ESOP Valuation: Overview, Valuation Methods & Rules

Employee Stock Options (ESOPs) are becoming an increasingly popular mechanism among start-ups for long-term retention and motivation of the employees. The private companies need to carry out ESOP valuation in order to book the expenses in the financials. This is also necessary to be compliant with the tax regulations and reporting true and fair views of the financial statements. Valuation of the stock options under the ESOPs may turn out to be a complex procedure but if done effectively , it results in effective implementation of the ESOP. ESOP valuation is required to estimate the cost of the ESOP plan. BizFoc is an ESOP valuation firm having expertise in getting the ESOP valuation for the private companies.

Different ESOP Valuation Methods

The valuation of ESOPs is done to find the Employee Compensation Expense to be incurred by the company while granting ESOPs to employees. There are two methods popular methoods of ESOP valuation which can be followed.

Method 1: Fair Value ESOP Valuation Method

The fair value represents the market value of the stock options granted under ESOPs. ESOPs fair value is calculated using option-pricing models such as Black Scholes Model or Binomial Model. This model takes into account the various factors that may affect the value of the stock options such as the vesting period, exercise price, current share price, dividend yield expected over the vesting period, etc. We now consider the Black Scholes model since this is the most popular method as it gives the most accurate value of the stock options. The following parameters must be taken into consideration while calculating the value of ESOPs using Black Scholes Model:

• Time to expiration
• Strike Price/ Exercise Price
• Current trading price per share (listed stock)/ Fair value per share (unlisted stock)
• Expected volatility of share price
• Risk-free interest rate
• C = S N(d₁) - K e^-rT N(d₂)
  
• d₁ = ln(S/K) + (r + 22)T / σ √T and d₂ = d₁ - σ √T
• S = Current Trading Price/ Fair Value of the share
• K = Option Strike Price
• r = Risk-free interest rate
• T = Time remaining until option expiration
• σ = Volatility of the stock
• Time to Expiration

  The time between the moment at which ESOPs are being valued and the exercise date of the option. For the ESOPs, it will be the sum of the vesting period and the expected time that the employees take to exercise the options after the options have vested at the end of the vesting period.

• Strike Price/ Exercise Price

  Price at which the option will be exercised. This is the discounted price that the employee will have to pay to buy the shares. Does not change during the life of the option.

• Current Trading Price/ Fair Value

  Current trading price for a listed stock is the price at which the share is being traded in the market. Fair value for an unlisted stock can be obtained from the valuation of the company done by a registered valuer.

• Expected Volatility

  Measure of amount by which share price is expected to fluctuate during the time to expiration. Higher volatility means higher fair value of the options.

• Risk Free Interest Rate

  Derived from the implied yield on zero-coupon government bonds. Required on the valuation date.

Assumptions of Black Scholes Model

The Black Scholes Model makes several key assumptions while doing ESOP valuation:

• No dividends: No dividends are paid on the stocks.
• Log-normal distribution: Stock prices follow a log-normal distribution.
• Constant Volatility: Price variation for the option remains constant.
• Expiration date: Option can be exercised only on the expiration date or maturity date.
• Random Walk: Market is unpredictable, hence, a state of random walk is assumed.
• Risk-free interest rate: Assumed to be constant, making the underlying asset risk-free.
• Frictionless Market: Assumes no transaction costs.
• No Arbitrage: Assumes no arbitrage opportunities (avoids the opportunity of making riskless profit).

Limitations of Black Scholes-Merton Model

• Assumption of Frictionless market: The assumption of no transaction costs is hardly the reality because trade always comes with a transaction cost.
• Limited approach: The assumption that options can only be exercised on maturity shows applicability limited only to the European market. It does not accurately value the options in the US.
• Risk-free interest rate: The assumption of a constant interest rate is hardly the reality.
• No Dividends: The assumption of no dividends is hardly the reality.

Method 2: Intrinsic Value ESOP Valuation Method

Intrinsic Value is the difference between the market price of the share and the exercise price of the option. In other words, it is the amount by which market price exceeds the exercise price of the option. It is the profit that accrues to employees on account of excess of market price over the exercise price. The exercise price also includes the administrative costs incurred on exercise of the options.

Advantages of ESOP Valuation

• To estimate the ESOP expenses in the book of accounts.
• To get the tax deduction for income tax.
• To estimate how much ESOP the company can issue in the future.
• To recognize the provision in the balance sheet.
• Stakeholders can get an estimate of the ESOP cost for the organization.

Process of ESOP Valuation

Step 1: Gather the Data

This step includes gathering of the data like numbers of ESOP granted, vesting period, strike price, number of ESOP exercised, ESOP granted.

Step 2: Process the Data

The data from step 1 is processed using the ESOP valuation technique for estimating the ESOP cost for the company.

Step 3: Discuss output with company

The results from step 2 are discussed with the company in order to understand the valuation and incorporate any feedback from the company.

Step 4: Submit the final report

The final ESOP valuation report is submitted to the company.

Why BizFoc: ESOP Valuation firm

Bizfoc is a leading ESOP valuation firm which has expertise in valuation of ESOP or RSU for the private limited or public listed company. BizFoc team will guide on the every step on the rationale followed by the ESOP valuation. It will help the company to recognise the expense in the financials and recognise liability in the balance sheet. It will assist the company in determining how much ESOP company can issue in the future.

Conclusion

ESOP is a powerful tool to drive employee motivation and engagement in the organization. Hence, carrying out the valuation accurately becomes important for successful implementation of employee stock ownership programs. Employee ownership programs are designed to provide a just portion of the company’s shareholding to the employee, thus, deciding the correct method of valuation forms a significant part. Appropriate method not only provides correct valuation but is also imperative in making future investment and business valuation decisions. Hence, selection of the valuation method should be a well-considered decision.

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