible Notes and related derivatives Why significant How our audit addressed the key audit matter During the year, the Group raised US$300 million through the issue of convertible notes, listed on the Singapore Exchange Securities Trading Limited (SGX-ST). In connection with the issuance, Xero also entered into call spread transactions. The lower strike call options are accounted for as derivative assets and are recorded by the Group at fair value. Gains and losses at each reporting period are recognised through the consolidated income statement. The upper strike call options are accounted for as equity. The conversion features of the notes are accounted for as a derivative financial liability at fair value through the consolidated income statement. Decisions regarding the appropriate accounting treatment of each element requires judgement. Significant judgement is also required to determine the value of the conversion features and related call spread transactions. Note 14 of the financial statements describes the accounting for the convertible notes and associated call spreads. Our work on the convertible notes and call spreads has focused on the appropriateness of the accounting treatment as well as the judgements made in determining their valuations. Our audit procedures included: – Involving our financial instrument accounting specialists to consider and challenge the group’s adopted accounting treatments; – Consideration of the external valuation of the derivative instruments and the conversion elements of the notes by engaging our internal financial instrument valuation specialists to assess the appropriateness of the valuation methods adopted, the inputs used in the valuations and the resulting valuation amounts adopted by management; – Reviewing the disclosures in the financial statements for appropriateness. Hubdoc business combination and goodwill impairment testing Why significant How our audit addressed the key audit matter During the year the Group acquired 100% of the ordinary shares in data capture solution provider Hubdoc Inc consideration included NZ $31.2m cash and NZ $54.9 million in ordinary shares of Xero Limited. A further US $10 million of shares may be payable contingent on certain conditions. The acquisition has been treated as a business combination under NZ IFRS 3: Business Combinations. The assessment of the fair value of the various assets and liabilities acquired requires judgement. The impact of the business combination is disclosed in Note 18 of the consolidated financial statements. As a result of the acquisition goodwill of $78.8 million has been recognised. The Group is required to test goodwill for impairment at least annually. This assessment requires judgment including consideration of both internal and external sources of information. Our audit procedures included: – Considering the appropriateness of the cash generating units to which the acquired net assets have been allocated; – Challenging the purchase price allocation from a methodology perspective and the key inputs used, including considering the experience and qualification of management’s experts used in the assessment of the fair values of assets and liabilities purchase; – Engaging our own internal valuation experts to assess the fair values determined; – Comparing the key inputs such as WACC used in the model to rates observed in similar situations and ensuring that the stated WACC was used in the calculations; – Discussing the basis on which management had assessed the likelihood of the contingent considerations being paid and its associated accounting treatment; – Performing a review of the business combination note disclosure in the financial statements to assess compliance with NZ IFRS 3; – Considering management’s impairment assessment, including Hubdoc’s actual trading performance against its forecasts. Independent Auditor's report — 38 Capitalisation of Software Development Costs Why significant How our audit addressed the key audit matter The Group capitalises costs incurred in the development of its software. These costs are then amortised over the estimated useful life of the software. The Group’s process for calculating the value of internally developed software involves judgment as it includes estimating time which staff spend developing software and determining the value attributable to that time. The Group’s capitalised costs are disclosed in Note 10 to the financial statements. Our work on capitalised development costs focused on the Group’s process for estimating the time spent by staff on software development that can be capitalised under NZ IAS 38: Intangible Assets. Our audit procedures included the following: – Assessing the nature of a sample of projects against the requirements of NZ IAS 38 to determine if they were capital in nature; – Assessing the procedures applied by the Group to review the rates applied to capitalise payroll costs; – Assessing the effectiveness of controls over the payroll process; – Assessing capitalised costs with reference to actual payroll information for a sample of employees; and – Assessing the adequacy of the disclosures related to capitalised development costs in the consolidated financial statements. Impairment Considerations Relating to Capitalised Software Development Costs Why significant How our audit addressed the key audit matter Intangible assets make up 76% of the Group’s non-current assets. The most significant of these intangibles is capitalised software development costs. We assessed the factors that the Group considered regarding impairment of capitalised development costs and whether any indicators of impairment existed. This included having regard to: NZ IAS 36: Impairment of Assets requires that finite life intangible assets be tested for impairment whenever there is an indication that the intangible assets may be impaired and this assessment requires judgment. – Significant changes in the extent or manner in which the associated software is used; – Potential or actual redundancy or disposal of developed software; Disclosures relating to Intangible Assets, including key assumptions, are disclosed in Note 10 to the consolidated financial statements. The assessment as to whether there are any indicators of impairment requires judgment including consideration of both internal and external sources of information. Significantly, during the year the Group entered into a new strategic partnership with external payroll provider, Gusto. This triggered the impairment of Xero’s own US payroll product of $11.1 million and goodwill related to the previous acquisition of Monchilla Inc of $5.2 million. – Forecast cash flows associated to the capitalised development costs; – Amortisation periods applied by the Group to developed software relative to its experience of software lifecycle; and – Significant changes in the market in which the assets are used. We considered the appropriateness of management’s decision to fully impair previously capitalised costs related to US payroll functionality. We also assessed the adequacy of the disclosures related to impairment considerations in the consolidated financial statements. 39 — Independent Auditor's report Information other than the financial statements and auditor’s report The directors of the company are responsible for the Annual Report, which includes information other than the consolidated financial statements and auditor’s report. Our opinion on the consolidated financial statements does not cover the other information and we do not express any form of assurance conclusion thereon. In connection with our audit of the consolidated financial statements, our responsibility is to read the other information and, in doing so, consider whether the other information is materially inconsistent with the consolidated financial statements or our knowledge obtained during the audit, or otherwise appears to be materially misstated. If, based upon the work we have performed, we conclude that there is a material misstatement of this other information, we are required to report that fact. We have nothing to report in this regard. Directors’ responsibilities for the financial statements The directors are responsible, on behalf of the entity, for the preparation and fair presentation of the consolidated financial statements in accordance with New Zealand equivalents to International Financial Reporting Standards and International Financial Reporting Standards, and for such internal control as the directors determine is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the consolidated financial statements, the directors are responsible for assessing on behalf of the entity the group’s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting unless the directors either intend to liquidate the group or cease operations, or have no realistic alternative but to do so. Auditor’s responsibilities for the audit of the financial statements Our objectives are to obtain reasonable assurance about whether the consolidated financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with International Standards on Auditing (New Zealand) will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these consolidated financial statements. A further description of the auditor’s responsibilities for the audit of the financial statements is located at the External Reporting Board’s website: https://www.xrb.govt.nz/standards-for- assurance-practitioners/auditors-responsibilities/audit-report-1/. This description forms part of our auditor’s report. The engagement partner on the audit resulting in this independent auditor’s report is Grant Taylor. Chartered Accountants Wellington 16 May 2019 Financial Statements Income Statement Year ended 31 March Subscription revenue Other operating revenue Total operating revenue Cost of revenue Gross profit Operating expenses Sales and marketing Product design and development General and administration Total operating expenses Asset impairments Other expenses Other income Operating deficit Finance income Finance expense Net loss before tax Income tax expense Net loss Basic and diluted loss per share Statement of Comprehensive Income Year ended 31 March Net loss Other comprehensive income* Movement in cash flow hedges (net of tax) Translation of foreign operations Total other comprehensive income for the year Total comprehensive loss for the year * Items of other comprehensive income may be reclassified to the Income Statement The accompanying notes form an integral part of these financial statements Financial Statements — 40 Notes 2019 ($000s) 2018 Restated ($000s) 538,384 397,772 14,435 8,887 552,819 406,659 (90,915) 461,904 (75,349) 331,310 4 5 (248,014) (137,795) (66,072) (189,203) (116,305) (46,737) 5 (451,881) (352,245) 9, 10 (18,604) 6 6 20 7 Note 16 (1,183) 1,087 (8,677) 8,035 (22,494) (23,136) (4,007) (27,143) (1,550) (723) 1,087 (22,121) 2,440 (4,190) (23,871) (1,043) (24,914) ($0.19) ($0.18) 2019 ($000s) (27,143) 999 1,006 2,005 2018 Restated ($000s) (24,914) 2,863 (9) 2,854 (25,138) (22,060) 41 — Financial Statements Statement of Financial Position Assets Current assets Cash and cash equivalents Short–term deposits Trade and other receivables Derivative assets Other current assets Total current assets Non–current assets Property, plant and equipment Intangible assets Deferred tax assets Derivative assets Other non–current assets Total non–current assets Total assets Liabilities Current liabilities Trade and other payables Employee entitlements Lease liabilities Income taxes payable Derivative liabilities Other current liabilities Total current liabilities Non–current liabilities Term debt Derivative liabilities Lease liabilities Deferred tax liabilities Other non–current liabilities Total non–current liabilities Total liabilities Equity Share capital Reserves Accumulated losses Total equity Total liabilities and shareholders' equity The accompanying notes form an integral part of these financial statements At 31 March 2019 ($000s) Notes At 31 March 2018 Restated ($000s) At 1 April 2017 Restated ($000s) 8 14, 16 9 10 20 16 11 13 20 16 12 14 14, 16 13 20 121,527 336,819 49,466 77,328 1,478 20,955 59,000 33,792 2,508 993 27,699 86,000 32,564 801 393 586,618 117,248 147,457 91,491 289,731 1,613 238 627 383,700 970,318 27,043 37,830 11,541 1,958 147 26,560 105,079 357,731 77,367 71,308 1,789 3,735 511,930 617,009 61,804 168,816 500 41 2,207 233,368 350,616 26,285 27,980 7,531 537 822 5,494 68,649 – – 37,906 613 2,364 40,883 109,532 40,862 145,539 37 17 1,958 188,413 335,870 31,995 27,336 6,475 1,105 2,397 2,228 71,536 – 17 21,286 821 2,880 25,004 96,540 17 627,848 69,333 537,744 20,069 522,610 8,535 (343,872) (316,729) (291,815) 353,309 970,318 241,084 350,616 239,330 335,870 Financial Statements — 42 Statement of Changes in Equity Share capital ($000s) Treasury shares ($000s) Notes Share- based payment reserve ($000s) Accumulated losses ($000s) Foreign currency translation reserve ($000s) Cash flow hedge reserve ($000s) Premium on call spread options ($000s) Total equity ($000s) Restated balance at 1 April 2018 549,596 (11,852) 18,904 (316,729) (102) 1,267 – 241,084 – – – – – – – – – (27,143) – – 1,006 (27,143) 1,006 – 999 999 Net loss Other comprehensive income Total comprehensive loss Transactions with owners: Share-based payments Exercising of employee and director share options Issue of shares – acquisition of Hubdoc, net of issue costs Premium on call spread options, net of issue costs 23 13,673 1,466 17,343 17, 23 20,115 18 54,850 14 – – – – (5,345) – – – – – – – – – – – – – – 35,261 35,261 Balance at 31 March 2019 638,234 (10,386) 30,902 (343,872) 904 2,266 35,261 353,309 Balance at 1 April 2017 532,583 (9,973) 10,224 (306,995) (93) (1,596) Adjustment on adoption of new IFRS – – – 15,180 – – Restated balance at 1 April 2017 532,583 (9,973) 10,224 (291,815) (93) (1,596) Net loss Other comprehensive income/(loss) Total comprehensive loss Transactions with owners: Share-based payments – – – – – – – – – (24,914) – (24,914) – (9) (9) – – – 2,863 2,863 – – Exercising of employee share options 17, 23 3,183 – (837) 23 13,830 (1,879) 9,517 – – Restated balance at 31 March 2018 549,596 (11,852) 18,904 (316,729) (102) 1,267 The accompanying notes form an integral part of these financial statements (27,143) 2,005 (25,138) 32,482 14,770 54,850 – – – – – – – – – – – – – – 224,150 15,180 239,330 (24,914) 2,854 (22,060) 21,468 2,346 241,084 Net cash flows from operating activities 21 114,226 43 — Financial Statements Statement of Cash Flows Year ended 31 March Operating activities Receipts from customers Other income Interest received Payments to suppliers and employees Interest paid Income tax paid Investing activities Capitalised development costs Acquisition of Hubdoc Purchase of property, plant and equipment Capitalised contract acquisition costs Rental bonds Sale of property, plant and equipment Net cash flows from investing activities Financing activities Proceeds from issuance of convertible notes, net of issue costs Purchase of call spread options Proceeds from borrowings Repayment of borrowings Receipt of lease incentive Payment of lease liabilities Exercising of share options Payments for short-term deposits Proceeds from short-term deposits Net cash flows from financing activities Net increase/(decrease) in cash and cash equivalents Foreign currency translation adjustment Cash and cash equivalents at the beginning of the year Cash and cash equivalents at the end of the year The accompanying notes form an integral part of these financial statements Note 2019 ($000s) 2018 Restated ($000s) 552,256 410,470 5,370 5,028 (435,043) (9,502) (3,883) (82,182) (30,312) (15,727) (13,512) 1,262 – 5,157 2,315 (351,141) (3,100) (2,505) 61,196 (63,767) – (15,329) (11,613) (507) 1,507 (140,471) (89,709) 447,766 (45,810) 30,850 (31,583) 14,500 (9,103) 14,770 (336,819) 59,000 143,571 117,326 (16,754) 20,955 121,527 – – 3,515 (2,782) – (8,432) 2,346 (74,000) 101,000 21,647 (6,866) 122 27,699 20,955 Notes to the Financial Statements — 44 Notes to the Financial Statements 1. Reporting entity and statutory base Xero Limited (‘the Company’) is a company registered under the New Zealand Companies Act 1993 and is listed on the Australian Securities Exchange (ASX). The audited consolidated financial statements of the Company and its subsidiaries (together ‘the Group’ or ‘Xero’) have been prepared in accordance with the ASX Listing Rules. The consolidated financial statements of the Group for the year ended 31 March 2019 were authorised for issue in accordance with resolution of the directors on 16 May 2019. 2. Basis of accounting (a) Basis of preparation The financial statements of the Group have been prepared in accordance with Generally Accepted Accounting Practice in New Zealand (NZ GAAP). The Group is a for-profit entity for the purposes of complying with NZ GAAP. The consolidated financial statements comply with New Zealand equivalents to International Financial Reporting Standards (NZ IFRS), other New Zealand accounting standards, and authoritative notices that are applicable to entities that apply NZ IFRS. The consolidated financial statements also comply with International Financial Reporting Standards. Other than where described below, or in the notes, the consolidated financial statements have been prepared using the historical cost convention. The consolidated financial statements are presented in New Zealand dollars ($) (the ‘presentation currency’). Items included in the financial statements of each of the Group’s entities are measured using the currency of the primary economic environment in which the entity operates (the ‘functional currency’). (b) Changes in accounting policies and disclosures Except as described below, the accounting policies and disclosures adopted are consistent with those of the previous year. The Group adopted the standards detailed below from 1 April 2018, resulting in restatements of comparative balances. No restatement of comparatives has been made outside of those required as a result of the new standards. Certain comparative information has also been reclassified to conform with the current period’s presentation. New Zealand Equivalent to International Financial Reporting Standard 15: Revenue from Contracts with Customers NZ IFRS 15 replaces NZ IAS 18: Revenue and related interpretations and applies to all revenue arising from contracts with customers. The new standard establishes a five-step model to account for revenue arising from contracts with customers. Under NZ IFRS 15 revenue is apportioned to individual performance obligations within customer contracts based on their relative stand-alone selling price. Based on certain criteria, revenue is then recognised either over time or at a point in time consistent with when these performance obligations are satisfied. The majority of the Group’s customers are on monthly recurring contracts, as a result NZ IFRS 15 has not had a material impact on recognition of revenue. Under NZ IFRS 15 the incremental costs of obtaining a contract, and costs directly related to fulfilling a contract are capitalised, where these costs are expected to be recovered. The costs are amortised over a period consistent with the estimated pattern of revenue recognition. The Group identified commission costs as an incremental cost of obtaining revenue contracts. These costs were expensed as incurred prior to the adoption of NZ IFRS 15 and are now capitalised. The Group adopted NZ IFRS 15 using the retrospective approach, resulting in restatement of comparative figures. All practical expedients available under this approach have been applied. 45 — Notes to the Financial Statements The effect of adopting NZ IFRS 15 on the Income Statement for the year ended 31 March 2018 is as follows: Income Statement impact Increase in subscription revenue Decrease in sales and marketing expenses Increase in income tax expense Decrease in net loss ($000s) 80 (4,168) 603 (3,645) The above effect on sales and marketing expenses includes an $11.4 million decrease in commission expense and a $7.2 million increase in amortisation expense. The effect of adopting NZ IFRS 15 on the Statement of Financial Position is as follows: Statement of Financial Position impact Assets Increase in intangible assets Decrease in deferred tax assets Total increase in assets Liabilities Increase in other current liabilities Increase in deferred tax liabilities Total increase in liabilities Total increase in equity At 31 March 2018 ($000s) At 1 April 2017 ($000s) 24,035 (2,658) 21,377 41 535 576 19,920 (2,206) 17,714 122 370 492 20,801 17,222 The adoption of NZ IFRS 15 also resulted in a reclassification in the Statement of Cash Flows between operating cash flows and investing cash flows. The reclassification resulted in an $11.6 million increase to operating cash flows and a corresponding decrease to investing cash flows. New Zealand Equivalent to International Financial Reporting Standard 9: Financial Instruments NZ IFRS 9: Financial Instruments replaces NZ IAS 39: Financial Instruments: Recognition and Measurement. The new standard includes three areas of change: 1. Classification and measurement of financial instruments 2. A single forward looking ‘expected loss’ impairment model 3. A new approach to hedge accounting Classification and measurement NZ IFRS 9 largely retains the existing requirements in NZ IAS 39 for the classification and measurement of financial liabilities. However, it eliminates the previous NZ IAS 39 categories for financial assets of held to maturity, loans and receivables, and available for sale. Under NZ IFRS 9, on initial recognition, a financial asset is classified as measured at amortised cost, fair value through other comprehensive income – debt investment, fair value through other comprehensive income – equity investment, or fair value through profit or loss. Additional information on the classification and measurement of the Group’s financial instruments under IFRS 9 is included in note 15. The adoption of the new categories has had no significant impact on the Group’s financial statements other than disclosure changes. New impairment model For financial assets, NZ IFRS 9 replaces the ‘incurred loss’ model in NZ IAS 39 with an ‘expected credit loss’ (ECL) model. Additional information on the recognition of impairment losses under NZ IFRS 9 is included in note 8. The adoption of the ECL requirements of NZ IFRS 9 resulted in an increase to the impairment allowances of Xero’s trade receivables. Notes to the Financial Statements — 46 Hedge accounting The Group applied the changes to hedge accounting under NZ IFRS 9 prospectively. At the date of the initial application, all of the Group’s existing hedging relationships were eligible to be treated as continuing hedging relationships. Consistent with prior periods, the Group has continued to designate the change in fair value of foreign exchange hedge derivative assets and liabilities in the Group’s cash flow hedge relationships. As such, the adoption of the hedge accounting requirements of NZ IFRS 9 had no significant impact on the Group’s financial statements. With the exception of hedge accounting which the Group applied prospectively, the Group applied NZ IFRS 9 retrospectively, resulting in restatement of comparative figures. The effect of adopting NZ IFRS 9 on the Income Statement for the year ended 31 March 2018 is as follows: Income Statement impact Increase in sales and marketing expenses Decrease in income tax expense Increase in net loss The effect of adopting NZ IFRS 9 on the Statement of Financial Position is as follows: Statement of Financial Position impact Assets Decrease in trade and other receivables Increase in deferred tax assets Total decrease in assets Liabilities Decrease in deferred tax liabilities Total decrease in liabilities Total decrease in equity ($000s) 76 (34) 42 At 31 March 2018 ($000s) At 1 April 2017 ($000s) (201) 30 (171) (4) (4) (126) - (126) - - (167) (126) New Zealand Equivalent to International Financial Reporting Standard 16: Leases NZ IFRS 16: Leases replaces NZ IAS 17: Leases. It introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value. Under the standard a right of use asset is recognised, representing the lessee’s right to use the underlying leased asset. A corresponding lease liability is recognised, representing the obligation to make lease payments. Under the new standard Xero recognises certain building and motor vehicle leases as right of use assets and lease liabilities. At lease inception the lease liability is measured at the present value of the remaining lease payments, discounted at Xero’s incremental borrowing rate. The unwind of the discount applied on recognition of a lease liability is recognised as interest expense in the Income Statement using the effective interest method. Right of use assets are measured at inception comprising the following: – The amount of initial measurement of lease liability – Any lease payments made at or before the commencement date, less any lease incentives received – Any initial direct costs and restoration costs Note 9 contains further disclosures on right of use assets. The Group early adopted NZ IFRS 16 using the retrospective approach, resulting in a restatement of comparative figures. 