Employee Stock Option Plan is a scheme through which a company rewards its hard-working and loyal employees. It is done by both well-established companies as well as startups that require a dedicated workforce to push the company to a stronghold in the market. The stock option is not mandatory or an obligation; rather, it is just a right that the employees can choose to exercise and reap the benefits in the long run. The company that issues the stock option has legal power over the scheme and whether it sees certain employees as eligible or not. It is basically a wealth-creating scheme for the employees and encourages them to perform better and maintain their loyalty to the company. The early joiners of the company have better ESOP pool options to choose from as compared to the employees that join after the growth of a company, which is only fair.
Valuation of ESOP is necessary for checking the Employee Compensation Cost at the time of granting of the scheme over its vesting period, and to do that, there are a few ways of doing so. Two methods can check ESOP value, the first is through the Intrinsic value Method, and the other is the Fair Value Method.
Two methods can Check ESOP Value
Intrinsic Value method
The excess price of the share in the market price under ESOP over the option's exercise price is called Intrinsic Value. For example, ESOP is granted to the employees by the company they work for, and the share's current market price is 100. It can be exercised after two and a half years for Rs. 60, in which case, the Intrinsic Value of the options is Rs. 40 as we get the sum after deducting from the CMP.
In another case, if the share's current market price were Rs. 50, there would be no Intrinsic Value of the option given to the employees since the exercise price is more than the current market price. Therefore, the options could not be exercised in such a case and ended up standing lapsed. The difference between the Intrinsic Value method and the Fair Value method is the time value.
Fair Value Method
Another method of checking ESOP Value is through the fair Value method. The fair value is estimated through the Black-Scholes model, binomial model, or the Monte Carlo method, which are option-pricing models and have different parameters for each.
Black Scholes method - The most widely used method in the Fair Value method is the Black Scholes method. It is considered to be fitting for small schemes that do not have complex rules. The ESOP value can be calculated once the parameters' value has been estimated, making it simple and adding to its advantage of usage. The parameters required are share price, exercise price, volatility, duration till exercise, and the risk-free rate, which will give appropriate results without any complexities. This method assumes a lognormal distribution of share price, which is less likely to work for all circumstances, which is one of the drawbacks of this method.
Binomial Method - The other method used in the Fair Value method is the binomial model, which is more advanced as compared to the previous method, the Black Scholes method. It involves the use of computational techniques wherein, with the help of the grant date and the exercise date, the share price is projected through vertically moving probabilities. This method can work for more complex rules during the vesting period as the probabilities are calculated through the share price volatility assumption. However, similar to the previous method, it assumes the lognormal distribution of share price.
Monte Carlo Method - Similar to the binomial method, the Monte Carlo Method requires share price projection. Still, pre-defined vertically moving probabilities do not restrict it, and the share price is 'sampled from the selected share price instead. This method is not common in Indian markets, but it can be used in this present day and age because of the increased computational power.
This method gives more accurate results than the other two pricing methods for checking ESOP value. It allows a greater extent of complex levels of the scheme rules while dealing with events before the vesting period. Unlike the previous method, it does not assume the lognormal distribution of share price because of which it is more likely to give accurate results. The Monte Carlo method can also be useful when the capital markets are stressed, and the use of lognormal distribution does not prove to be very effective.
The only disadvantage of this method is the time requirement, which results from computation complexity in the calculation through this method and could be difficult to understand to some extent for a lot of people.
Stock Option Plans have been proven to be highly convenient for the companies as they use these options to reimburse the employees and align the interests of both. While opting for the ESOP scheme, a certain valuation needs to be done, such as checking the ESOP value. For the ESOP scheme to be successful, the ESOP value needs to be determined not to create any miscalculation during the fluctuations in the market.
In the methods mentioned above for checking ESOP value, every method has its convenience factor for every set of companies. The Intrinsic Value and the Fair method value are the two basic ways of checking the ESOP, and although the Intrinsic value may be simple, it is often not used for companies that have complex structures and rules. The fair value method involves the use of formulas for calculating certain market fluctuations with the help of the parameters that have been estimated. However, even the three methods under the fair value methods can have different implications and result and need to be checked for different purposes.
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