ESOP Valuation 101: How to Value Your ESOPs
ESOPs are a great way to provide shareholders with a stake in the company. Issuing stock options have become commonplace in the world of startups to compensate and retain good talent.. However, ESOP valuation can be tricky, and there are factors to consider.
This article will provide a basic overview of stock valuation, so that you can understand how it works.
What is an ESOP?
An Employee Stock Ownership Plan is essentially a plan that allows employees to own a fractional share in a company.
It also allows the employer to provide its employees with a stock option as a way to reward them for their continued association with the company.
The purpose of an ESOP, therefore, is to continue to encourage employees to contribute to the company’s growth and retain the employees in the long-term.
By allowing employees to have a stake in the company, ESOPs can help to improve morale and create a sense of community within the workplace.
How Do ESOPs Work?
When an employee is offered ESOPs, the employee gets a “right” to buy the equity shares of the company. There is a key difference between issuing stocks and issuing ESOPs. When startups issue stocks to investors, the holder of the stock becomes an owner of the startup. However, in the case of ESOPs, employees get a “right” to become an owner in the future.
What are the Methods of Doing ESOP Valuation?
There are three main methods to do ESOP valuation: Black Scholes, Binomial, and Monte Carlo method. Now, let’s take a look at each of these methods in more detail.
Intrinsic Value Method
Intrinsic value of an employee share-based payment is the excess of the market price per share, over the exercise price of the option. In other words, this is the ‘imputed gain’ that an employee receives by selling their option.
Black Scholes Method
Black Scholes is the standard valuation technique that companies use to determine the fair market price for employee stock options. The major benefit of using this strategy is that it makes the valuation very easy. You can determine the price of an option when all of its parameters are set.
Under the Black-Scholes method, the value of the option is decided based on:
- The expected life of the option
- Expected volatility of share price
- Expected dividend yield
- Risk free rate
- Exercise price
- The fair value per share
One disadvantage to this method is that the exercise price of an option can vary from time to time. The method makes the assumption that share prices follow a log-normal distribution. This assumption might not hold true under certain circumstances, such as when markets are under pressure.
The standard model utilizes an extremely complex combination of probability and statistical techniques to predict share prices. The price of a share will change as the shares are acquired in the future, based on how likely it seems that they may change between the date of granting them and the date of their exercise.
The binomial method, though, is quite strong for ESOP valuation services as it can deal with more complex rules as well as occurrences over the vesting period (e.g. probability of departure from the service). Its assumption of a log-normal stock price distribution is the main problem.
Monte Carlo Method
This is a very similar strategy to the Binomial method to predict how much a particular share will cost. The strategy of not predicting share prices is independent of any pre-established up or comedown probabilities.
The derivation of the share prices is by sampling a specific set of prices for which there are many options. This is useful when the capital markets are tight because there are many situations where the distribution of money is different from what the logarithmic distribution would show.
What’s disadvantageous about this method is that it requires a lot of time to produce a result, because the computer algorithms to perform this task are very complex.
Who Can Perform ESOP Valuations?
According to the Indian Income Tax Law, it is only a SEBI (Securities and Exchange Board of India) Registered (Cat-I) Merchant Banker who can do the ESOP valuations to assess the perquisite tax payable of the employees, promoters, directors, as well as the others. This is because the valuation is an act of assessment and is meant to ascertain the perquisites which may be due to any person holding any interest in the company.
Valuation of ESOPs are also done for meeting accounting purposes. If you are a listed company or an unlisted private company, the guidance note issued by the ICAI requires you to account for stock options issued. This requires an independent valuation for accounting purposes.
Tax Valuation of an ESOP
Conducting an ESOP valuation is essential to determine the value of employee benefits in order to comply with the applicable requirements of the Indian Income Tax Act 1961, as well as CBDT notices for that matter.
So, if you’re considering an ESOP for your company, it’s important to consult with a tax professional to ensure that all the proper paperwork is completed.
The Challenges of ESOP Valuation
Future shareholders who participate in ESOPs receive minority stakes. Therefore, when valuing minority investors, it becomes necessary to employ minority valuation methods in order to determine minority shareholder values for ESOPs.
If there are any control mechanisms being enacted, it may be necessary to provide discounts on the evidence available and the particular circumstances in which they were enacted.
Although it is possible to consider certain scenarios for both Financial Statements (for the company) and Tax Statements (for employees), differences in valuation approaches could arise from a variety of different scenarios.
An ESOP is a great way for employees to have a stake in the company and to receive financial benefits in the form of stock dividends. By understanding how ESOPs work and what methods are available for valuing them, you can ensure that your company’s valuation is accurate and compliant with all applicable regulations.