47 — Notes to the Financial Statements The effect of adopting NZ IFRS 16 on the Income Statement for the year ended 31 March 2018 is as follows: Income Statement impact Decrease in cost of revenue Decrease in sales and marketing expenses Decrease in product design and development expenses Decrease in general and administration expenses Decrease in other income Increase in finance expense Decrease in income tax expense Increase in net loss ($000s) (897) (614) (992) (214) (340) 3,100 (50) 674 The above changes include an $11.2 million decrease in rental expense and an $8.5 million increase in depreciation expense. The effect of adopting NZ IFRS 16 on the Statement of Financial Position is as follows: Statement of Financial Position impact Assets Decrease in trade and other receivables Increase in property, plant and equipment Increase in deferred tax assets Total increase in assets Liabilities Decrease in trade and other payables Increase in short-term lease liabilities Increase in long-term lease liabilities Decrease in deferred tax liabilities Decrease in other non-current liabilities Total increase in liabilities Total decrease in equity At 31 March 2018 ($000s) At 1 April 2017 ($000s) (530) 40,632 232 40,334 - 7,531 37,906 (91) (2,335) 43,011 (127) 24,981 178 25,032 (717) 6,475 21,286 (95) - 26,949 (2,677) (1,917) The adoption of NZ IFRS 16 also resulted in a reclassification in the Statement of Cash Flows between operating cash flows and financing cash flows. The reclassification resulted in a $8.4 million increase to operating cash flows and a corresponding decrease to financing cash flows. New Zealand Equivalent to International Financial Reporting Standard 3: Business Combinations During the year, the Group early adopted the amendments to NZ IFRS 3: Business Combinations as issued on 22 October 2018. The amendments narrow the scope of the definition of a business and introduce a ‘concentration test’ which, if met, eliminates the need for further assessment. Under this optional test, where substantially all of the fair value of gross assets acquired is concentrated in a single asset (or a group of similar assets), the assets acquired would not represent a business. Under the amendments the acquisition of Cicerone Limited (trading as Instafile) on 14 December 2018 is accounted for as an asset acquisition under NZ IAS 38: Intangible Assets with further detail disclosed in note 10. The adoption of the standards detailed above did not impact earnings per share (EPS) for the comparitive period, apart from the adoption of NZ IFRS 15 which resulted in a decrease in basic and diluted loss per share of $0.02 for the year ended 31 March 2018. (c) Standards or interpretations issued but not yet effective and relevant to the Group There are no standards or amendments that have been issued but are not yet effective that are expected to have a significant impact on the Group. The Group has not adopted, and currently does not anticipate adopting, any standards prior to their effective dates other than those detailed above. Notes to the Financial Statements — 48 (d) Critical accounting estimates In applying the Group’s accounting policies, management continually evaluates judgements, estimates and assumptions based on experience and other factors, including expectations of future events that may have an impact on the Group. All judgements, estimates and assumptions made are believed to be reasonable based on the most current set of circumstances available to the Group. Actual results may differ from the judgements, estimates and assumptions. The significant judgements, estimates and assumptions made by management in the preparation of these financial statements are outlined within the financial statement notes to which they relate. 3. Segment information The Group operates in one business segment, providing online business solutions for small businesses and their advisors. Xero has two operating segments: Australia and New Zealand (ANZ) and International. These segments have been determined based on how the Xero leadership team (the chief operating decision-maker) reviews financial performance. Segment operating expenses represent sales and marketing costs and service delivery costs, including both in-country costs and an allocation of centrally managed costs. Year ended 31 March 2019 Operating revenue Expenses Other income Segment contribution Year ended 31 March 2018 restated Operating revenue Expenses Other income Segment contribution Reconciliation from segment contribution to net loss before tax Year ended 31 March Segment contribution Product design and development General and administration Asset impairments Other expenses Other income Finance income Finance expense Net loss before tax ANZ ($000s) International ($000s) Total ($000s) 359,107 (140,175) 69 219,001 193,712 552,819 (198,754) (338,929) 331 (4,711) 400 214,290 275,901 130,758 406,659 (118,683) (145,869) (264,552) 16 1,071 1,087 157,234 (14,040) 143,194 2019 ($000s) 214,290 2018 Restated ($000s) 143,194 (137,795) (116,305) (66,072) (18,604) (1,183) 687 8,035 (22,494) (23,136) (46,737) (1,550) (723) – 2,440 (4,190) (23,871) At 31 March 2019, $316.6 million, or 83%, of the Group's property, plant and equipment and intangible assets were domiciled in New Zealand (restated 2018: $181.8 million, or 79%) 49 — Notes to the Financial Statements Depreciation and amortisation by segment Year ended 31 March ANZ International Corporate (not allocated to a segment) Total Non-cash share-based payments by segment Year ended 31 March ANZ International Corporate (not allocated to a segment) Total 4. Revenue Revenue by geographic location Year ended 31 March Australia United Kingdom New Zealand North America Rest of World 2019 ($000s) 11,379 14,542 55,927 81,848 2019 ($000s) 5,600 8,325 15,021 2018 Restated ($000s) 8,526 12,173 49,619 70,318 2018 ($000s) 3,577 5,888 7,539 28,946 17,004 2019 ($000s) 261,468 119,521 97,639 44,270 29,921 2018 Restated ($000s) 197,094 79,611 78,807 31,873 19,274 Total operating revenue 552,819 406,659 Subscription revenue Subscription revenue comprises the recurring monthly fees from subscribers to Xero’s online software. Subscribers are invoiced monthly. Unbilled revenue at year end is recognised in the Statement of Financial Position as accrued income and included within trade and other receivables. Unearned revenue at year end is recognised in the Statement of Financial Position as income in advance and included within other current liabilities. Other operating revenue Other operating revenue comprises revenue from related services such as education and the implementation of the online software services, along with conference income, and financial web income. Notes to the Financial Statements — 50 Revenue is recognised as performance obligations under customer contracts are met. Performance obligations for subscriptions to Xero’s cloud based software consist of the provisioning of the software and related support services over the term of the contract. Where the performance obligations of add-ons are usage based (such as payroll and expenses), revenue is recognised consistent with the usage profile. Performance obligations under financial web arrangements include the referral of customers to the revenue share counterparty and the continued servicing of that customer by the counterparty. Performance obligations for implementation revenue consist of the delivery of the implementation services. Implementation service revenue is recognised based on percentage of completion of the relating services. Performance obligations for conference and event revenue consists of the delivery of the conference or event. 5. Expenses Overhead allocation The presentation of the Income Statement by function requires certain overhead costs to be allocated to functions. These allocations require management to apply judgement. Facilities, internal information technology costs, and depreciation and amortisation not relating to product software development have been allocated to each function on a headcount basis. Recruitment costs have been allocated according to the number of employees employed in each function during the period. The amortisation of product-related software development is included in product design and development. Sales tax The Income Statement and the Statement of Cash Flows have been prepared so that all components are stated exclusive of sales tax, except where sales tax is not recoverable. All items in the Statement of Financial Position are stated net of sales tax with the exception of receivables and payables, which include sales tax invoiced. Sales tax includes Goods and Services Tax and Value Added Tax where applicable. Cost of revenue and operating expenses Year ended 31 March Employee entitlements Employee entitlements capitalised Share-based payments Share-based payments capitalised Advertising and marketing Platform costs Consultants and contractors Computer equipment and software Travel-related costs Superannuation costs Communication, insurance and office administration Rental costs Staff recruitment Auditors' remuneration Other operating expenses 2019 ($000s) 301,559 (82,200) 36,612 (7,666) 76,421 33,468 18,506 19,380 11,601 11,373 6,820 3,487 2,166 821 2018 Restated ($000s) 234,758 (65,003) 21,589 (4,585) 61,122 30,068 14,804 13,815 9,245 8,188 5,051 2,372 2,340 417 28,600 23,095 Total cost of revenue and operating expenses excl. depreciation and amortisation * 460,948 357,276 *Includes grant income of $5.2 million (2018: $4.5 million) 51 — Notes to the Financial Statements Depreciation and amortisation Year ended 31 March Relating to: Amortisation of development costs Amortisation of other intangible assets Depreciation of property, plant and equipment Total depreciation and amortisation Total cost of revenue and operating expenses Depreciation and amortisation included in function expenses as follows: Product design and development Cost of revenue Sales and marketing General and administration Total depreciation and amortisation Auditors' remuneration Year ended 31 March Audit and review of financial statements Other assurance services * Taxation services Other services ** Total fees paid to auditors 2019 ($000s) 2018 Restated ($000s) 53,600 10,358 17,890 81,848 45,614 8,195 16,509 70,318 542,796 427,594 53,012 5,393 20,529 2,914 81,848 47,850 5,603 15,055 1,810 70,318 2019 ($000s) 2018 ($000s) 323 452 43 3 821 252 135 28 2 417 * Services relate to assurance services in connection with reporting on service organisation controls, ISO 27001 certification, comfort letter over convertible notes issuance, and compliance engagement in respect of grant funding. These additional independent assurance services are closely related to the financial statement audit ** Services relate to provision of remuneration market data 6. Finance income and expense Finance income Finance income comprises interest income on cash and short-term deposits. Interest income is recognised as it is accrued using the effective interest method. The effective interest method calculates the amortised cost of the financial asset and allocates the interest income over its expected life. Finance expense Year ended 31 March Interest on convertible notes Bank standby facility costs Finance lease interest Other finance expense Total finance expense 2019 ($000s) 12,753 1,847 4,987 2,907 22,494 2018 Restated ($000s) – 775 3,100 315 4,190 Notes to the Financial Statements — 52 7. Earnings per share The Group presents basic and diluted earnings per share (EPS) for its ordinary shares. Basic EPS is calculated by dividing the net loss attributable to ordinary shareholders of the Company by the weighted average number of ordinary shares on issue during the year, excluding shares held as treasury shares. Diluted EPS is determined by adjusting the net loss attributable to ordinary shareholders and the weighted average number of ordinary shares on issue for the effects of all dilutive potential ordinary shares, which comprise treasury shares, options, and restricted stock units (RSUs) granted to employees, directors, and advisors. Potential ordinary shares are treated as dilutive when their conversion to ordinary shares would decrease EPS or increase the loss per share. Year ended 31 March Weighted average number of issued ordinary shares Net loss after tax Basic and diluted loss per share (in New Zealand dollars) *Except for per share amounts 8. Trade and other receivables At 31 March Accrued income Prepayments Trade receivables Provision for doubtful debts Interest receivable Rental bonds and other receivables Total trade and other receivables 2019 (000s)* 139,204 ($27,143) ($0.19) 2018 Restated (000s)* 137,566 ($24,914) ($0.18) 2019 ($000s) 21,957 16,405 7,064 (504) 3,465 1,079 2018 Restated ($000s) 19,089 8,477 5,525 (426) 455 672 49,466 33,792 Trade and other receivables are initially recognised at the fair value of the amounts to be received, plus transaction costs (if any). They are subsequently measured at amortised cost (using the effective interest method) less impairment losses. Trade receivables relate primarily to the monthly subscriptions to Xero's products. Subscriptions are charged monthly, the majority being paid by direct debit. At 31 March 2019 trade receivables of the Group of $704,000 were past due and are considered partially impaired (2018: $444,000). At 1 April 2017 accrued income was $14.0 million. Key estimates and assumptions In accordance with NZ IFRS 9, the Group recognises impairment losses using the Expected Credit Loss (ECL) model. ECLs are based on the difference between the contractual cash flows due in accordance with the contract and the cash flows that the Group expects to receive. The shortfall is discounted at an approximation to the asset’s original effective interest rate. Under the ECL model, impairment losses may be measured as either the 12 month ECL, which is the portion of lifetime ECLs that result from default events that are possible within 12 months after the reporting date, or the lifetime ECL, which is the expected credit loss resulting from all possible default events over the expected life of the financial instrument. The Group has elected to use the lifetime ECL model to calculate the impairment for trade receivables. A six month historical default rate is applied to the current period trade receivable balance to calculate any impairment. The carrying amount of the asset is reduced through the use of a provision account, and the amount of the loss is recognised in the Income Statement. When a receivable is uncollectible, it is written off against the provision account for receivables. Subsequent recoveries of amounts previously written off are credited to the Income Statement. 53 — Notes to the Financial Statements 9. Property, plant and equipment Cost Restated balance at 1 April 2018 Additions Disposals and write-offs Impairments Foreign exchange adjustment Balance at 31 March 2019 Accumulated depreciation Restated balance at 1 April 2018 Depreciation expense Disposals and write-offs Impairments Foreign exchange adjustment Balance at 31 March 2019 Net book value at 31 March 2019 Leasehold improvements ($000s) Motor vehicles ($000s) Computer equipment ($000s) Furniture and equipment ($000s) Right of use asset ($000s) Total ($000s) 89,223 50,368 (9,044) (2,136) 1,001 5,817 4,669 (1,655) – 59 10,761 3,828 (1,660) – 123 57,680 33,520 (3,148) (2,136) 848 8,890 13,052 86,764 129,412 2,390 3,084 (1,646) – 27 3,855 5,035 5,074 2,020 (1,660) – 76 5,510 7,542 15,261 10,709 (1,285) (1,639) 278 23,324 63,440 27,419 17,890 (6,125) (1,639) 376 37,921 91,491 14,938 8,351 (2,554) – (29) 20,706 4,667 2,077 (1,507) – (5) 5,232 15,474 27 – (27) – – – 27 – (27) – – – – Leasehold improvements ($000s) Motor vehicles ($000s) Computer equipment ($000s) Furniture and equipment ($000s) Right of use asset ($000s) Total ($000s) Cost Restated balance at 1 April 2017 Additions Disposals and write-offs Foreign exchange adjustment Restated balance at 31 March 2018 Accumulated depreciation Restated balance at 1 April 2017 Depreciation expense Disposals and write-offs Foreign exchange adjustment Restated balance at 31 March 2018 Restated net book value at 31 March 2018 13,159 6,838 (5,052) (7) 14,938 5,955 3,301 (4,621) 32 4,667 10,271 147 – (120) – 27 135 12 (120) – 27 – 6,331 3,964 (4,502) 24 5,817 3,009 2,454 (3,075) 2 2,390 3,427 9,558 2,674 (1,436) (35) 41,825 27,857 (11,600) (402) 71,020 41,333 (22,710) (420) 10,761 57,680 89,223 4,611 1,861 (1,431) 33 5,074 5,687 16,448 8,881 (9,966) (102) 30,158 16,509 (19,213) (35) 15,261 27,419 42,419 61,804 Notes to the Financial Statements — 54 Key estimates and assumptions Property, plant and equipment are stated at historical cost less depreciation. Depreciation on assets is charged on a straight-line basis to allocate the differences between their original cost and the residual values over their estimated useful lives, as follows: Leasehold improvements Motor vehicles Computer equipment Furniture and equipment Right of use asset* *Substantially all of the right of use asset relates to building leases. Term of lease 5 years 2 – 3 years 2 – 7 years Term of lease The residual values and useful lives of assets are reviewed and adjusted if appropriate at each balance date. If an asset's carrying amount is greater than its estimated recoverable amount, the carrying amount is immediately written down to its recoverable amount. 