ESOP Valuation Methods

ESOP Valuation Methods

Every native and nascent start-up company is advised to help their employees in one way or another by rewarding their work and loyalty. It can be done in ESOP, which provides tax benefits to the company and develops an ownership mentality in the employees.

Employee Stock Ownership Plan, abbreviated as ESOP, is used by both the listed and unlisted private companies. Its protocols were issued in the Companies Act, 1956, but the protocols were put into action during the Companies Act, 2013. ESOP has proved beneficial to a company because if it meets the needs of the employees, then the loyal and high-efficient workers can stay with them for a longer run witnessing the company's growth.

ESOP valuation methods are mainly required:

  1. During grants time
  2. During income tax payment
  3. Evaluation during management

Why is the ESOP valuation method important?

ESOP valuation method is important to issue ESOPs over a vesting period (a period during which employees stay in a company for a longer-term) and calculate the required tax that has to be paid by its employees. Under guidance note 18, ESOP valuation is done in India using various income, assets, market approach, and fair value methods. 

Valuation of ESOP:

A registered valuer should do the valuation of ESOP according to guidance note on accounting for employee share-based payment". The Merchant banker does the valuation at the time of exercise. Merchant Bankers can do the ESOP valuation as per Indian Income Tax law.

For an independent ESOP valuation, 3 things should be kept in mind:-

  • The value of ESOP needs to be understood-

One should seek expertise or consult professionals to reach more accurate conclusive values to know this. This initial value can be thought of as the root of the future valuation.

Act in accordance with the regulatory agencies-

There are various rules and regulations associated with the ESOP scheme. We need to comply with the regulations to ensure that there should not any drawbacks. 

 Obligations should be repurchased-

The obligations during the purchase of the shares should be followed properly, or else that may lead to the financial strain on the company.

Inputs for the Esop Valuation Methods:

  1. Expected option life is based on the vesting date, exercise date, and grant dates.
  2. Fair values of the shares of the company.
  3. Expected volatility- It measures the fluctuations in terms of equity shares.
  4. Expected dividends

Apart from these few inputs, many more can be included.

Esop Valuation Methods:

There are 3 types of valuation methods used, which are as follows-

  1. Binomial Method- useful method
  2. Black Scholes Merton method- widely used method across different countries
  3. Monte Carlo method- rarely used method
  • Binomial Method

It is considered to be the most flexible method out of the 2 methods used. It is an American method that can be applied anytime until expiration. This method usually requires the building up of a binomial tree that is very complex and difficult to predict. It requires computational techniques to get the result. It is the most advanced form of the method. 

The disadvantage of using this method is that it has more complicated rules. This method is restricted in India.

  • Black Scholes Merton Method

It was first introduced by Fischer Black, Myron Scholes, and Robert Merton. It is a European form of method that is applied at the end of the exercise date.

The formula is as follows:

C = SN(d1) – N(d2)Ke-rt

where, 

c= call premium

S= stock price

t= time till exercise date

K= open striking price

r= risk free interest rate

 n= normal distribution

e= exponent

d1 = ln() + (r+)t/S.

d2 = d1 - S.

where, S= standard deviation

This method is simple. It can be easily calculated once all the values of the parameters are known. 

The disadvantage of using this method is that the exercise price varies sometimes. In India, this formula is widely followed for valuation.

  • Monte Carlo Method

It is similar to the binomial method, which projects the share price. It is not based on the probabilities. A single share price is projected under different scenarios by constructing various unique paths. It is the most accurate method of all. 

The disadvantage of using this method is that it is time-consuming as it involves computational methods. It is not understood well yet. In India, this method is not followed at all.

Private organizations frequently use ESOP. It is described as a tool by the companies to award their employees. It is the right of an employee over the company's shares at a predetermined price over the actual market price, rather than being an obligation. It is not an easy task for a company to let go of taxes and pay a bonus to the employees. But as we know, we need to lose something for the gain of others, and the same applies here too. Though the company promises its employees to be a shareholder of the company's profit, it is for the employer's benefit as the company's growth will be inevitable in the future.

The ESOP  valuation method is also faced with many challenges. We need to apply the best valuation method, or else it may result in minority stakes for the shareholders' employees. 

If you are looking for any Employee stock option plan ESOP services or consultants in Noida, Delhi, Gurgaon or anywhere in India, write to us at accounts@especia.co.in. Or Call On :(+91)-9711021268 +91-9310165114

- Share this post on -