Employee Stock Option Plans (ESOPs) plan in which companies issue Stock Options to employees depending on their performance. It is a call option, which means that under an employee stock ownership plan (ESOP), workers have no obligations and have the opportunity to purchase the company's shares at a predetermined price on a predetermined date.
The purpose of an ESOP is to inspire employees to be more productive and increase shareholder value. ESOP Valuation is a frequent facilitator used by a corporation to engage, keep, and enumerate its personnel and award them for being affiliated with the company while instilling a sense of ownership in employees' minds and maintaining their interest in the organization.
Why Should One Get Done ESOP Valuation?
ESOP valuation is required for accounting purposes to register Compensation Expense by the company issuing ESOPs over the Vesting period and for taxation purposes of calculating perquisite Tax payable by its personnel. The compensation expense affects the company's EPS, plus the potential of employees paying Excess Tax, making the ESOP scheme unappealing. As a result, appropriate ESOP valuation from an experienced ESOP valuation firm or ESOP valuation company is unavoidable.
ESOP valuation report is required in this context because:
- It focuses on motivating, keeping, and rewarding people who contributed to the success of the firm in the first instance;
- It also gives an exit strategy for changing ownership or founding members of an organization;
- It helps in establishing the value of perquisite taxable in the hands of employees to comply with applicable requirements of the Indian Income Tax Act, 1961 and CBDT notification in this regard.
ESOP Valuation Techniques and Methodologies
ESOP valuation in India is governed by the ICAI's guidance note 18 on accounting for employee share-based payments (2005 ed.). ESOPs can be valued using the Intrinsic Value approach, which employs the Income, Asset, or Market Approach (similar to Business Valuation), or using the Fair Value method (through Option Pricing valuation including Black Scholes or Binomial method).
1. BLACK SCHOLES FORMULA
In India, the Black Scholes method is the most common technique used by the ESOP valuation company to value employee stock options. On the other hand, companies must grasp the constraints and ensure that this strategy is acceptable for their specific circumstances. The main benefit of this strategy is its ease. The option price can be simply determined once the parameters' values are known.
The disadvantage of this strategy is that it may not allow for complex characteristics, such as varying exercise prices based on a formula. The technique assumes a lognormal distribution of share prices, which may or may not be valid in certain conditions, such as when strained markets.
2. BINOMIAL MODEL
The binomial model is more complex and employs computing approaches. The share price is projected from the date of grant to the date of exercise using ‘up' and ‘down' probability in this model. The probabilities are calculated using the assumption of share price volatility.
The binomial method is quite robust for ESOP valuation services and can accommodate more sophisticated rules and occurrences over the vesting period (e.g. probability of leaving the service). The key issue is that it also assumes a lognormal share price distribution.
3. MONTE CARLO METHOD
This strategy, like the Binomial model, involves projecting the share price. The prediction of share price, on the other hand, is not constrained by pre-defined up and down probability. Instead, the share price is sampled from the distribution of share prices specified. The Monte Carlo method, suggested by ESOP valuation consultants, is the most accurate of all option pricing methodologies.
It can accommodate any amount of intricacy in the scheme's regulations and deal with pre-vesting events. It can deal with non-lognormal share price distributions, yielding more accurate findings. This could be especially useful when capital markets are strained, and the lognormal distribution may not be applicable. The disadvantage of this strategy is that it takes time to provide results due to the computational complexity needed. It could also be tough to comprehend.
Who is qualified to perform ESOP valuations?
According to Indian Income Tax Law, only a SEBI Registered (Cat-I) Merchant Banker is entitled to do ESOP/ Sweat Equity valuations to determine the perquisite tax payable in the hands of employees, directors, promoters, and others.
What are the Challenges for ESOP Valuation?
By definition, ESOPs result in minority stakes for future shareholders. As a result, we must use minority valuation methods to arrive at minority shareholder valuation in an ESOP. Appropriate discounts should be supplied based on empirical evidence and case details if any control mechanism is being considered. Even in the case of Accounting Valuation (for the company) and Tax Valuation (for employees), there may be a difference in the valuation approach due to the number of possibilities available.
Our ESOP Valuation Practice
We are a SEBI Registered (Cat-I) Merchant Banker, and our specialist valuation team will assist you in assessing the value of ESOPs for option holders. We thoroughly examine the Company's history, operations, and comparative market multiples to determine worth for ESOP holders. We have a specialist ESOP (Employee Stock Ownership Plan) staff that ranks among the best ESOP Valuation & RSU Consultants, having completed numerous ESOP Valuations.
Thus, ESOP valuation (both for the accounting of “Compensation Expense” by a company and for perquisite Tax payable by employees) is critical to the viability of an ESOP plan. The compensation expense affects the company's EPS, and the prospect of excessive tax payout by employees may make the ESOP scheme unappealing; therefore, adequate ESOP planning is required.