10. Intangible assets Software development ($000s) Software licences ($000s) Note Contract acquisition asset ($000s) Other intangible assets ($000s) Goodwill ($000s) Total ($000s) Cost Restated balance at 1 April 2018 239,575 1,939 40,704 Additions * Acquisitions Disposals and write-offs Impairments ** Foreign exchange adjustment Balance at 31 March 2019 Accumulated amortisation Restated balance at 1 April 2018 Amortisation Disposals and write-offs Impairments Foreign exchange adjustment Balance at 31 March 2019 Net book value at 31 March 2019 89,583 15,508 18 – – 13,384 (30,726) (1,939) (4,301) (30,696) – 283,244 – – – – 648 464 – 5,165 287,847 – 102,967 – 5,270 78,773 99,551 (1) – – – (36,967) (5,165) (35,861) – 648 50,435 5,733 78,773 418,185 100,429 53,600 1,757 182 (30,726) (1,939) (17,754) – 105,549 177,695 – – – – 16,669 9,154 (4,301) – 186 21,708 28,727 176 1,022 (1) – – 1,197 – – – – – – 119,031 63,958 (36,967) (17,754) 186 128,454 4,536 78,773 289,731 * Includes $14.5 million of externally purchased assets, of which $2.5m related to the acquisition of Instafile (2018: externally purchased assets of $9.0 million) ** Included within impairments for the period ended 31 March 2019 is a $16.3 million impairment of software development and goodwill related to decision to discontinue the US payroll product and move to a full service payroll solution in the US provided by our partner Gusto 55 — Notes to the Financial Statements Software development ($000s) Software licences ($000s) Contract acquisition asset ($000s) Other intangible assets ($000s) Goodwill ($000s) Total ($000s) Cost Restated balance at 1 April 2017 185,093 2,004 Additions * Disposals and write-offs Impairments Foreign exchange adjustment Adjustment due to change in tax rates Restated balance at 31 March 2018 Accumulated amortisation Restated balance at 1 April 2017 Amortisation Disposals and write-offs Impairments Foreign exchange adjustment 67,524 (10,810) (2,232) – – – (65) – – – 31,135 11,369 (1,631) – (169) – 941 – (477) – – – 5,352 224,525 – – – – (187) 78,893 (12,983) (2,232) (169) (187) 239,575 1,939 40,704 464 5,165 287,847 66,307 45,614 (10,810) (682) – 858 964 (65) – – 11,215 7,184 (1,631) – (99) 606 47 (477) – – 176 288 – – – – – – 78,986 53,809 (12,983) (682) (99) 119,031 5,165 168,816 Restated balance at 31 March 2018 100,429 1,757 16,669 Restated net book value at 31 March 2018 139,146 182 24,035 Key estimates and assumptions Software development Costs that are directly associated with the development of software are recognised as intangible assets where the following criteria are met: – It is technically feasible to complete the software product so that it will be available for use – Management intends to complete the software product and use or sell it – There is an ability to use or sell the software product – It can be demonstrated how the software product will generate probable future economic benefits – Adequate technical, financial and other resources to complete the development and to use or sell the software product are available – The expenditure attributable to the software product during its development can be reliably measured Other development expenditure that does not meet the above criteria is recognised as an expense as incurred. Development costs previously recognised as expenses are not recognised as assets in a subsequent period. Research costs and costs associated with maintenance are recognised as an expense as incurred. At 31 March 2019, if software development capitalisation rates had been 10% higher/lower with all other variables held constant, the impact on operational expenses would have been $7.4 million lower/higher. Contract acquisition costs In accordance with NZ IFRS 15, Xero capitalises incremental costs of obtaining customer contracts. Capitalisable costs consist of sales commissions that have a direct relationship to new revenue contracts obtained. Costs capitalised are amortised to sales and marketing and expensed over the average period of benefit associated with the costs. The period of benefit for the contract acquisition asset is determined to be five years. Management have determined this as appropriate with reference to estimated customer lifespans and the useful lives of the software sold to which the commissions relate. Notes to the Financial Statements — 56 Other intangible assets Other intangible assets consist of patents, domains, and trademark costs, along with customer contracts. Other intangible assets acquired are initially measured at cost. Internally generated assets, excluding capitalised development costs, are not capitalised and expenditure is recognised in the Income Statement when the expenditure is incurred. Useful lives of intangible assets With the exception of goodwill, the useful lives of the Group's intangible assets are assessed to be finite. Assets with finite lives are amortised over their useful lives and tested for impairment whenever there are indications that the assets may be impaired. Amortisation is recognised in the Income Statement on a straight-line basis over the estimated useful life of the intangible asset, from the date it is available for use. The estimated useful lives are as follows: Software development Software licences Contract acquisition asset Customer contracts Patents, domains and trademark costs Impairment considerations 3 – 7.5 years 1 – 3 years 5 years 3 years 5 – 10 years At each reporting date, the Group assesses whether there is any indication that an asset may be impaired. Where an indicator of impairment exists, the Group makes a formal estimate of the recoverable amount. Where the carrying value of an asset exceeds its recoverable amount, the asset is considered impaired and is written down to its recoverable amount. The recoverable amount is the greater of fair value less costs to sell or the asset’s value in use. For the purposes of assessing impairment, assets are grouped at the lowest levels for which there are separately identifiable cash flows. The Group recognised impairment losses of $12.9 million during the year ended 31 March 2019 on write-down of software development (2018: $1.5 million). Goodwill is tested at least annually for impairment, or whenever indicators of impairment exist. An impairment loss is recorded if its recoverable amount is less than its carrying amount. The recoverable amount is the higher of fair value less costs to sell and value in use. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate. The Group recognised impairment losses of $5.2 million during the year ended 31 March 2019 on the write down of goodwill that arose from the acquisition of Monchilla Inc as the Group decided to discontinue its payroll product. Goodwill and goodwill impairment testing Goodwill represents the excess of purchase considerations over the fair value of net assets acquired in a business combination. Goodwill is allocated to cash-generating units (CGUs), which are the lowest level of assets for which separately identifiable cash flows can be attributed. Xero's goodwill at 31 March 2019 relates to the acquisition of Hubdoc Inc. and has been allocated to the Hubdoc CGU. The recoverable amount of the Hubdoc CGU was calculated on the basis of value in use using a discounted cash flow model. Future cash flows were projected for ten years, with key assumptions being CGU earnings which is based on expected future performance of the CGU. A growth rate of 15.0% was applied for years 10 to 20, with a terminal growth rate of 3.0% being applied. A pre-tax discount rate of 20.0% was utilised. The terminal growth rate is determined based on the long-term anticipated growth rate of the business. The forecast financial information is based on both past experience and future expectations of CGU performance. The major inputs and assumptions used in performing an impairment assessment that require judgement include revenue forecasts, operating cost projections, discount rates, terminal growth rates, and future technology paths. During the year ended 31 March 2019, no impairment arose as a result of the review of the Hubdoc goodwill. The recoverable amount of the Hubdoc CGU is greater than the carrying amount. 57 — Notes to the Financial Statements 11. Trade and other payables At 31 March Trade payables Accrued expenses Sales tax payable Total trade and other payables 2019 ($000s) 5,690 15,434 5,919 2018 ($000s) 7,383 13,461 5,441 27,043 26,285 The Group recognises trade and other payables initially at fair value and subsequently at amortised cost using the effective interest method. The amounts are unsecured and non-interest bearing. 12. Other current liabilities At 31 March Contingent consideration Income in advance Accrued interest Other short-term liabilities Total other current liabilities 2019 ($000s) 13,455 7,682 5,114 309 26,560 2018 Restated ($000s) – 4,146 – 1,348 5,494 The Group recognises other current liabilities, excluding contingent consideration, initially at fair value, and subsequently at amortised cost using the effective interest method. Contingent consideration is recognised at the present value of expected future cash flows, adjustments are made to the fair value where expected achievement against targets changes. Income in advance is recognised when the Group has received consideration prior to services being rendered. All income in advance from the prior period was subsequently recognised as revenue in the year. 13. Lease liabilities At 31 March Balance at 1 April Leases entered into during the period Principal repayments Change in future lease payments Foreign exchange adjustment Total lease liabilities Current Non-current 2019 ($000s) 45,437 47,767 (9,103) (1,889) 637 2018 Restated ($000s) 27,761 28,042 (8,432) (1,867) (67) 82,849 45,437 11,541 71,308 7,531 37,906 Under NZ IFRS 16: Leases the Group is required to recognise lease liabilities for contracts identified as containing a lease, except when the lease is for 12 months or less or the underlying asset is of low value. Payments associated with short-term leases and leases of low-value assets are recognised on a straight-line basis as an expense in the Income Statement. Low-value assets comprise IT equipment and small items of office furniture. The expense relating to low-value assets for the year ended 31 March 2019 was $2.2 million (2018: $0.6 million). Notes to the Financial Statements — 58 Lease liabilities are initially measured at the present value of the remaining lease payments, discounted at Xero's incremental borrowing rate. Subsequently the carrying value of the liability is adjusted to reflect interest and lease payments made. Lease liabilities may be re-measured when there is a change in future lease payments arising from a change in an index or market rate, or if there is a change in the Group's estimate of the amount expected to be payable. Key estimates and assumptions The Group assesses at lease commencement whether it expects to exercise renewal options where these are included in the contract. Where it is reasonably certain that renewal options will be exercised, the extension period is included in the lease liability calculation. 14. Term debt Convertible notes In September 2018, Xero Investments Limited, a wholly owned subsidiary of the Company, made an offering of USD300 million of convertible notes. The convertible notes were settled and listed on the Singapore Exchange Securities Trading Limited (SGX-ST) on 5 October 2018. The notes have a coupon interest rate of 2.375% per annum, payable six-monthly in arrears. The initial conversion of the notes is USD46.3386 per ordinary share based on a fixed exchange rate of AUD1.00 = USD0.72745. The notes are unsubordinated, unsecured obligations of Xero, and are scheduled to mature on 4 October 2023. The settlement of the notes will be in cash unless Xero elects to settle in shares, in which case Xero will be obliged to deliver ordinary shares to relevant noteholders. The cash settlement amount will be calculated based on the volume-weighted average price of the ordinary shares over a 90 day trading period. In connection with the issue of the notes, Xero entered into derivative financial instruments in the form of call spread options. Transaction costs Xero incurred $11.2 million of transaction costs related to the issuance of the convertible notes and call spread options. Transaction costs relating to the convertible notes have been allocated between the debt component and the conversion derivatives using the relative proportions of these on initial measurement of the instruments. Costs attributed to the debt component are amortised to finance expense over the term of the convertible notes using the effective interest method. Costs attributable to the conversion derivatives were immediately recognised in the Income Statement. Transaction costs related to the call spread options have been attributed equally between the lower call options and the upper call options, with the lower call option costs being immediately recognised in the Income Statement. Costs attributable to the upper strike call options are deducted from the amount recognised in equity. Notes and conversion feature derivative The conversion feature of the notes is required to be separated from the notes and is accounted for as a derivative financial liability. The fair value of the embedded conversion derivative at the time of issuance was $85.0 million and was recorded at a discount for purposes of accounting for the debt component of the notes. The discount is amortised as interest expense using the effective interest method over the term of the notes. 59 — Notes to the Financial Statements The principal amount, unamortised debt discount, unamortised issue costs, and net carrying amount of the liability component of the convertible notes as at 31 March 2019 is as follows: At 31 March 2019 Principal amount Unamortised debt discount Unamortised issue costs Term debt ($000s) 440,787 (75,984) (7,072) 357,731 The effective interest rate for the convertible notes is 7.30%. Coupon interest expense, and amortisation of debt discount and issue costs for the year ended 31 March 2019 were as follows: Year ended 31 March 2019 Coupon interest expense Amortisation of debt discount and issue costs Total finance expense on convertible notes ($000s) 5,126 7,627 12,753 Call spread options In connection with the issue of the convertible notes, Xero purchased call spread options which are expected to reduce potential dilution to shareholders upon conversion of the notes and to offset any cash payments Xero may be required to make in excess of the principal amounts on conversion. The call spread options consist of 6.5 million lower strike call options purchased with an average strike price equal to the conversion price of the notes, and 6.5 million upper strike call options sold with an average strike price of USD60.5966. The call spread options expire in October 2023. The aggregate cost of the call spread was $44.9 million, which was paid from proceeds of the convertible notes. The upper strike call options are accounted for as equity, and are recognised at their initial fair value, less transaction costs. The carrying value of the upper strike options is $35.3 million. Bank loan In August 2018 Xero entered into a $30.9 million term loan with the BNZ and ANZ banks to fund the cash portion of the acquisition of Hubdoc. The loan was repaid early in October 2018 with proceeds from the convertible notes. 15. Financial instruments, capital and financial risk management Financial instruments Financial instruments recognised in the Statement of Financial Position include cash and cash equivalents, short-term deposits, receivables and payables, contingent consideration, term debt, and derivative financial instruments. The Group’s policy is that no speculative trading in financial instruments may be undertaken. Classification and fair values Xero has carried out a fair value assessment of its financial assets and liabilities at 31 March 2019 in accordance with NZ IFRS 9: Financial Instruments. Under NZ IFRS 9 financial instruments are classified into either measured at amortised cost, fair value through other comprehensive income or fair value through profit or loss. The classification of the Group's financial instruments into these categories is included within the table below. The Group’s foreign exchange hedging derivatives are recognised at fair value. Fair value is determined using forward exchange rates that are quoted in an active market (level two on the fair value hierarchy). The fair values of the conversion feature and call option derivative asset are determined using valuation techniques. These valuation techniques maximise the use of observable market data where it is available and rely as little as possible on entity-specific estimates. Inputs into the valuation include share price volitility and time to expiration. The fair value of the convertible notes on initial recognition is determined using a market interest rate for an equivalent non-convertible bond, with the residual amount allocated to the derivative conversion feature. The fair value of the debt component of the convertible notes at 31 March 2019 was $362.6 million. The carrying value of the Group’s other financial instruments do not materially differ from their fair value. Notes to the Financial Statements — 60 Financial assets at amortised cost ($000s) Financial instruments at fair value through profit or loss ($000s) Financial liabilities at amortised cost ($000s) Total carrying value ($000s) 121,527 336,819 33,688 3,567 73,999 569,600 21,124 147 77,367 357,731 18,569 600 – – – 3,567 73,999 77,566 – 147 77,367 – – – – – – 21,124 – – – 357,731 5,114 – 13,455 600 91,569 – – – 2,549 2,549 – 822 822 383,969 475,538 – – – – – 20,844 – 20,844 20,955 59,000 27,522 2,549 110,026 20,844 822 21,666 At 31 March 2019 Assets Cash and cash equivalents Term deposits Trade and other receivables Derivative assets (hedging derivatives)* Derivative assets (call spread options) Total financial assets Liabilities Trade and other payables Derivative liabilities (hedging instruments)* Derivative liabilities (conversion feature on convertible notes) Term debt Other current liabilities Other non-current liabilities Total financial liabilities Restated balance at 31 March 2018 Assets Cash and cash equivalents Term deposits Trade and other receivables Derivative assets (hedging derivatives)* Total financial assets Liabilities Trade and other payables Derivative liabilities (hedging derivatives)* Total financial liabilities 121,527 336,819 33,688 – – 492,034 – – – – – – – 20,955 59,000 27,522 – 107,477 – – – *Hedging derivatives are hedge accounted when possible with unrealised gains and losses recognised in other comprehensive income until the underlying expense impacts the Income Statement Capital management The capital structure of the Group primarily consists of equity raised by the issue of ordinary shares in the Company and issued debt. Xero manages its capital to ensure that it maintains an appropriate capital structure to support its business and maximise shareholder value. The Group’s capital structure is adjusted based on business needs and economic conditions. During the year ended 31 March 2019, Xero issued USD300 million of convertible notes for the purpose of investments into strategic and complementary businesses and assets which are in line with the Group’s strategy to drive long-term shareholder value. As part of the Group's ongoing risk management, a $100 million syndicated (with BNZ and ANZ) standby debt facility was put in place in November 2017. The facility expires in November 2019. This facility was put in place to provide additional liquidity headroom to navigate against unanticipated events. It is undrawn and there are no current plans to draw down on the facility. The facility agreement contains financial undertakings usual for facilities of this nature. 61 — Notes to the Financial Statements Financial risk management The Group is exposed to the following risks through the normal course of business and from its use of financial instruments: a. Market risk b. Liquidity risk c. Credit risk The following presents both qualitative and quantitative information on the Group's exposure to each of the above risks, along with policies and processes for managing risk. (a) Market risk The Group is exposed to market risk primarily through changes in foreign currency exchange rates and interest rates. Foreign currency risk Nature of risk Foreign currency risk is the risk that the New Zealand dollar (NZD) net cash flows that flow through to the Group are negatively impacted by changes to foreign currency exchange rates. Exposure and risk management Xero is exposed to currency risk from the operations of foreign subsidiaries and foreign currency denominated expenses in the parent Company. The Group has significant operations in three other currencies, being Great British pounds (GBP), Australian dollars (AUD), and United States dollars (USD), with exposures to other currencies to a lesser degree. The material exposures are USD outflows as well as AUD and GBP inflows. In order to reduce the impact of short-term movements in exchange rates, the Group's treasury policy requires a portion of the next 18 months' cash flows to be hedged with forward exchange contracts and vanilla options (outright purchased options and vanilla collars). The Group's exposure to monetary foreign currency financial instruments and lease liabilities is outlined below in New Zealand dollars: AUD ($000s) USD ($000s) GBP ($000s) At 31 March 2019 Exposures Cash and cash equivalents, and short-term deposits 14,664 366,744 Trade and other receivables Trade and other payables Other current liabilities Other non-current liabilities Lease liabilities Term debt (including conversion feature) Derivative financial instruments (hedging derivatives) Total foreign currency exposure Restated balance at 31 March 2018 Exposures Cash and cash equivalents Trade and other receivables Trade and other payables Lease liabilities Derivative financial instruments Total foreign currency exposure 914 (2,649) – – 635 (3,639) (18,569) – (5,872) (19,557) – (440,788) 5,734 1,928 (4,787) – (600) (3,135) – (64,667) (57,610) 65,804 (49,370) (58,957) (59,817) 4,583 1,127 (2,949) (5,685) (68,781) 1,642 396 (3,948) (11,791) 59,771 (71,705) 46,070 5,816 1,387 (3,767) (4,248) (30,541) (31,353) Notes to the Financial Statements — 62 As at 31 March 2019 a movement of 10% in the NZD would impact the Income Statement and Statement of Changes in Equity (after hedging) as detailed in the table below: Impact on: Net loss before income tax (increase/(decrease)) Equity (before income tax) (increase/(decrease)) 10% decrease 10% increase 2019 ($000s) 2018 ($000s) 2019 ($000s) 2018 ($000s) (905) 1,199 (4,456) (7,671) 740 889 3,646 6,211 This analysis assumes a movement in the NZD across all currencies and only includes the effect of foreign exchange movements on financial instruments. All other variables remain constant. Interest rate risk Nature of risk Interest rate risk is the risk that changes in interest rates negatively impact the Group's financial performance or the value of its financial instruments. Exposure and risk management The Group's interest rate risk arises from its cash and cash equivalents and short-term deposit balances, and when term debt at fixed rates is refinanced. Cash and cash equivalents comprise cash on hand, deposits held on call with banks, and other short-term and highly liquid investments with original maturities of 90 days or less. Balances are placed on short-term deposit at fixed rates. The repricing of these at maturity exposes the Group to interest rate risk. The convertible notes give rise to interest rate risk at maturity (October 2023) if the Group were to refinance at interest rates prevailing at the time, with higher interest rates increasing the cost of debt financing. The Group does not currently enter into interest rate hedges. However, management regularly reviews its banking arrangements to ensure it achieves the best returns on its funds while maintaining access to necessary liquidity levels to service the Group’s day-to-day activities. Sensitivity to interest rate risk If interest rates for the year had been 1.0% higher/lower with all other variables held constant, the impact on the interest income, net loss and accumulated losses of the Group would have been $4.6 million lower/higher (2018: $0.8 million). This analysis assumes that the cash and cash equivalents and short-term deposits balance was consistent with the year end balance throughout the year. (b) Liquidity risk Nature of risk Liquidity risk is the risk that the Group cannot pay contractual liabilities as they fall due. Exposure and risk management At 31 March 2019 the Group held cash and cash equivalents of $121.5 million and term deposits of $336.8 million. Of this, $87.4 million of cash and cash equivalents and $271.8 million of term deposits relates to the proceeds from the issue of convertible notes, which is intended to be used for investments into strategic and complementary businesses and assets. The remaining $34.1 million of cash and cash equivalents and $65.0 million of term deposits available to service the Group’s day-to-day activities. The $100 million syndicated standby facility provides additional liquidity to cover unforeseen operating cash flow requirements. The facility expires in November 2019 and is currently expected to be replaced with a similar standby facility arrangement. The liquidity risk that arises on maturity of the convertible notes in October 2023 is being closely monitored by management, with the intention that there will be repayment or refinancing plans in place in advance of this, to ensure that the Group has sufficient liquidity to meets its contractual obligations as they fall due. 63 — Notes to the Financial Statements The Group's exposure to liquidity risk based on undiscounted contractual cash flows relating to financial liabilities and lease liabilities is summarised below: At 31 March 2019 Non-derivative financial liabilities Trade and other payables Lease liabilities Term debt* Other current liabilities Other non-current liabilities Contractual cash flows Derivative financial liabilities Forward exchange contracts Inflows Outflows Contractual cash flows Less than 12 months Between 1 and 2 years Between 2 and 5 years ($000s) ($000s) ($000s) Over 5 years ($000s) Total contractual cash flows ($000s) Carrying amount ($000s) 21,124 17,819 10,349 13,455 – – 17,009 10,469 – 600 – 30,849 472,193 – – – 53,200 – – – 21,124 118,877 493,011 13,455 600 21,124 82,849 362,845 13,455 600 62,747 28,078 503,042 53,200 647,067 480,873 – 17,467 (17,899) (432) – – – – – – – – – – – – – 17,467 (17,899) (432) 147 – – 147 * Term debt cashflows include $5.1m of interest included in other current liabilities as at 31 March 2019 Restated balance at 31 March 2018 Non-derivative financial liabilities Trade and other payables Lease liabilities Contractual cash flows Derivative financial liabilities Forward exchange contracts Inflows Outflows Contractual cash flows (c) Credit risk 20,844 11,574 32,418 – 50,625 (51,278) (653) – 10,888 10,888 – 7,083 (7,100) (17) – 19,940 19,940 – 17,323 17,323 – – – – – – – – 20,844 59,725 80,569 – 57,708 (58,378) (670) 20,844 45,437 66,281 822 – – 822 Nature of risk Credit risk arises in the normal course of Xero’s business on financial assets if a counterparty fails to meet its contractual obligations. Exposure and risk management Financial instruments that potentially subject the Group to credit risk principally consist of cash and cash equivalents, short-term deposits, derivatives, and receivables. The Group manages credit risk by placing cash, short-term deposits and derivative contracts with high quality financial institutions. The exposure to the credit risk of the call option counterparties means that in the event of default we may have to pay an increased amount on settlement of the convertible notes. The Group manages liquidity factoring in any risk of default. The credit risk associated with trade receivables is small due to the inherently low individual transaction value and the distribution over a large number of customers. Notes to the Financial Statements — 64 Group financial assets subject to credit risk at balance date are as follows: At 31 March Cash and cash equivalents Short-term deposits Trade and other receivables Derivative financial assets Non-current assets 2019 ($000s) 121,527 336,819 33,061 77,566 627 2018 Restated ($000s) 20,955 59,000 25,315 2,549 2,207 Total financial assets subject to credit risk 569,600 110,026 A summary of the Group's exposure to credit risk on cash and cash equivalents, short term deposits and derivatives categorised by external credit risk grading is as follows: At 31 March Cash, and cash equivalents and short term deposits A-1+ A-1 A-2 Total cash, and cash equivalents and short-term deposits Derivative assets A-1+ A-1 Total derivative assets Total 2019 ($000s) 2018 ($000s) 406,613 47,533 4,201 78,539 1 1,415 458,347 79,955 2,923 74,643 77,566 535,913 1,775 774 2,549 82,504 The Group's trade and other receivables and non-current assets are with counter-parties who have no external credit risk rating. Due to the nature of the Group's business the balances do not consist of any concentration of risk that is considered individually material. Of the total trade and other receivables and non-current asset balance, $704,000 is past due and considered to be partially impaired (2018: $444,000). 65 — Notes to the Financial Statements 16. Derivatives and hedge accounting The Group's derivative financial instruments consist of forward exchange contracts, vanilla foreign exchange options (outright purchased options and vanilla collars), conversion feature of the convertible notes, and call spread options entered into in connection with the convertible notes. At 31 March Current derivative assets Call spread options Forward exchange contracts Foreign exchange options Non-current derivative assets Forward exchange contracts Foreign exchange options Total derivative assets Current derivative liabilities Forward exchange contracts Foreign exchange options Non-current derivative liabilities Conversion feature of convertible notes Total derivative liabilities 2019 ($000s) 2018 ($000s) 73,999 2,703 626 189 49 – 2,508 – 40 1 77,566 2,549 (89) (58) (77,367) (77,514) (759) (63) – (822) Foreign currency hedges The Group uses derivatives in the form of forward exchange contracts and vanilla foreign exchange options (outright purchased options and vanilla collars) to reduce the risk that movements in foreign exchange rate will affect the Group’s NZD cash flows. Whenever possible, these hedges have been designated as a hedge of a highly probable forecast transaction (a cash flow hedge under NZ IFRS 9: Financial Instruments). The Group determines the existence of an economic relationship between the hedging instrument and the hedged item based on the currency, and timing of respective cash flows. Derivatives in hedge relationships are designated based on a hedge ratio of 1:1. Hedges that do not have a highly probable forecast transaction are recognised as ineffective hedges. The Group’s policy is to hedge a portion of the next 18 months' forecasted cash flows. The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges is recognised in other comprehensive income. The gain or loss relating to the ineffective portion is recognised immediately in the Income Statement. Amounts accumulated in equity are reclassified to the Income Statement in the periods when the hedged transaction affects profit and loss. Only the intrinsic value of options are designated as hedge relationships with movements in the time value of foreign exchange options recognised immediately in the Income Statement. The Group has taken up the option under NZ IFRS 9 to defer forward points into other comprehensive income. During the year, a net hedging gain of $6.9 million (before taxation) was recognised in other comprehensive income (2018: gain of $0.6 million). During the year, a gain of $5.5 million (before taxation) was reclassified out of other comprehensive income to the Income Statement (2018: loss of $2.7 million). The remaining balance will be reclassified to the Income Statement in the 18 months following 31 March 2019. Notes to the Financial Statements — 66 Hedge position The Group's hedging instruments are as follows: At 31 March Derivative assets Buy USD – Sell NZD Buy NZD – Sell AUD Buy NZD – Sell GBP Total Derivative liabilities Buy USD – Sell NZD Buy NZD – Sell AUD Buy NZD – Sell GBP Total 2019 Average forward price 2019 Fair value ($000s) 2019 Notional amount hedged (NZD) ($000s) 2018 Average forward price 2018 Fair value ($000s) 2018 Notional amount hedged (NZD) ($000s) 0.6898 0.9214 0.5083 0.6723 0.9633 - 553 2,262 730 3,545 (121) (16) – (137) 53,641 58,957 46,400 12,162 5,710 – 0.7325 0.9113 0.5078 0.7155 0.9430 0.5235 362 2,172 15 2,549 (333) (2) (487) (822) 29,010 68,859 3,938 30,748 2,121 18,031 Conversion feature and call option derivative The conversion feature derivative liability of the convertible notes represents an embedded derivative financial instrument in the host debt contract. The conversion feature represents the Group’s obligation to issue Xero Limited shares (or an equivalent amount of cash) should noteholders exercise their conversion option. The embedded conversion derivatives are carried in the Statement of Financial Position at their estimated fair value and adjusted at the end of each reporting period, with any unrealised gain or loss reflected in the Income Statement. During the period, the Group recognised a $5.7 million revaluation gain in the Income Statement relating to the conversion feature derivative. In connection with the issue of the convertible notes, the Group entered into call spread options. The lower strike call options mirror the conversion option embedded in the convertible notes, and are accounted for as derivative assets in the Statement of Financial Position at their estimated fair value. The derivative assets are adjusted to fair value each reporting period, with unrealised gains or losses reflected in the Income Statement. During the period, the Group recognised a $5.0 million revaluation loss in the Income Statement relating to the call lower strike call options. 17. Share capital Balance at 1 April Issue of ordinary shares – acquisition of Hubdoc Issue of ordinary shares – exercising of employee share options Issue of ordinary shares – employee restricted share plan Issue of ordinary shares – restricted stock unit schemes Issue of ordinary shares – director exercising options Issue of ordinary shares – directors' fees Ordinary shares on issue at 31 March Treasury shares Ordinary shares on issue at 31 March excluding treasury shares All shares have been issued, are fully paid, and have no par value. Notes 18 23 23 23 23 2019 (000s) 138,449 1,133 748 228 180 26 10 2018 (000s) 137,761 – 133 494 54 – 7 140,774 138,449 (411) (609) 140,363 137,840 During the year the Company acquired 100% of the ordinary shares of Hubdoc Inc. issuing 1,133,303 ordinary shares as partial consideration at a deemed issue price of AUD44.64. 67 — Notes to the Financial Statements During the year employees exercised 747,821 share options with a weighted average exercise price of $19.20 (2018: 133,420 at a weighted average price of $17.58). During the year, the Company allocated 364,955 shares under the employee restricted share plan (RSP), at a weighted average price of AUD45.22 (2018: 600,095 at a weighted average price of $26.03). Of the shares allocated, 228,459 were new shares issued, and 136,496 were the reissue of shares held as treasury stock (2018: 493,568 and 106,527 respectively). During the year, a director exercised 25,730 share options, with an exercise price of $16.14. During the year, the Company issued 10,072 shares at a weighted average price of AUD40.17 to directors in lieu of cash payment for directors’ fees (2018: 7,131 shares at $26.70). During the period, 249,608 restricted stock units vested, of which 179,554 were converted to shares with average price of $20.89. The remaining 70,504 were surrendered to settle payroll tax liabilities (2018: 59,888 vested, 53,816 converted at average price of $17.31). 18. Business combinations On 2 August 2018 Xero acquired 100% of the ordinary shares in data capture solution provider Hubdoc Inc. for consideration of $31.2 million cash, and $54.9 million in ordinary shares of Xero Limited. An additional USD10 million in shares may be issued to the previous shareholders of Hubdoc, 18 months from acquisition date, if certain targets are met. The USD10 million, or $14.6 million, in shares issuable in February 2020 is dependent on achievement of specific targets. Of this amount, $5.4 million is issuable contingent on both the achievement of the targets and on the continued service of Hubdoc's two founders. The proportion of this $5.4 million that is payable to the founders is considered compensation for continued service and is excluded from the purchase price below, resulting in contingent consideration of $12.4 million. The remaining $2.2 million is recorded as compensation straight-line over the 18 month period from acquisition. The number of shares issued on settlement of the contingent consideration will be based on the five-day volume-weighted average price of Xero Limited shares preceding issue date. Based on management's projections it is expected that the targets will be met and therefore the contingent consideration is recorded at 100%. Management will continue to assess the probability of achievement throughout the 18 month period and will record any revaluation adjustments accordingly. Goodwill of $78.8 million has been recognised because Hubdoc's expertise and technology will enable the Group to accelerate its ability to streamline the collection and classification of the data small businesses and their advisors need in order to focus on driving better business outcomes. The following values are recognised in the financial statements in respect of the Hubdoc acquisition: Assets acquired and liabilities assumed Software development asset Customer contracts intangible asset Brand intangible asset Goodwill Tangible assets acquired Tangible liabilities assumed Net assets acquired Consideration transferred Cash* Shares issued Contingent consideration Total consideration * Net of cash acquired as part of the business combination, cash outflows relating to the acquisition was $30.3 million 2 August 2018 ($000s) 15,508 3,809 1,461 78,773 2,125 (3,152) 98,524 31,194 54,904 12,426 98,524 Notes to the Financial Statements — 68 The acquired software development asset, customer contracts, and brand have been determined to have useful lives of 7.5 years, 5 years, and 3 years respectively. For the period from acquisition date to 31 March 2019, Hubdoc contributed $5.3 million in operating revenue and $10.4 million in net loss. If the acquisition had occurred on 1 April 2018, management estimates that consolidated revenues and net loss would have been $3.0 million and $2.5 million higher respectively for the year ended 31 March 2019. 19. Group entities Consolidation subsidiaries are all entities over which the Group has control. The Group controls an entity when the Group is exposed to, or has rights to, variable returns from its involvement with the entity and has the ability to affect those returns through its power over the entity. Subsidiaries are fully consolidated from the date on which control is transferred to the Group. They are deconsolidated from the date that control ceases. Inter-company transactions and balances between Group companies are eliminated on consolidation. The financial statements of each of the Group’s subsidiaries are prepared in the functional currency of that entity. The functional currency is determined for each entity based on factors such as the principal trading currency. The assets and liabilities of these entities are translated at exchange rates existing at balance date. Revenue and expenses are translated at rates approximating the exchange rates ruling at the dates of the transactions. The exchange gains or losses arising on translation are recorded in other comprehensive income and accumulated in the foreign currency translation reserve in equity. Xero (NZ) Limited Xero (UK) Limited Xero Australia Pty Limited Xero, Inc. Xero (Singapore) Pte. Ltd Xero Software (Canada) Ltd Xero (HK) Limited Xero South Africa (Pty) Ltd Xero Trustee Limited Hubdoc Inc. Hubdoc Pty Limited Hubdoc (UK) Limited Principal activity Reseller Reseller Reseller Reseller Service provider Service provider Service provider Service provider Trustee Reseller Reseller Reseller Country of incorporation New Zealand United Kingdom Australia Balance date 31 March 31 March 31 March United States 31 March Singapore Canada Hong Kong South Africa New Zealand 31 March 31 March 31 March 31 March 31 March Canada 31 December Australia United Kingdom 30 June 31 March 31 March 30 April Interest 2019 (%) Interest 2018 (%) 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 – – – – – Xero Investments Limited Funding & Investment New Zealand Cicerone Limited Non–active United Kingdom The following changes in relation to the Group's entities occurred during the year ended 31 March 2019: – Xero Acquisition I Ltd was incorporated in Canada as a wholly owned subsidiary of Xero Limited on 24 July 2018 – Xero Acquisition I Ltd acquired Hubdoc Inc. along with its wholly owned subsidiaries Hubdoc Pty Limited and 10914819 Canada Inc. on 2 August 2018 – Hubdoc Inc., 10914819 Canada Inc., and Xero Acquisition I Ltd amalgamated to form Hubdoc Inc. on 16 August 2018 – Hubdoc (UK) Limited was incorporated as a wholly owned subsidiary of Xero Limited on 5 September 2018 – Xero Investments Limited was incorporated as a wholly owned subsidiary of Xero Limited on 17 September 2018 – Xero Investments Limited acquired Cicerone Limited on 14 December 2018 69 — Notes to the Financial Statements 20. Current and deferred income tax Tax expense comprises current and deferred tax. Income tax is recognised in the Income Statement or Statement of Comprehensive Income except when it relates to items recognised directly in equity (in which case the income tax is recognised in equity). Income tax is based on tax rates and regulation enacted in the jurisdictions in which the entities operate. Deferred tax is recognised in respect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for taxation purposes. The amount of deferred tax is based on the expected manner of realisation of the carrying amount of assets and liabilities, using tax rates enacted or substantially enacted at the end of the reporting period. A deferred tax asset is recognised only to the extent that it is probable that future taxable profits will be available against which the asset can be utilised. Income tax expense The tax on the Group’s loss before tax differs from the theoretical amount that would arise using the New Zealand statutory income tax rate as follows: Year ended 31 March Accounting loss before income tax At the New Zealand statutory income tax rate of 28% Non-deductible expenditure Prior period adjustment Impact of prior year research and development credit claims Utilisation of tax losses not previously recognised Net research and development expense deferred Tax rate variance of subsidiaries Total year tax losses not recognised in current year Income tax expense Comprising: Income tax payable Prior period adjustment Impact of prior year research and development credit claims Deferred tax Tax losses utilised Effect of changes in foreign currency Income tax expense Income tax payable At 31 March Opening balance Prior period adjustment Impact of prior period research and development credit claims Income tax liability for the year Income tax paid Effects of changes in foreign currency Current tax payable 2019 ($000s) (23,136) (6,478) 1,640 119 – (10,074) 4,023 2,890 11,887 4,007 5,361 119 – (1,153) (398) 78 4,007 2019 ($000s) 537 177 – 5,361 (3,883) (234) 1,958 2018 Restated ($000s) (23,871) (6,684) 1,038 (23) (1,089) (7,690) 8,327 (3,368) 10,532 1,043 3,030 (23) (1,089) (353) (483) (39) 1,043 2018 Restated ($000s) 1,105 (43) (1,089) 3,030 (2,505) 39 537 Notes to the Financial Statements — 70 Provisions and employee benefits ($000s) Tax depreciation ($000s) Derivatives ($000s) Tax losses ($000s) Total ($000s) – – – – – 1,629 42 3,273 717 5,661 (1,129) (48) (1,672) – – 21 (503) (717) (2,849) (1,199) (483) 6,603 (17,041) 10,308 – – (398) – – – (5) 671 2,053 – (46) – (409) (268) – – 88 (1,418) 322 (390) (1,774) 398 – – Deferred income tax Year ended 31 March 2019 Deferred tax asset balances: Restated balance at 1 April 2018 Prior period adjustment Charged to Income Statement Charged to equity At 31 March 2019 Deferred tax liability balances: Restated balance at 1 April 2018 Prior period adjustment Charged to Income Statement Charged to equity Tax losses utilised Impact of change in tax rates Recognition of deferred tax on business combination At 31 March 2019 (881) 9,276 (19,048) 8,864 Year ended 31 March 2018 Deferred tax asset balances: Restated balance at 1 April 2017 Prior period adjustment Charged to Income Statement Restated balance at 31 March 2018 Deferred tax liability balances: Restated balance at 1 April 2017 Prior period adjustment Charged to Income Statement Charged to equity Tax losses utilised Impact of change in tax rates – – – – 447 – – (930) – – 1,164 41 424 1,629 4,148 118 2,093 762 – (518) (1,127) 80 (82) (1,129) (13,521) (50) (4,553) – – 1,083 – – – – 8,105 (17) 2,283 (169) 483 (377) Restated balance at 31 March 2018 (483) 6,603 (17,041) 10,308 500 15 1,098 – 1,613 (613) (92) 13 (119) 398 42 (1,418) (1,789) 37 121 342 500 (821) 51 (177) (337) 483 188 (613) 71 — Notes to the Financial Statements Recognised temporary differences The Group’s recognised deferred tax asset and deferred tax liability are expected to be recovered by $0.4 million and $1.3 million respectively within the next 12 months. Deferred tax assets and liabilities have been offset where the balances are due to/receivable from the same counterparties. Deferred income tax assets are recognised for carried forward tax losses to the extent of deferred tax liabilities. Unrecognised temporary differences The Group has elected to defer the deduction of research and development expenditure in accordance with sections DB 34(7) and EE 1(5) of the Income Tax Act 2007. The total amount of deferred research and development expenditure available to the Group is $58.6 million (2018: $54.7 million). The deferred research and development expenditure can be deducted from taxable income in future periods, and the ability to carry forward deferred research and development expenditure is not dependent on maintaining shareholder continuity. The Group has estimated unrecognised tax losses available to carry forward of $296.9 million (2018 restated: $310.2 million) subject to shareholder continuity being maintained. Key estimates and assumptions The Group recognises a deferred tax asset in relation to tax losses to the extent of the Group’s deferred tax liabilities. Where it is probable that future taxable profit will be available against which carried forward tax losses can be utilised, a deferred tax asset will be recognised for these amounts, subject to shareholder continuity (or other legislative requirements). No material deferred tax asset has been recognised for losses in the Group, given the uncertainty of the timing of future profitability and the requirement for shareholder continuity. 21. Reconciliation of operating cash flows Year ended 31 March Net loss Adjustments: Depreciation Amortisation Employee share-based payments Non-employee share-based payments Impairment of assets Amortisation of debt discount and issue cost Deferred tax Tax losses utilised Bad debts Other non-cash items Changes in working capital: Increase in trade receivables and prepayments Increase in interest receivable Increase/(decrease) in trade payables and other related items Increase/(decrease) in current tax payable Increase in employee entitlements Increase in income in advance Net cash flows from operating activities 2019 ($000s) (27,143) 17,890 63,958 28,087 859 18,604 7,627 (1,153) (398) 1,459 766 (14,111) (3,008) 5,068 1,421 10,764 3,536 2018 Restated ($000s) (24,914) 16,509 53,809 15,965 1,039 1,550 – (353) (483) 1,412 641 168 (125) (6,142) (561) 40 2,641 114,226 61,196 Notes to the Financial Statements — 72 22. Changes in financial assets and liabilities arising from financing activities Year ended 31 March 2019 At 1 April 2018 ($000s) Proceeds ($000s) Payments ($000s) Amortisation expense ($000s) Fair value changes ($000s) Short-term deposits 59,000 (59,000) 349,459 Other current liabilities (733) - 733 Bank loans Term debt* - - (30,850) 30,850 (455,721) 7,955 (7,627) - - - Foreign exchange movement ($000s) Other non-cash items ($000s) (12,640) - - - - - At 31 March 2019 ($000s) 336,819 - - 12,197 85,465 (357,731) - - - - * Other non-cash movements reflects the fair value of the embedded conversion derivative at inception of the debt 23. Share-based payments The Group operates equity-settled, share-based compensation plans, under which employees provide services in exchange for non- transferable options, RSUs, or shares. The value of the employee services rendered for the grant of non-transferable options, RSUs and shares is recognised as an expense over the vesting period, and the amount is determined by reference to the fair value of the options, RSUs, and shares granted. Employee restricted share plan Under the employee restricted share plan, ordinary shares in the Company are issued to a trustee, Xero Limited Employee Restricted Share Trust, a wholly owned subsidiary, and allocated to participants, on grant date, using funds lent to them by the Company. The shares are beneficially owned by the participants. The length of retention period before the shares vest is up to three years. If the individual is still employed by the Group at the end of each specific period, the employee is given a bonus that must be used to repay the loan and shares are then transferred to the employee. The weighted average grant date fair value of restricted shares issued during the year was AUD45.22 (2018: $26.03) and was determined by the volume-weighted average price of the Company shares for the 20 trading days preceding the grant date. Shares with a grant date fair value of $12.7 million vested during the year (2018: $10.8 million). The Group has no legal or constructive obligation to repurchase or settle the shares for cash. Unvested shares at 1 April Granted Forfeited Vested Unvested shares at 31 March – allocated to employees Forfeited shares not yet reallocated – held by Trustee Total Percentage of total ordinary shares Ageing of unvested shares Vest within one year Vest after one year Total unvested shares at 31 March 2019 Number of shares (000s) 2018 Number of shares (000s) 522 365 (90) (426) 371 40 411 0.3% 261 110 371 582 600 (141) (519) 522 87 609 0.4% 344 178 522 The number of shares awarded pursuant to the RSP does not equal the number of shares created for the scheme as forfeited shares are held in the trust and reissued. 73 — Notes to the Financial Statements Share options scheme Options are granted to selected employees, directors and service providers. Options are conditional on the completion of the necessary years of service (the vesting period) as appropriate to that tranche. The options' tranches vest over three to four years from the grant date. No options can be exercised later than the first anniversary of the final vesting date. There were 44 holders of options at 31 March 2019 (2018: 43). The Group has no legal or constructive obligation to repurchase or settle the options in cash. Movements in the number of options outstanding and their related weighted average exercise prices are as follows: Outstanding at 1 April Granted Forfeited/expired Exercised Outstanding at 31 March Exercisable at 31 March 2019 Weighted average exercise price ($) 2019 Options (000s) 2018 Weighted average exercise price ($) 2018 Options (000s) 20.65 39.13 31.48 19.10 31.91 19.55 2,225 2,092 (548) (774) 2,995 365 18.55 26.51 18.86 17.58 20.65 22.09 2,188 585 (415) (133) 2,225 747 The weighted average share price on date of exercise for options exercised in the year ended 31 March 2019 was AUD43.31 (2018: $25.20). The weighted average remaining contractual term of options outstanding at 31 March 2019 is 3.6 years (2018: 3.2 years). Options outstanding at 31 March 2019 fall within the following ranges: Granted 2013–14 2014–15 2015–16 2016–17 2017–18 2018–19 Exercise price NZD38.24 NZD16.14 NZD16.00–NZD19.51 NZD17.51–NZD19.50 NZD19.77–NZD32.48 AUD34.00–AUD48.33 2019 Options (000s) 2018 Options (000s) – – 30 830 327 1,808 2,995 61 26 206 1,407 525 – 2,225 The weighted average fair value of options granted during the year, determined using the Black-Scholes valuation model, was $21.41 per option (2018: $9.67). The significant inputs into the model were the market share price at grant date, the exercise price as shown above, expected annualised volatility of between 35% and 41%, a dividend yield of 0%, an expected option life of between three and five years, and an annual risk-free interest rate of between 1.7% and 2.2%. The volatility input is measured as the standard deviation of continuously compounded share returns and is based on a statistical analysis of daily share prices over a period consistent with the options expected life. Notes to the Financial Statements — 74 Restricted stock units RSUs are issued to certain employees and executives of the Group. On the grant date, an RSU agreement is entered into between employee and Company stipulating the number of units granted and their vesting schedules. On the vest date, the RSUs are converted to ordinary shares in the Company. No cash consideration is required to be paid on vesting of the RSUs. The fair value of RSUs granted in the year ended 31 March 2019 was $12.8 million (2018: $5.8 million) as determined by the volume-weighted average share price. The RSUs are conditional on the employees completing up to three years' service (the vesting period) and are, for the most part, convert to shares in equal amounts over the vesting period. Outstanding at 1 April Granted Forfeited Converted to shares Surrendered to pay payroll tax Outstanding at 31 March 2019 Weighted average grant date fair value ($) 2019 RSUs (000s) 2018 Weighted average grant date fair value ($) 2018 RSUs (000s) 21.64 46.23 32.05 20.93 20.76 38.89 401 277 (57) (180) (71) 370 17.41 26.31 21.93 17.31 20.21 21.64 327 222 (88) (54) (6) 401 The Company withholds shares under certain circumstances to settle tax obligations on vesting. Based on the market share price on 31 March 2019, future cash payments to meet tax obligations on the vesting of RSUs are expected to be $4.9 million (2018: $3.9 million). 24. Key management personnel and related parties Key management personnel Key management personnel are defined as those persons having authority and responsibility for planning, directing and controlling the activities of the Group, directly or indirectly, and include the directors, the Chief Executive, and his direct reports. The following table summarises remuneration paid to key management personnel. Year ended 31 March Short-term employee benefits Directors' fees Share-based payments – options Share-based payments – restricted stock units Share-based payments – employee restricted share plan 2019 ($000s) 2018 ($000s) 7,807 1,214 5,841 2,008 889 6,317 926 1,571 854 1,417 A number of key management personnel, or their related parties, hold positions in other entities that result in them having control or significant influence over the financial or operating policies of these entities. A number of these entities subscribe to services provided by the Group. None of these related party transactions are significant to either party, and are completed on arm's length terms. During the year Givia Pty Limited, a related party, was reimbursed $15,000 for legal and tax costs in relation to a share borrow transaction undertaken as part of the convertible notes transaction. There were no other related party transactions during the year. No amounts with any related parties have been written off or foregone during the year (2018: nil). 75 — Notes to the Financial Statements 25. COMMITMENTS AND CONTINGENCIES Capital commitments Capital commitments of $1.0 million for building fit-outs were contracted for at 31 March 2019 but not yet incurred (2018: $0.9 million). Contingent liabilities There were no contingent liabilities at 31 March 2019 (2018: nil). 26. EVENTS AFTER THE BALANCE SHEET DATE There were no significant events between balance date and the date these financial statements were authorised for issue. Directors’ Responsibilities Statement — 76 Directors’ Responsibilities Statement The directors are required to prepare financial statements for each financial year that present fairly the financial position of the Group and its operations and cash flows for that period. The directors consider these financial statements have been prepared using accounting policies suitable to the Group’s circumstances, that these have been consistently applied and are supported by reasonable judgements and estimates, and that all relevant financial reporting and accounting standards have been followed. The directors are responsible for keeping proper accounting records that disclose with reasonable accuracy, at any time, the financial position of the Group and to enable them to ensure that the financial statements comply with the Companies Act 1993 (New Zealand). They are also responsible for safeguarding the assets of the Group and for taking reasonable steps for the prevention and detection of fraud and other irregularities. During the year ended 31 March 2019, the principal activities of the Group were for the provision of an online business platform to small businesses and their advisors. Other than as disclosed in this Annual Report, there were no significant changes in the state of affairs or activities of the Group during the year. The Board authorised these financial statements for issue on 16 May 2019. For and on behalf of the Board Graham Smith Chair Xero Limited 16 May 2019 Lee Hatton Director Xero Limited 16 May 2019 77 — Corporate Governance Statement Corporate Governance Statement Xero is committed to high standards of corporate governance. We believe this is essential for the long-term performance and sustainability of Xero and supports the interests of our shareholders. The Xero Board of Directors (the Board) is responsible for ensuring that Xero has an appropriate corporate governance framework to protect and enhance Xero’s performance and to build sustainable value. Xero’s corporate governance framework is designed to support our business operations, deliver on our strategy, monitor performance, and manage risk. Xero has a sole listing on the Australian Securities Exchange (ASX) but remains a New Zealand incorporated and domiciled company. From a regulatory perspective, this means that while the ASX Listing Rules will apply to Xero, certain provisions of the Australian Corporations Act 2001 (Cth) will not.1 Xero’s corporate governance reporting framework has been developed with regard to the ASX Listing Rules and the ASX Corporate Governance Principles and Recommendations (3rd Edition). This Corporate Governance Statement (Statement) addresses the recommendations contained in the ASX Principles and Recommendations. This Statement is current as at 18 April 2019, and has been approved by the Board. This Statement should be read in conjunction with this Annual Report and the Investor section of Xero’s website at www.xero. com/about/investors/governance, where there are further details on Xero’s corporate governance policies and charters. References to FY19 are to the reporting period which is the year ended 31 March 2019. 1. Xero complies with the ASX Listing Rules. As Xero is not incorporated in Australia, it is not a disclosing entity for the purpose of Chapter 2M of the Australian Corporations Act 2001 (Cth) ( financial reports and audit) and certain provisions of that will not apply (eg section 295 on annual financial report contents, section 298 regarding directors' report or section 300A regarding remuneration reporting). As a New Zealand company, Xero’s annual reporting is primarily governed by the Companies Act 1993 (New Zealand) Corporate Governance Statement — 78 ASX Principles and Recommendations Principle 1: Lay solid foundations for management and oversight The Board Charter The Board’s Charter outlines the Board’s roles and responsibilities and describes those matters expressly reserved for the Board’s determination and those matters delegated to management. Xero’s CEO has responsibility for the day-to-day management and administration of the Xero business, supported by the rest of Xero’s leadership team. The CEO manages Xero in accordance with the strategic plan, annual budget, and the risk management strategies approved by the Board. The Board comprises directors who bring a mix of skills, knowledge, experience, diversity and independence, together with a deep understanding of, and competence to deal with, current and emerging issues to guide the business. Xero’s Board Charter is available on Xero’s website. Responsibilities The Board retains full responsibility for overseeing and appraising Xero’s strategies, policies, performance and governance framework. To assist with discharging its responsibilities, the Board has established the following committees: 1. Audit and Risk Management Committee (ARM Committee) 2. People and Remuneration Committee (P&R Committee) 3. Nominations Committee From time to time, the Board may form other committees or delegate specific functions to ad hoc committees. The Board is responsible for monitoring the management and performance of Xero and for ensuring that management’s activities are aligned with the expectations and risks identified by the Board and management. The Board has a number of mechanisms to ensure this is achieved, including: 1. Approving Xero’s corporate strategic plan, and overseeing performance to ensure its performance is aligned with the strategic plan 2. Focusing Xero’s objectives on long-term shareholder value 3. Adopting an annual budget for financial performance and monitoring progress against that budget 4. Confirming accurate and reliable systems are in place to identify, manage, mitigate and report risks Other functions reserved to the Board include: 1. Selecting, appointing, evaluating and removing (if necessary) the CEO 2. Confirming that Xero’s financial position is sound, that Xero is able to meet its debts and other obligations when they are due, and that Xero has sufficient financial resources to achieve its strategic plan 3. Assessing that an appropriate culture and management framework is in place 4. Determining that Xero’s governance policies and practices are appropriate and are aligned with shareholder interests and relevant laws and regulations 5. Ensuring that any significant risks that arise are identified, assessed, appropriately managed, and monitored Appointment Before electing a candidate as a director, Xero undertakes appropriate background checks to determine that candidate’s suitability. Board and Committee membership and meeting attendance The members of Xero’s Board and each of Xero’s committees for FY19, the number of scheduled1 meetings and attendance at those meetings is: Director Board Nominations Committee ARM Committee P&R Committee Mr Graham Smith Mr Rod Drury Ms Lee Hatton Ms Dale Murray3 Ms Susan Peterson Mr Bill Veghte Mr Craig Winkler Held2 Attended Held2 Attended Held2 Attended Held2 Attended 8 8 8 7 8 8 8 8 7 7 7 8 7 8 44 - - - - 4 4 4 - - - - 4 4 5 - 54 5 - - - 5 - 5 5 - - - - - - - 6 64 6 - - - - 6 6 6 1. In addition to scheduled meetings, the Board also holds unscheduled meetings as appropriate to meet governance demands 2. Held represents the number of meetings held that the relevant director was eligible to attend 3. Appointed as a director effective 13 April 2018 4. Committee Chair 79 — Corporate Governance Statement The qualifications of each director are detailed on pages 17 and 18 of this Annual Report. All directors and members of Xero’s leadership team are appointed pursuant to formal letters of appointment or agreements setting out the key terms and conditions of their appointment (including remuneration and other duties). Director appointment letters also include further details regarding committee responsibilities, directors’ duties and responsibilities, the time commitment envisaged, Board performance evaluation, confidentiality of information, the Board’s policy on obtaining independent advice, disclosure of interests and matters affecting independence, and entering into deeds of indemnity, insurance, and access. Company Secretary Chaman Sidhu is the Chief Legal Officer & Company Secretary of Xero. Ms Sidhu’s qualifications and experience are set out on Xero’s website. The Company Secretary is accountable to the Board, through the Chair, on all matters to do with the proper functioning of the Board. The formal reporting line of the Company Secretary is through the Chief Executive (CEO). All directors have access to the Company Secretary. Diversity and inclusion Xero values diversity and inclusion and considers it a priority in the creation of a sustainable business capable of delivering long- term shareholder value. Xero embraces the diverse experience, ideas, skills and perspectives of our people. Having a diverse workforce enables Xero to innovate, attract and retain top talent, and to better reflect and serve our customers, partners, and the communities we interact with every day. Xero takes a broad view of the meaning of diversity and believes that it’s through inclusion that we will tap into the potential and power of our people’s differences. Diversity and Inclusion Policy Xero has a Diversity and Inclusion Policy, which is available on Xero’s website. This policy includes requirements for the Board to establish measurable objectives for achieving diversity and to annually assess those objectives and the progress towards achieving them. A Head of Diversity, Inclusion and Community is employed to further Xero’s activities and progress towards achieving diversity. The Diversity and Inclusion Policy reflects six key principles that provide the framework for Xero’s goal of developing and maintaining a diverse and inclusive workplace and the implementation of Xero’s initiatives to support this. The key principles are: 1. We value diversity because it reflects and serves our customers and ensures our people thrive 2. We’re all accountable to create an inclusive culture 3. We’re committed to attracting diverse talent and hiring fairly 4. We support flexible ways of working 5. We’re committed to equal pay for equal work 6. We have an obligation to champion diversity and inclusion in the community Respect and Responsibility Policy Xero’s global Respect and Responsibility Policy supports a clear and consistent approach to equal opportunity, promotes a workplace free from discrimination, harassment, sexual harassment and bullying and sets out the internal process to resolve concerns and complaints. In FY19, face-to-face training for people managers was conducted and a new online training module for employees was launched with an introduction video from the CEO. Xero’s Australian subsidiaries submit an annual Workplace Gender Equality Report under the Australian Workplace Gender Equality Act 2012 (available once published on WGEA’s website at www.wgea.gov.au). Corporate Governance Statement — 80 Measurable objectives The following is a summary of progress achieved against Xero’s measurable objectives for FY19: Objective Progress Xero attracts diverse – At 31 March 2019, 42% of employees were female, 50% of Xero’s leadership team were female and 43% of Xero’s Board talent in the tech industry with a particular focus on women in tech were female – Our Head of Diversity, Inclusion and Community promoted global initiatives and supported our regions to set and monitor local diversity priorities – Continued to incorporate diversity and inclusion in Xero’s external communications and activities – Maintained our support of organisations and initiatives to attract a more gender-diverse workforce, including Girl Geek Dinners, Code Like A Girl and Work180 – Commenced a phased roll out of a mentoring programme through Mentorloop to support our employees – Delivered a global International Women’s Day campaign including local events across our offices and a video from our CEO and other business leaders – Piloted an internship with Specialisterne (an organisation that supports employment of people on the autism spectrum) in Australia and delivered autism awareness training to some employees – Hired an employee through the Asylum Seeker Resource Centre in Australia and participated in the TupuToa internship programme in New Zealand – Developed new guidelines to set out the support available to those experiencing or impacted by domestic and family violence – Held meetings for our internal recruiters network to discuss and promote diversity in Xero’s hiring process – Maintained an internal diversity dashboard to track diversity data for internal monitoring Xero promotes flexible – Continued to maintain Xero’s Flexible Working Guidelines and a resource for managers on this topic working across the organisation where possible – Developed a flexible work learning video to build understanding of flexible working and how managers can support this – Actively communicated real stories of employees working in flexible work arrangements – Delivered internal surveys to understand the utilisation and satisfaction with flexible work arrangements – Held keeping in touch events to promote an inclusive environment for employees on parental leave in some offices – Maintained a child-friendly workspace in our Melbourne office and also offered child-friendly workspaces in New Zealand during school breaks – Achieved a highly commended recognition in work/life balance category for Diversity Works awards in New Zealand Xero is an inclusive work – Implemented a new Respect & Responsibility Policy setting expectations on discrimination, harassment, sexual environment where harassment, and bullying, supported by face-to-face training for people managers and an online training module for difference is valued and employees everyone can bring their whole self to work – Delivered training on topics including diversity, inclusion, bias awareness and LGBTI awareness to certain employees throughout the business – Introduced an option for employees to update their pronoun preferences related to gender identity – Joined the Australian Network on Disability in Australia and signed up to the Government’s Disability Confident Scheme in the United Kingdom – Developed a new disability confidence learning video and implemented new workplace adjustments guidelines to support employees with disability and explain how employees can request an adjustment – Delivered surveys to capture feedback on the extent to which employees feel that Xero is an inclusive workplace – Held memberships of organisations supporting LGBTI workplace inclusion – Pride in Diversity in Australia, Stonewall in the United Kingdom – and achieved the Rainbow Tick in New Zealand – Delivered training workshops on mental health and wellbeing topics and launched a new Flourishing@Xero guide with tips for mental health and wellbeing – Held internal events for World Mental Health day and partnered with Beyond Blue on a Xero Now episode on mental health at work – Expanded our definition of sick leave and positioned it as ‘wellbeing leave’ to encourage employees to look after overall health and mental wellbeing – Commenced pilot of Unmind, a mental wellbeing platform (with mobile app) for the workplace in the United Kingdom – Developed an internal Welcome to and Acknowledgement of Country guide and held NAIDOC week activities to support indigenous awareness in Australia – Shared Xero stories of cultural diversity on World Day for Cultural Diversity, delivered Māori language week activities and Māori language courses in New Zealand, and held shared cultural lunches in some of our offices 81 — Corporate Governance Statement Gender diversity statistics The proportion of females employed by Xero (and its wholly owned subsidiaries) as at 31 March 2019 was as follows:1 At 31 March 2019 women 2019 men 2019 total 2019 % 2018 women 2018 men 2018 total Directors Xero’s leadership team² Employees 3 5 4 5 7 10 1,060 1,464 2,531³ 43% 50% 42% 2 4 4 6 6 10 814 1,191 2,010 2018 % 33% 40% 40% 1. These figures include permanent full-time, permanent part-time, fixed-term, casual employees and interns. 2. Xero’s leadership team is defined as the CEO and all senior executives who report directly to the CEO. 3. Xero has an optional self-selection gender identification question that allows employees to choose from the following options: female, male, other and not declared. Employees can also leave this question unanswered. In 2019, the total includes three employees who selected other and four employees who selected not declared. 46 employees were excluded from the total because they did not respond to the gender identification question. Evaluation of the Board In accordance with the Board Charter, the performance of the Board is reviewed annually, assisted by the Nominations Committee. The Nominations Committee assists in developing and implementing a process to review and evaluate the performance of the Board (including its performance against the requirements of the Board Charter), Committees, and individual directors. These performance reviews are conducted both internally and, on a periodic basis, externally with the assistance of a facilitator. The Board conducted an externally facilitated performance review during FY19. This review evaluated Board, Committee, and individual director performance. The Board, with guidance from the Nominations Committee, determines the size and composition of the Board (having regard to the size of Xero and other factors), and the appointment, re- election or retirement of directors. A director does not participate in the decision regarding their own re-election. After considering the results of the performance reviews, the Board determines whether it will endorse the directors who will stand for re-election at the Annual General Meeting. Evaluation of leadership team The Chair of the Board, with support from the P&R Committee, reviews and makes recommendations to the Board on the performance evaluation of the CEO. The CEO, with oversight from the P&R Committee, reviews and makes recommendations on the performance evaluation of the rest of Xero’s leadership team. The performance of Xero’s leadership team is reviewed annually. Performance reviews are conducted by assessing each executive’s performance against specific and measurable quantitative and qualitative performance criteria. The assessment is then discussed with the P&R Committee or Board (as appropriate). The performance criteria against which the executives are assessed are aligned with the financial and non- financial objectives of Xero. Performance evaluations for Xero’s leadership team took place for FY19 in accordance with the process referred to above. Corporate Governance Statement — 82 Principle 2: Structure the Board to add value Nominations Committee The Board has established a Nominations Committee that operates under a Charter, which is available on Xero’s website. The Charter provides that the Committee will consist of a majority of independent directors, be chaired by an independent non-executive director, and have at least three members. The current composition of the Committee meets these requirements. The Committee meets at least three times per year and all directors have a standing invitation to attend its meetings. Responsibilities The Committee’s role is to assist the Board in relation to: – Board and Committee size and composition – Director selection, appointment, election, and re-election – The selection, appointment and, if necessary, termination of the CEO – Director induction and continuing professional development – Evaluating the performance of the Board, its Committees, and individual directors – Succession planning for the Board (in particular the Chair) and the CEO Board skills matrix Capability Director appointment The Board’s policy and procedures for selecting and appointing new directors to the Board is to identify and consider qualified potential candidates, in light of the appropriate mix of skills, knowledge, experience, diversity, and independence that the Board and Committees are seeking to achieve, and the time commitment required from non- executive directors. Suitable candidates are appointed by the Board. Any new director appointed by the Board holds office until Xero’s next Annual General Meeting and is then eligible for election. In determining Board membership, the Board seeks to achieve a mix of skills and diversity that includes experience in the areas set out in the table below. The table summarises the directors’ relevant skills as at 31 March 2019. The Board is satisfied that the skills matrix demonstrates that the Board has the appropriate mix of skills and experience necessary to oversee the governance and operations of Xero. Number of directors with the capability Cloud Expertise in business software and delivering solutions at scale through cloud platforms within the SaaS industry Digital product management and marketing Digital product expertise with extensive experience across technology trends, and implications and the software and technology product value chain Strategy and development Corporate strategy and development including M&A and strategic partnerships Go-to-market and customer experience Deep customer insight and advocacy. Go-to-market expertise including direct sales, internet sales and new markets, and specific customer channel experience Financial expertise Public company-experienced financial expert with deep experience in finance, accounting, planning and investor relations International markets Exposure to at least two of Xero’s key International markets (Asia, Americas, UK, New Zealand and/or Australian markets) Listed company governance; risk Depth of expertise in listed company governance, compliance and risk management People and culture Remuneration, workforce planning, talent, culture, and diversity and inclusion High capability Medium capability 83 — Corporate Governance Statement Independence Xero considers a director to be independent when they are a non- executive director who is independent of management and free of any business or other relationship that could materially interfere with – or could reasonably be perceived to materially interfere with – the independent exercise of their unfettered judgement, having regard to the best interests of Xero as a whole. In the context of director independence, “materiality” is considered from both Xero and an individual director perspective. The Board makes an assessment of the independence of each director upon their appointment and annually thereafter. Directors are required on an ongoing basis to disclose to the Board relevant personal interests and conflicts of interest. In accordance with the definition of independence above, and having regard to the relevant factors listed in the ASX Principles and Recommendations, the following directors of Xero are considered to be independent: – Mr Graham Smith (Chair) – Ms Lee Hatton – Ms Susan Peterson – Mr Bill Veghte – Ms Dale Murray The length of service of each director is ascertainable from the information on pages 17 and 18 of this Annual Report. Board composition and Chair The Board Charter states that the Board will consist of a majority of independent non-executive directors. The Chair of Xero, Graham Smith, is assessed as an independent non- executive director. The Chair’s role is to lead the Board, facilitate constructive discussion at Board meetings, and ensure that the Board functions effectively. Induction All new Board members are given an appropriate induction programme to enable new directors to gain an understanding of Xero, its operations and values, its financial, strategic, and risk management position, and the rights, duties and responsibilities of the Board, its Committees and management. Each new Board member has the opportunity to meet with existing Board members, Xero’s leadership team, and relevant members of the senior management team. All Board members are expected to maintain the skills required to discharge their respective roles. Principle 3: Act ethically and responsibly Code of Conduct In FY19 Xero adopted a new Code of Conduct (the Code), which applies to all directors, officers, employees, and contractors in the Xero group. The Code captures the standards and values of Xero and sets out the way Xero conducts business and how we believe we should behave. The Code is underpinned by Xero policies, some of which are global and some of which are country specific, and which include topics covering diversity and inclusion, fraud, respect and responsibility, workplace behaviour, and work health and safety. The Code of Conduct is available on Xero’s website and is also made available to employees via Xero’s intranet. Principle 4: Safeguard integrity in corporate reporting Audit and Risk Management Committee Purpose The Board has an ARM Committee that operates under a Charter, which is available on Xero’s website. The Committee was established to review and make recommendations to the Board on areas including financial reporting principles and policies, risk management, compliance, external audit functions, and internal control processes. Composition The Committee Charter states that the Committee will comprise at least three members. All members must be non-executive directors, and the majority must be independent. The Committee is to be chaired by an independent member, who is not the Chair of the Board. The Charter also states that the members should be financially literate, and at least one member will have accounting or related financial management expertise. The current Committee composition meets these requirements. The Committee Charter provides that the Committee will meet at least four times per year. The CEO and CFO are routinely invited to attend meetings of the Committee, and other senior managers are invited to relevant parts of the meetings. Details of the membership of the Committee and attendance at its meetings are set out under Principle 1. Responsibilities The Committee is responsible for reviewing and making recommendations to the Board on areas including the following: 1. The financial statements and reports intended for publication at half year and full year 2. The adequacy of accounting policies, processes and financial reporting practices, and ensuring appropriate new policies and revisions to existing policies are made to ensure compliance with relevant accounting standards 3. Approval of the appointment, reappointment or replacement, and remuneration of the external auditor 4. The provision of non-audit services by the external auditor, and whether it may compromise the independence of the external auditor Corporate Governance Statement — 84 5. The overall adequacy and effectiveness of the internal control Principle 6: Respect the rights of security holders Shareholder communication Investor centre Xero has a dedicated Investor Centre on Xero’s website. This provides important information relevant to Xero to its shareholders, and enables two-way communication with investors. Xero’s Investor Centre includes: – Copies of Board and Committee Charters and policies – Profiles of Xero’s directors and leadership team – ASX and media releases – Half and full year financial results and investor presentations – Historical financial reports and share price history – Details of Xero’s share register, Link Market Services Limited – An online form to enable investors to send enquiries directly to the Xero investor relations function Investor relations function Xero has an investor relations function which, in collaboration with the company secretariat function, has a programme to support Xero’s commitment to ensuring its shareholders receive important information in a timely and effective manner, including the following: 1. The Investor Centre on Xero’s website is accessible by shareholders and updated in a timely manner 2. The Annual Report is made available to all shareholders, either electronically or by post, and includes relevant information about the operations of Xero and other required disclosures 3. Each shareholder receives a Notice of Annual General Meeting invitation, and has the opportunity to attend and participate in the meeting. Shareholders may vote electronically or appoint a proxy. For the last three years, Xero has held a hybrid Annual General Meeting, meaning shareholders can attend the meeting in person or virtually via an online platform. If shareholders attend the Annual General Meeting virtually, they are able to watch the meeting live, vote, and ask questions online Electronic communications Shareholders can elect to communicate with Xero’s share registry electronically. systems, controls to safeguard assets, compliance with applicable laws, ethical compliance, and insurance coverage 6. The overall adequacy and effectiveness of the risk management framework and the methodology and processes for assessing, monitoring, and managing financial and non- financial risks Reporting The Chair of the Committee communicates the findings of the Committee to the Board at the next Board meeting. To ensure that the external auditor remains independent at all times, non-audit work is authorised by the Committee. Xero is committed to ensuring that the external auditor carries out its function independently and has adopted an Auditor Independence Policy. The policy requires that the senior audit partner must be rotated at least every five years. The auditor was last changed in 2015. The policy also requires the external auditor to confirm annually that it has complied with all professional regulations relating to auditor competency and independence. The external auditor will attend and be available to answer shareholder questions at the Annual General Meeting. Declaration regarding financial statements As a New Zealand company, section 295A of the Australian Corporations Act 2001 (Cth) is not applicable to Xero. However, the CEO and the CFO provide written statements to the Board in accordance with the ASX Principles and Recommendations, in respect of the half and full-year reporting periods. These statements confirm that, in their opinion, the financial records of Xero have been properly maintained and that the financial statements comply with the accounting standards and give a true and fair view of the financial position and performance of Xero, and that their view is founded on the basis of a sound system of risk management and internal control which is operating effectively in all material respects. Principle 5: Make timely and balanced disclosure Disclosure Policy Xero’s Continuous Disclosure Policy is available on Xero’s website. The policy describes the key obligations of the Board and Xero’s leadership team to ensure that Xero complies with its disclosure obligations under the ASX Listing Rules. The Board is responsible for compliance with Xero’s continuous disclosure obligations. The Board has established a Disclosure Committee, comprising the CEO, a director, the CFO, and the Chief Legal Officer and Company Secretary to support this primary responsibility and provide assurance. Xero’s Chief Legal Officer and Company Secretary is primarily responsible for overseeing and coordinating all communications with the ASX, and is the Disclosure Officer for the purpose of the policy. The Authorised Spokespersons of Xero include the Chair, the CEO, the CFO, the Director of Corporate Affairs, and any other person authorised by the CEO. 85 — Corporate Governance Statement Principle 7: Recognise and manage risk Audit and Risk Management Committee Purpose As mentioned in Principle 4, the Board has established an ARM Committee that operates under a Charter, which is available on Xero’s website. The Board is ultimately responsible for ensuring that material risks facing Xero have been identified and that adequate controls, monitoring, and reporting mechanisms are in place and operating effectively. The Board has delegated its oversight of risk management, audit, and compliance to the Committee. The Committee operates in accordance with its Charter, which sets out its responsibilities for monitoring Xero’s risk management, including how Xero identifies, assesses, and controls strategic, operational, and financial risks within the Board approved risk appetite. This is designed to ensure the adequacy and effectiveness of Xero’s ongoing risk management programme, including policies and guidelines relating to corporate governance, legal, regulatory and ethical compliance, business continuity management, data privacy, and information systems security. Risk framework Xero has a risk management framework which is managed by the internal strategy function (reporting to the CFO) and overseen by the Committee. Xero’s risk framework was developed through a series of workshops conducted by the strategy function and included Xero’s leadership team, senior management, and operational specialists. These assessed areas of potential risk to the business, estimated likelihoods, impacts and mitigation strategies. The identified discrete risks are now included in a risk dashboard according to the key risk categories, including operational, strategic, legal, and financial. The risk dashboard is reviewed with each member of Xero’s leadership team at least twice each year. Risks lying outside the boundaries of Xero’s agreed risk appetite require proactive mitigation and are included as part of an ongoing action plan, which is tracked and monitored on a periodic basis by Xero’s leadership team. The Committee has reviewed and approved the risk appetite parameters, and reviews the risk dashboard at least twice per year to ensure it has oversight of status and key changes. It also periodically oversees the action plan and, together with the Board, key mitigation actions arising from the dashboard. The Committee has reviewed Xero’s overall risk management framework during FY19 and considers that it is sound. Internal audit Xero has established an internal Business Assurance function in the reporting period, which provides independent and objective assurance and advice on Xero’s organisational governance, risk management and internal control processes. Business Assurance assists the business in understanding and managing risk and provides confidence that key elements of the business that are relied on to manage risk are in place and working effectively. To maintain independence, the Head of Assurance has a reporting line to the Chair of the ARM Committee and regularly meets with the Chair without management present. Business Assurance develops an assurance plan which is endorsed by the ARM Committee twice each year. The ARM Committee receives and reviews reports regarding assurance activity undertaken and through these reports, monitors the progress of management action plans. Management of economic, environmental, and social sustainability risks Xero is an online business and our operational model primarily utilises office-based employees. Accordingly, Xero’s environmental footprint is relatively small and arises largely from the energy used in its offices, in third party-data centres and for employee travel, and from the typical consumables of an office-based business. However, we acknowledge that how we conduct our business has an impact on a range of stakeholders and on the environment more broadly. More information about our approach to social and environmental impact is set out on pages 13 to 15 of this Annual Report. There are a number of business risks that could materially impact Xero. As part of the risk management process described above, Xero has identified and assessed those areas of risk that may impact the business. Effective monitoring and mitigation of these risks supports Xero’s ongoing growth and profitability. Key areas of risk are described below. Other risks relevant to economic sustainability are noted on pages 61 to 64 of this Annual Report in the Notes to the Financial Statements. Technology platform & data security As Xero continues to grow its customer base and broaden product usage across current users, it must ensure that its platform is scalable. This enables Xero to continue to provide the same high levels of quality user experience as traffic grows on the platform. We closely monitor all relevant aspects of the platform to identify areas that may need to be addressed to ensure future performance robustness. Xero is committed to the security of its customers’ data and has partnered with industry-leading security vendors to leverage their platforms and expertise to protect its systems. Xero has a security team that is responsible for security risk management, product and platform security, security operations, security compliance, and training and awareness. Corporate Governance Statement — 86 Xero takes a risk-based approach to security, which means tighter security controls are implemented where business risk is higher. In order to manage security risks within Xero’s risk appetite, processes are in place for identification, assessment, and treatment of security risks. On 3 December 2018, Xero achieved global ISO/IEC 27001 Information Security Certification. ISO/IEC 27001 is globally recognised as the premier information security management system standard and Xero achieved certification by demonstrating a robust security management programme, including a comprehensive information security management system. Xero hosts its data in AWS in US locations. All locations have the same security measures to protect Xero’s and its customers’ data. Xero has the following enterprise-wide security practices and procedures in place: – An information security management framework – An information security policy – Information security standards – An internal security governance group, which meets regularly Xero has in place a Business Continuity Management policy and plans and a Data Classification Standard. Xero produces a SOC 2 (Service Organization Control 2) report annually which is the result of an independent assessment of controls in place for security, confidentiality, and availability. Strategic direction and implementation A clear and disciplined approach to strategic choices and delivery is key to success as Xero grows and pursues a wider range of strategic objectives in more markets. With the oversight of the Board, Xero’s leadership team reviews the strategic direction on an ongoing basis and shares learnings from across the business as well as incorporating the impact of external developments as required. Underlying initiatives are reviewed and updated, assigned owners, and tracked on a regular basis. Innovation momentum and delivery It is critical that Xero maintains its ability to stay ahead of the competition and continues to build and deliver innovative products and services to customers as it has in the past, providing Xero with a competitive advantage. Xero proactively aligns our teams with our strategy to more rapidly and efficiently advance our goals. We have processes to monitor progress, as well as enabling delivery through improving Xero’s product management capability. This foundation of strategic alignment, tracking, oversight, and capability development supports Xero’s ongoing delivery of product innovation. Access to talent As Xero grows, it requires more talent working across the globe. The organisational architecture needs to constantly evolve to serve more independent teams in more diverse locations. In addition to current strategies to attract talent into current locations, alternative approaches are being explored to attract talent to new locations. Principle 8: Remunerate fairly and responsibly People & Remuneration Committee Purpose Xero has a P&R Committee that operates under a Charter, which is available on Xero’s website. The Committee has the role of assisting the Board in overseeing the human resources activities of Xero. The Committee’s principal function is to oversee Xero’s strategies and policies relating to organisational structure, culture, employee performance and development, succession planning, workforce planning, growth, and remuneration. Composition The Committee Charter states that the Committee will consist of a minimum of three non-executive directors, the majority of whom are independent, and that it is chaired by an independent member. The current Committee composition meets these requirements. Further details of the membership of the Committee and attendance at its meetings are set out in Principle 1. Responsibilities The Committee Charter sets out the responsibilities of the Committee to review and make recommendations to the Board on: 1. Remuneration of the Board 2. Executive remuneration, including the remuneration of Xero’s leadership team (comprising the CEO and all senior executives who report directly to the CEO) 3. Xero’s remuneration strategy, structure and policy, and short and long-term incentive plans, including amendments to such plans, and other material employee benefits 4. Diversity and inclusion at Xero, including measurable objectives for achieving diversity 5. Management succession planning for key roles within Xero Employee remuneration Xero is dependent on highly skilled employees who specialise in a broad range of disciplines. Our ability to implement a competitive strategy to attract, retain, reward, and motivate our people is fundamental to our long-term success. 87 — Corporate Governance Statement Remuneration policy and practices To align employee interests with shareholders, Xero has a remuneration policy and practices geared towards specific objectives, including to: – Differentiate and reward excellent performance and key talent, both in the short and long term, and recognise our values – Enable Xero to attract and retain employees, and motivate them to achieve results with integrity and fairness, while being market-competitive – Balance the mix of fixed and variable compensation to reflect the value and responsibility of a role, and to influence appropriate behaviours and actions to support a growing business – Ensure that objectives linked to remuneration are aligned to Xero’s overall strategy via quantitative, measurable metrics – Foster teamwork and collaboration across Xero – Take into account the long-term performance of Xero in order to create sustainable value for our shareholders – Ensure diversity has no influence on employees’ remuneration, whether it be gender, race, religion, or factors other than performance, experience, education, knowledge, and size/ scope of the role Remuneration model Xero aims to remunerate employees competitively in each of the markets in which we operate. We partner with local and global remuneration data providers to obtain the most relevant IT industry market data. All Xero employees receive fixed annual remuneration, comprising base salary and retirement benefits (superannuation in Australia, KiwiSaver in New Zealand, and the equivalent in other markets where required). Fixed remuneration is set according to individual skills, experience, accountabilities, performance, potential and behaviours. Fixed remuneration is reviewed on an annual basis and where appropriate is adjusted based on these factors. Some employees receive commission- based remuneration in addition to fixed remuneration. All permanent employees, other than Xero’s leadership team and certain senior management roles, participate in Xero’s long term incentive (LTI) employee share plan. This is a time-based retention plan that provides employees with the opportunity to be rewarded with equity that is allocated annually and vests in equal portions over a three-year period subject to the individual remaining employed by Xero. The value of the annual allocation is calculated as a percentage of an employee’s fixed salary and based on the seniority of the role they perform and their country of residence. The LTI plan has been established to assist in the reward and retention of all employees and to align the interests of employees with shareholders by providing them with equity in Xero. Senior leaders are also able to earn a short-term incentive based on agreed performance criteria. Employment agreements All Xero employees have individual employment contracts. Collective bargaining agreements are not typical in the industry within which Xero operates. Xero’s employment contracts and remuneration arrangements are designed to attract and retain talent within the highly competitive technology industry. Executive remuneration Remuneration philosophy Xero’s executive remuneration philosophy links remuneration to long-term value creation for shareholders by: – Aligning shareholder and executive interests – Directly linking strategic objectives and remuneration measures via quantitative, measurable metrics – Balancing short-term financial performance and long-term sustainability – Incorporating a mix of financial and non-financial measures and targets Remuneration principles Xero’s executive remuneration framework is designed around the following guiding principles: Principle Alignment Fairness How it is followed Incentive measures are directly aligned to overall strategic priorities and drive long-term, sustainable value for our shareholders Market competitive remuneration that enables Xero to attract and retain executives and motivate them to achieve results with integrity and fairness. A commitment to pay equality Collaboration Foster teamwork and collaboration across the company, specifically via shared incentive plan measures and targets Simplicity Simple, consistent, transparent remuneration structures and incentive plans that are clearly understood, motivating and driving the right behaviours Flexibility A flexible approach that recognises executives, their roles and the market in which they operate are unique Corporate Governance Statement — 88 Remuneration structure Xero’s executive remuneration structure is deliberately weighted to have a substantial portion of total remuneration at risk. A large part of this at-risk component consists of option grants, providing leverage and a growth orientation for our executives, which is aligned to our overall strategy. Component Description Link to strategy and performance Fixed annual remuneration – Base salary – Retirement benefits (superannuation / KiwiSaver or local equivalent) It is set and reviewed annually based on individual skills, experience, accountabilities, performance, leadership and behaviours Short-term incentive – An at-risk component set as a percentage of base salary, based on seniority and country of residence – Calculated based on achievement against a range of organisational performance measures (financial and non- financial) and individual objectives – For Xero’s leadership team, STI has evolved to be paid after a 12 month performance period (1 April to 31 March, aligned with Xero’s financial year) and to include a deferred component. STI comprises 50% cash and 50% deferred equity (in the form of restricted stock units). Deferred equity vests 12 months after grant subject to continuing employment and confirmation that no award adjustment events have occured (see page 89) Rewards delivery of key strategic and financial objectives, in line with the annual business plan, and reward outcomes aligned to Xero’s aspirations for growth and operational discipline Organisational measures are approved by P&R Committee and aligned with the strategic objectives of Xero Long-term incentive – An at-risk component in the form of a block options grant plan – Participating executives are granted a block of options that vest in equal portions in each of the second, third and fourth years after grant – Executives will not receive any new equity grants under the LTI employee share plan (any historical grants under that plan will continue to vest) – New hires / promotions may be invited to participate in the block options plan, with a pro rata allocation to reflect their later entry into the plan Rewards delivery against longer-term strategy and sustained shareholder value creation. Provides alignment between shareholder and executive outcomes. Vesting is subject to continuing employment, which provides an additional time-based retention incentive, and confirmation that no award adjustment events have occured (see page 89) 89 — Corporate Governance Statement Target remuneration mix Remuneration mix refers to the proportion of total remuneration that is made up of each remuneration component. The following diagrams set out the target remuneration mix for the CEO and the rest of Xero’s leadership team: CEO Leadership team (other than CEO)* 12.5% 10% 10% 12.5% 40% 45% 35% 35% Fixed annual remuneration Long-term incentive STI cash STI equity * This reflects the target remuneration mix but actual percentages vary according to roles Market position & benchmarking As Xero continues to grow, it is important to ensure that executive remuneration is set at a level to attract and retain high-calibre talent within what is a competitive market. For executive roles based in Australia and New Zealand, total remuneration is benchmarked to a combination of two comparator groups of ASX100 companies based on market capitalisation and revenue levels. For executive roles based outside Australia and New Zealand, total remuneration is benchmarked to the local technology industry. Oversight of variable remuneration The P&R Committee considers all proposals to award variable remuneration to Xero’s leadership team, including recommended cash STI payments and awards of deferred equity, and any upcoming LTI equity vests, to determine whether there is any reason to adjust, delay or withhold those awards. Adjustment, delay or withholding may occur in circumstances where an executive has acted fraudulently or dishonestly, is in material breach of their obligations to Xero or has acted contrary to Xero’s values, where Xero becomes aware of a material misstatement or omission in the financial statements of the Xero group, or in any other circumstances (for example, relating to the executive’s conduct) where the award would result in an unfair benefit to the executive (collectively, award adjustment events). No protection arrangements Xero’s Securities Trading Policy (available on Xero’s website) prohibits employees and directors from entering into transactions that are intended to limit the economic risk of unvested or restricted Xero securities. Non-executive director remuneration The Board sets the fees for the non-executive directors at a level that provides Xero with the ability to attract and retain directors of a high calibre. The fees paid to directors are structured to reflect time commitment, responsibilities, and workloads. Target fees for non- executive directors are benchmarked to the Australia and New Zealand market, except where directors would receive higher fees in their local markets, in which case local benchmarks are used. This reflects the global composition of the Board. The actual fees paid to individual directors take into account the target fees, as well as individual directors’ skills, experience and specialist knowledge. To preserve independence and impartiality, non-executive directors have not been granted any performance-related or at-risk compensation (such as options) since 2016. Xero does not provide any scheme for retirement benefits, other than statutory superannuation, for non-executive directors. The annual total aggregate non-executive directors’ remuneration pool is currently capped at NZ$1.4 million. Any increase is subject to shareholder approval based on a recommendation from the Board. For the details of the total remuneration of, and value of other benefits received by, the non-executive directors for FY19, please refer to page 92 of this Annual Report. Disclosures — 90 Disclosures All financial figures in this section of the Annual Report are in New Zealand dollars except where indicated otherwise. References to FY19 are to the year ended 31 March 2019. References to FY18 are to the year ended 31 March 2018. Group means Xero Limited and its subsidiaries. Equity holdings of directors, CEO & CFO At 31 March 2019 Non-executive Directors Graham Smith Rod Drury1 Lee Hatton Dale Murray Susan Peterson Bill Veghte2 Craig Winkler3 CEO & CFO Steve Vamos4 Kirsty Godfrey-Billy5 Number of shares Number of options Number of restricted stock units (RSUs) - 17,719,779 7,852 950 1,827 65,598 13,025,990 10,000 3,833 - - - - 29,530 - 180,000 160,000 - - - - - - - 32,658 3,051 1. Shares are held by Rodanna Ventures Trust. Rodney Kenneth Drury, Anna Margaret Clare Drury, and Scott Moran are the trustees 2. All options held by Bill Veghte have vested (meaning that they are capable of being exercised). 27,117 shares are held by National Financial Services LLC on behalf of Bean Brook Farm 2013 Annuity Trust. Bill Veghte is the trustee of the trust. 38,481 shares are held directly by Bill Veghte 3. 12,004,545 shares are held by Givia Pty Limited, the trustee of an Australian charitable trust. Craig Winkler is a director of Givia Pty Limited; he and his family members are not beneficiaries of the trust. A further 1,000,000 of Givia's shares are the subject of a stock borrow arrangement in connection with the Group's convertible notes issue, as disclosed to ASX on 26 September 2018. 21,445 shares are held by a custodian for the benefit of Bangarie Investments Pty Limited. Craig Winkler is a director of Bangarie Investments Pty Limited 4. 20,383 RSUs will vest (be converted to shares) as set out on page 95 reflecting the FY19 outcome under the CEO LTI/retention structure. The balance will be forfeited 5. Of the 3,833 shares held by Kirsty Godfrey-Billy, 1,359 were issued to her on a restricted basis in previous years under Xero’s LTI employee share plan. She currently has a beneficial interest in those shares, which will vest over coming years in accordance with their terms of issue, subject to continuing employment. The 3,051 RSUs will vest (be converted to shares) in May 2019 Entries recorded in the interests register Xero maintains an interests register in accordance with the Companies Act 1993 (New Zealand). The following are particulars of entries made in the interests register during FY19. Directors’ interests Directors disclosed the following relevant interests, or cessations of interest, in the following entities. Director/Entity Rod Drury Atomic.io Limited Dale Murray Relationship Director/Entity Relationship Graham Smith director & minority shareholder Citrix Systems, Inc. ceased to be a director Slack Technologies, Inc. director Sussex Place Ventures Limited director MINDBODY, Inc. ceased to be a director Peter Jones Foundation ceased to be a trustee and director Splunk, Inc. Obelisk Legal Support Solutions Limited Seedrs Limited New Zealand Trade and Enterprise Beachheads Network in Europe advisor advisor advisor Bill Veghte Embroker, Inc Craig Winkler BLD Group Pty Ltd. Philanthropy Australia Ltd ceased to be a director director chair director 91 — Disclosures Share dealings of directors Directors disclosed the following acquisitions or disposals of relevant interests in Xero shares during the year. All dollar figures in this table are in Australian dollars except where indicated otherwise. Registered holder Lee Hatton Christopher Hatton1 Lee Hatton Lee Hatton Lee Hatton2 Lee Hatton3 Dale Murray Dale Jane Murray Susan Peterson Susan Ruth Peterson Bill Veghte William Lewis Veghte² William Lewis Veghte³ William Lewis Veghte William Lewis Veghte Craig Winkler Givia Pty Limited5 Givia Pty Limited5 Givia Pty Limited5 Date of acquisition/ disposal Consideration per share Number of shares acquired/(disposed) 17 May 2018 17 May 2018 18 May 2018 24 May 2018 14 November 2018 22 November 2018 13 November 2018 24 May 2018 14 November 2018 6 February 2019 6 February 2019 17 May 2018 14 June 2018 18 June 2018 $39.48 $39.98 $40.02 $39.66 $41.04 $37.50 $39.22 $39.66 $41.04 NZD $16.144 $45.03 $40.00 $45.00 $45.00 (200) (2,600) (5,000) 1,999 1,152 950 1,265 4,333 2,588 25,730 12,865 (750,000) (300,000) (400,000) 1. Christopher Hatton is Lee Hatton’s husband 2. Shares issued as full payment in lieu of cash remuneration for role as a director of Xero. At the date of issue, shares issued represented, as a percentage of total issued capital, 0.0014% for Lee Hatton and 0.0031% for Bill Veghte 3. Shares issued as full payment in lieu of cash remuneration for role as a director of Xero. At the date of issue, shares issued represented, as a percentage of total issued capital, 0.0008% for Lee Hatton and 0.0018% for Bill Veghte 4. Exercise of vested options at an exercise price of NZD $16.14 each 5. Craig Winkler is a director of Givia Pty Limited, the trustee of an Australian charitable trust. Craig Winkler and his family members are not beneficiaries of the trust. See ASX announcement dated 16 May 2017 for information on disposals by Givia Insurance In accordance with the Companies Act 1993 (New Zealand), Xero has continued to insure its directors and officers (through renewal of its D&O insurance policy) against potential liability or costs incurred in any proceeding, except to the extent prohibited by law. Deeds of Indemnity Xero has provided Deeds of Indemnity to all directors and officers of Xero and its subsidaries for potential liabilities and costs they may incur for acts or omissions in their capacity as directors or officers of Xero or its subsidaries. Disclosures — 92 Remuneration disclosures Xero’s remuneration policy and practices are summarised on pages 87 to 89 of this Annual Report. Below is information about non- executive director (NED) and executive remuneration during FY19. Non-executive director remuneration The total of the remuneration1 and the value of other benefits received by each director from Xero during FY19 was as follows: Director Country of residence Graham Smith United States Rod Drury4 New Zealand Lee Hatton Australia Committee Chair Nominations Committee - Role Chair NED Independent NED ARM Committee Dale Murray5 United Kingdom Susan Peterson New Zealand Independent NED Independent NED - - Bill Veghte6 United States Independent NED P&R Committee Craig Winkler Australia NED - Total 2019 base fees ($000s) 2019 committee chair fees ($000s) 2019 one-off payment2 ($000s) 2019 Total fees ($000s) 2018 Total fees3 ($000s) 310 90 90 111 90 285 90 1,066 - - 20 - - 14 - 34 150 460 - - - - - - 90 110 111 90 299 90 150 1,2501 310 - 110 - 90 357 90 957 1. Other than the treatment of options as described in footnote 6, total remuneration is presented based on accounting expense and may include amounts earned, but not yet received. Note that there were two additional paid NEDs in FY19 compared to FY18 2. For activities undertaken for Xero outside the role of Chair in relation to M&A and US$300m convertible notes issue 3. Includes director and Committee Chair fees for the year ended 31 March 2018 4. Became a non-executive director effective 1 April 2018. Rod Drury was an executive director for the year ended 31 March 2018 and received executive remuneration from Xero that year 5. Appointed as a director effective 13 April 2018 6. The fees for Bill Veghte differ from the standard annual fees, because they include the value of options granted to him in prior periods (2015 and 2016) that vested in FY19. For conformity with the current year presentation, fees for the period ended 31 March 2018 for Bill Veghte have been restated so that the value of the options are included at the point of vest. Previously, the value of options was spread over the period from grant to vest The total remuneration available to non-executive directors is fixed by shareholders. Currently, the annual total aggregate non- executive directors’ remuneration is capped at $1.4 million, as approved by shareholders at the Annual General Meeting in July 2017. Set out below are the standard annual fees payable to non-executive directors during FY19. Due to the global composition of the Board, fees are benchmarked and determined in the currency of each director’s country of residence (as explained on page 89), and are converted to New Zealand dollars at the start of each financial year. Hence New Zealand dollar fees vary by each country in the table below. Country of residence New Zealand Australia United States United Kingdom Chair ($000s) 180 180 310 260 Director¹ ($000s) ARM Committee Chair ($000s) P&R Committee Chair ($000s) 90 90 226 115 20 20 21 19 15 15 14 19 1. No additional fees are paid for Chair of the Nominations Committee 93 — Disclosures Executive remuneration The remuneration structure for Xero’s leadership team for FY19 comprises the fixed, LTI and STI components outlined on page 88 of this Annual Report. This revised remuneration structure was implemented during the year following a review of executive remuneration, which included input from external remuneration consultants. Below is more information about the variable components of the remuneration structure for Xero’s leadership team, including details of CEO and CFO remuneration, for the year. Short-term incentive The following table summarises the short-term incentive arrangements for Xero’s leadership team during FY19: Deferred short-term incentive plan Participants Award type Xero’s leadership team (CEO and senior executives who report directly to the CEO) – 50% payable in cash at the end of the performance period – 50% payable in equity as restricted stock units (RSUs) and deferred for 12 months from the grant date Performance period FY19 When are performance conditions tested? Performance against financial and non-financial measures is determined in parallel with the finalisation of the Group’s financial statements and following a review of executive performance by the CEO in consultation with the P&R Committee (and in the case of the CEO, by the Board). If the executive is still employed by Xero 12 months after the end of the performance period, the RSUs will vest and be converted into fully paid ordinary shares of Xero. The P&R Committee reviews and approves upcoming incentive payments and equity vests to ensure all applicable conditions are satisfied and no award adjustment events have occured (see page 89). Performance metrics and Leadership team (other than regional leads) weightings 60% 10% 10% 20% Voice of Shareholder Comprises company financial measures (revenue growth, cash flow and EBITDA) Voice of Customer Partner and small business net promoter score (NPS) targets Voice of Employee Employee NPS and engagement targets Individual Objectives Goals aligned to company strategic objectives Regional leads 80% Voice of Shareholder Comprises 40% company financial measures (revenue growth, cash flow and EBITDA) and 40% regional financial measures (monthly recurring revenue (MRR) growth and subscriber additions) 5% 5% 10% Voice of Customer Partner and small business NPS targets Voice of Employee Employee NPS and engagement targets Individual Objectives Goals aligned to company strategic objectives Relationship between performance and payment Performance targets have been set to drive the desired behaviours consistent with Xero’s values and strategic objectives. Depending on achievement against targets, executives have the ability to earn between 0 and 130% of their target short-term incentive. Overachievement against targets is possible in relation to the “Voice of Shareholder” metrics. Calculation of outcome Achievement against each metric is calculated, then applied against the weightings shown above and then added to provide the total STI outcome. Disclosures — 94 Long-term incentive The following table summarises the long-term incentive arrangements for Xero’s leadership team during FY19: Executive block options plan Participants Award type Initial grant date Vesting period Xero’s leadership team & selected senior management roles Options to acquire fully paid ordinary shares in Xero June 2018 (leadership team / senior management roles), August 2018 (CEO), October 2018 (additional grant to CFO following promotion). Other grants are made as executives are invited to join the plan following promotion or appointment. Options vest in three equal tranches in June 2020, June 2021, and June 2022 (or, in the case of the CEO, two equal tranches vesting in June 2021 and June 2022) Expiry date 30 June 2023 (for options granted during 2018) What are the Vesting is conditional on employment on the vesting date. performance vesting conditions? The P&R Committee reviews and approves all upcoming option vests to ensure all applicable conditions are satisfied and no award adjustment events have occured (see page 89). How is the option grant determined? The number of options was determined for each participant based on a combination of their role type and a target amount using a Black-Scholes value at the time of grant. Interaction with other – Executives participating in the block options plan no longer participate in Xero’s LTI employee share plan, but grants LTI/equity grants made to executives in previous years under that plan will continue to vest in accordance with their terms. Some executives have also previously received other options as part of their remuneration arrangements and these will also continue to vest in accordance with their terms. – The CEO was invited to participate in the executive block options plan from August 2018. To reflect his existing RSU grants under the CEO LTI/retention structure outlined below, the total number of options granted to the CEO was reduced by 25% and vesting in June 2020 was foregone. CEO & CFO option grants – 180,000 options were granted to S Vamos in October 2018 at an exercise price of A$34.00 each (calculated as at 1 April in FY19 2018 to align with the start of Xero’s financial year and the exercise price applicable for other executives) – 100,000 options were granted to K Godfrey-Billy in 2018 (80,000 granted in June 2018 at an exercise price of A$34.00 each and 20,000 granted in October 2018 at an exercise price of A$48.33 each following promotion to the CFO role) CEO LTI / retention (LTI/R) structure Participants CEO Award type Grant date Vesting period RSUs (restricted stock units) – one-off LTI/R target RSU amount equivalent to 70% of FY19 starting base salary April 2018 & June 2018 Vesting in three equal tranches over a 3 year period in May 2019, May 2020, and May 2021, subject to employment on the vesting date Performance period FY19 When are performance conditions tested? Performance against the metrics described below is determined in parallel with the finalisation of the Group’s financial statements and following a review of the CEO’s performance by the Board. The P&R Committee reviews and approves the annual RSU vests to ensure that no award adjustment events have occured (see page 89). Performance metrics and weightings Revenue Growth MRR (Monthly Recurring Revenue) Growth EBITDA 40% 40% 20% Relationship between performance and payment Calculation of outcome The total amount of RSUs to vest (on the vesting schedule above) is determined by performance against the metrics above. The Board has allowed for stretch goals for overachievement, which can increase the amount of RSUs to vest from 70% to 140% of FY19 starting base salary. Achievement against each metric is calculated, then applied to the weightings shown above and then added to provide the total LTI outcome. 95 — Disclosures CEO and CFO remuneration The following table provides details of the remuneration received by the CEO and CFO in FY19. Fixed annual remuneration Variable remuneration Total remuneration Salary ($000s) 1,0142 4194 Superannuation/ KiwiSaver ($000s) 54 11 Short-term incentive ($000s) Long-term incentive ($000s) n/a3 485 n/a3 2146 ($000s) 1,067 692 S Vamos1 K Godfrey-Billy 1. Amounts shown for CEO were paid in AUD but are shown in NZD (the functional currency of the Group) translated at the average exchange rate for the year 2. Base salary increased to A$1,012,500 effective 1 November 2018, following retirement from the Telstra board. Actual remuneration for the year ended 31 March 2019 reflects a blend of the rates that applied before and after that date 3. No STI or LTI amounts were paid to Steve Vamos during FY19 as his employment with Xero commenced on 1 April 2018. The STI and LTI outcomes summarised in the tables below will be reflected in his actual remuneration from FY20 onwards 4. Base salary increased to $450,000 effective 1 October 2018 following promotion to the role of CFO. Actual remuneration for the year ended 31 March 2019 reflects a blend of the rates that applied before and after that date 5. Consists of cash paid during FY19 under the STI arrangements that applied for the prior year. The below STI outcomes for FY19 will be reflected in actual remuneration in FY20 6. Consists of the value of options and restricted shares granted in prior years that vested in FY19 The following table summarises the short-term incentive outcomes for Xero’s CEO and CFO for FY19 under the executive deferred short-term incentive plan detailed on page 93: S Vamos K Godfrey-Billy 1. To be paid in May 2019 Achievement against target Actual STI awarded ($000s) 50% cash1 ($000s) 50% equity2 ($000s) 89.6% 89.6% 510 150 255 75 255 75 2. The equity component of the short-term incentive will be granted in May 2019 in the form of RSUs, and deferred for 12 months from grant date. The number of RSUs granted will depend on the volume weighted average price of Xero shares at the grant date The following table summarises the long-term incentive outcome for Xero’s CEO for FY19 under the CEO LTI/retention structure detailed on page 94: Achievement against target Total number of RSUs to vest based on achievement against target RSUs vesting in May 2019 RSUs vesting in May 2020 RSUs vesting in May 2021 S Vamos 110%¹ 20,383 6,794 6,794 6,795 1. This correlates to 77% of FY19 starting base salary Disclosures — 96 Employee remuneration The following table shows the number of employees of the Group whose remuneration and benefits for FY19 were within the specified bands above $100,000. The remuneration covered in the table includes monetary payments received and share-based payments vested (ie. restricted shares, RSUs and vested options). The table includes the CEO and CFO. Remuneration including share-based compensation 2019 Number of employees Remuneration including share-based compensation 2019 Number of employees 100,000 to 109,999 110,000 to 119,999 120,000 to 129,999 130,000 to 139,999 140,000 to 149,999 150,000 to 159,999 160,000 to 169,999 170,000 to 179,999 180,000 to 189,999 190,000 to 199,999 200,000 to 209,999 210,000 to 219,999 220,000 to 229,999 230,000 to 239,999 240,000 to 249,999 250,000 to 259,999 260,000 to 269,999 270,000 to 279,999 280,000 to 289,999 290,000 to 299,999 300,000 to 309,999 310,000 to 319,999 320,000 to 329,999 330,000 to 339,999 340,000 to 349,999 350,000 to 359,999 360,000 to 369,999 370,000 to 379,999 150 162 129 132 96 91 82 72 50 35 29 39 26 26 17 12 15 19 14 7 8 5 1 6 6 2 2 1 380,000 to 389,999 390,000 to 399,999 410,000 to 419,999 420,000 to 429,999 430,000 to 439,999 440,000 to 449,999 460,000 to 469,999 470,000 to 479,999 480,000 to 489,999 490,000 to 499,999 500,000 to 509,999 520,000 to 529,999 530,000 to 539,999 540,000 to 549,999 550,000 to 559,999 560,000 to 569,999 580,000 to 589,999 680,000 to 689,999 690,000 to 699,999 700,000 to 709,999 740,000 to 749,999 800,000 to 809,999 820,000 to 829,999 870,000 to 879,999 1,030,000 to 1,030,999 1,060,000 to 1,069,999 1,200,000 to 1,209,999 1,330,000 to 1,339,999 1,940,000 to 1,949,999 3 3 1 5 1 2 1 3 1 4 2 1 1 1 1 2 1 1 1 1 1 1 1 1 1 1 1 1 1 97 — Disclosures Shareholder information The shareholder information set out below is current at 18 April 2019, unless otherwise specified. Issued capital The total number of issued ordinary shares in Xero Limited at 31 March 2019 was 140,850,806, of which 411,359 ordinary shares are held on a restricted basis in connection with Xero’s share-based compensation plans. Distribution of shareholding Range 1 to 1,000 1,001 to 5,000 5,001 to 10,000 10,001 to 100,000 100,001 and over Total Number of holders 18,693 2,997 341 230 34 22,295 % 83.84 13.44 1.53 1.03 0.15 Ordinary shares 5,204,386 6,268,837 2,476,386 5,686,716 121,214,708 100.00 140,850,806 % 3.69 4.45 1.76 4.04 86.06 100.00 There were 361 holders of less than a marketable parcel of ordinary shares. RSUs and options There were 44 individuals holding a total of 2,994,591 unlisted options and 492 individuals holding a total of 244,312 RSUs. RSUs are a conditional contractual right to be issued an equivalent number of ordinary shares in Xero. Substantial holdings and limitations on the acquisition of securities Xero is a New Zealand incorporated and domiciled company listed on the Australian Securities Exchange (ASX). From a regulatory perspective, this means that while the ASX Listing Rules apply to Xero, certain provisions of the Australian Corporations Act 2001 (Cth) do not. Xero is not subject to chapters 6, 6A, 6B, and 6C of the Australian Corporations Act 2001 (Cth) dealing with the acquisition of its shares (including substantial holdings and takeovers). The Companies Act 1993 (New Zealand) applies to Xero, while certain provisions of the Financial Markets Conduct Act 2013 (New Zealand) do not. There is no requirement on Xero’s substantial shareholders to provide substantial holder notices to Xero. Where, however, Xero receives such notices during the year, the most recent notice is detailed. Substantial holder UBS Group AG Date of most recent notice received by Xero Ordinary shares in which a relevant interest is held 30 August 2018 N/A (cessation of substantial holder) Key limitations on the acquisition of shares in Xero are imposed by the following New Zealand legislation: Commerce Act 1986, Overseas Investment Act 2005 and Takeovers Act 1993, together with various regulations and codes promulgated under such legislation. Disclosures — 98 Top 20 holders The names of the 20 largest holders of Xero’s ordinary shares are set out below. Name 1. HSBC Custody Nominees (Australia) Limited 2. J P Morgan Nominees Australia Limited 3. Anna Margaret Clare Drury & Rodney Kenneth Drury & Scott Moran 4. Citicorp Nominees Pty Limited 5. Givia Pty Limited1 6. National Nominees Limited 7. Citicorp Nominees Pty Limited (Colonial First State Inc A/C) 8. HSBC Custody Nominees (Australia) Limited - GSCO ECA 9. JBWere (NZ) Nominees Limited (56968 A/C) 10. Custodial Services Limited (Beneficiaries Holding A/C) 11. BNP Paribas Nominees Pty Ltd (Agency Lending DRP A/C) 12. BNP Paribas Noms Pty Ltd (DRP) 13. Nelson Nien Sheng Wang & Pei-Chun Ko (Wang Family A/C) 14. Nicola Jane Wilson & David Jonathan Wilson (Wilson Family A/C) 15. HSBC Custody Nominees (Australia) Limited - A/C 2 16. Australian Foundation Investment Company Limited 17. BNP Paribas Nominees Pty Ltd (IB AU Noms Retail Client DRP) 18. CS Third Nominees Pty Limited (HSBC Cust Nom AU Ltd 13 A/C) 19. HSBC Custody Nominees (Australia) Limited (NT-Comnwlth Super Corp A/C) 20. Xero Limited (Employee Restricted Share Plan A/C) Top 20 holders of ordinary fully paid shares (total) Other shareholders (balance on register) Grand total 1. Refer to page 90 for additional information about Givia's holdings Number of ordinary shares held % of total issued capital 27,566,146 22,918,378 17,719,779 14,228,200 12,004,545 4,730,732 3,115,971 2,978,248 1,947,050 1,791,632 1,427,188 1,316,342 1,150,288 915,857 873,162 740,500 711,122 666,373 638,218 411,359 117,851,090 22,999,716 140,850,806 19.57 16.27 12.58 10.10 8.52 3.36 2.21 2.11 1.38 1.27 1.01 0.93 0.82 0.65 0.62 0.53 0.50 0.47 0.45 0.29 83.67 16.33 100.00 Voting rights Xero has a single class of ordinary shares on issue. Where voting at a meeting of shareholders is by voice or a show of hands, every shareholder present in person, or by representative, has one vote. On a poll, every shareholder present in person, or by representative, has one vote for each fully paid ordinary share. In practice, Xero ensures that all resolutions at shareholder meetings are decided by a poll rather than on a show of hands. On-market buy-back There is no on-market buy-back for Xero’s shares. 99 — Disclosures Company information Donations The Group made charitable donations totalling $32,379.77 during FY19. The Group made no donations to political parties during FY19. Company subsidiaries and directors Xero has 14 wholly owned subsidiaries as shown in the table below. The following people held office as directors of Xero’s subsidiary companies during FY19: Subsidiary Current directors Directors ceased during year Jurisdiction Australia Hubdoc Pty Ltd Xero Australia Pty Ltd Canada Hubdoc Inc. Xero Software (Canada) Ltd Hong Kong Xero (HK) Limited New Zealand Xero Investments Limited Xero (NZ) Limited Kirsty Godfrey-Billy Trent Innes Chaman Sidhu Kirsty Godfrey-Billy Trent Innes Chaman Sidhu Kirsty Godfrey-Billy Keri Gohman James McDonald James Shulman Kirsty Godfrey-Billy Keri Gohman Kevin Fitzgerald Kirsty Godfrey-Billy Anna Curzon Kirsty Godfrey-Billy Craig Hudson Anna Curzon Kirsty Godfrey-Billy Craig Hudson James McDonald (ceased 2 August 2018) James Shulman (ceased 2 August 2018) David Torrible (ceased 2 August 2018) Rod Drury (ceased 5 October 2018) Kevin Wood (ceased 16 August 2018) Rod Drury (ceased 4 October 2018) Rod Drury (ceased 19 October 2018) Alexander Campbell (ceased 15 February 2019) Susan Peterson (ceased 15 February 2019) Graham Smith (ceased 15 February 2019) Rod Drury (ceased 5 October 2018) Xero Trustee Limited Kirsty Godfrey-Billy Rod Drury (ceased 5 October 2018) Singapore Xero (Singapore) Pte. Ltd South Africa Xero South Africa (Pty) Ltd United Kingdom Cicerone Ltd Hubdoc (UK) Limited Xero (UK) Limited Kevin Fitzgerald Kirsty Godfrey-Billy Kirsty Godfrey-Billy Gary Turner Anna Curzon Kirsty Godfrey-Billy Gary Turner Anna Curzon Kirsty Godfrey-Billy Gary Turner Anna Curzon Kirsty Godfrey-Billy Gary Turner Rod Drury (ceased 4 October 2018) Rod Drury (ceased 5 October 2018) Keith Carsley (ceased 14 December 2018) Alvin Ho (ceased 14 December 2018) Rod Drury (ceased 4 October 2018) United States Xero, Inc. Keri Gohman Rod Drury (ceased 4 October 2018) During the year, Gary Turner became an advisor to Enterprise Nation. There were no other changes to the interests of the directors of Xero's subsidiaries during FY19. No employee appointed as a director of Xero’s subsidiary companies receives any remuneration or other benefits from Xero in their role as a director. The remuneration and other benefits of such employees, received as employees, are included in the relevant bandings for employee remuneration disclosed on page 96. Annual General Meeting Xero’s AGM will be held on Thursday, 15 August 2019 in Auckland, New Zealand, and virtually through an online platform provided by Xero’s share registrar, Link Market Services Limited. Corporate Directory — 100 Corporate Directory Registered Offices Directors Leadership Team Auditor New Zealand 19-23 Taranaki Street Te Aro, Wellington 6011 New Zealand Telephone: +64 4 819 4800 Australia 1/6 Elizabeth Street Hawthorn, Vic 3122 Australia Telephone: +61 3 9981 0408 Company Numbers 183 0488 (New Zealand) ARBN 160 661 183 (Australia) Web Address: www.xero.com Ernst & Young Stock Exchange Xero’s ordinary shares are listed on the ASX Share Registrar Link Market Services Limited Level 13, Tower 4, 727 Collins Street Melbourne, Vic 3000 Australia Telephone: +61 3 9067 2005 Annual General Meeting Date: 15 August 2019 Time: 11am (NZST) Location: Auckland, New Zealand Graham Smith (Chair) Rod Drury Lee Hatton Dale Murray, CBE Susan Peterson Bill Veghte Craig Winkler Steve Vamos Chief Executive Officer Anna Curzon Chief Product Officer Kirsty Godfrey-Billy Chief Financial Officer Keri Gohman Chief Platform Business Officer Craig Hudson Managing Director, New Zealand & Pacific Islands Trent Innes Managing Director, Australia & Asia Rachael Powell Chief Customer, People & Marketing Officer Mark Rees Chief Technology Officer Chaman Sidhu Chief Legal Officer & Company Secretary Damien Tampling Chief Strategy & Corporate Development Officer Gary Turner Managing Director, United Kingdom & EMEA Tony Ward President, Americas Cover images: Streamline Management, Australia Volare, New Zealand Hunt & Gather Bee Co, New Zealand The Mindful Company, Singapore Factor1, Australia Nubian Skin, United Kingdom The Little Veggie Patch Co, Australia Armanino, United States Beaufort Tax Consultants Pte Ltd, Singapore