Understanding ESOPs valuation and its importance for the Startups
The development of Startups
has also proclaimed the new age of employee compensation structures. There
isn't an issue that our Startups can not solve- which includes, overcoming cash
constraints while hiring the best talent the market has to offer. How do
Startups figure out how to hire & retain top talent despite lack of cash
resources? The simplest solution to that is Employee Stock Option Plan.
Purpose of ESOP
Business owners typically implement ESOPs to allow employees to purchase stock in the company.
Companies can use it to help keep employees focused on the business’s performance. It also encourages them to do what’s best for shareholders since the employees themselves are shareholders.
Understanding ESOPs valuation
Generally, startups reveal the plan for selected employees,
based on their position and ability to affect the organization. ESOPs empower
employees to buy the company’s shares at a discounted price.
Typically, this is a part of the retirement and employee
benefit plan giving the ownership of interest to employees. This ownership
comes in the form of company shares, which is guaranteed after satisfying
predefined conditions. But mainly, ESOPs become a part of their compensation
offering in startups, to propel employees to give their best at work.
The organizations offering ESOPs are required to provide the
ESOPs as expense in income statement. Providing for ESOPs as the expense has an
impact on the determination of distributable profits for dividend declaration,
calculation of EPS (Earnings Per Share), determination of profits for senior
management remuneration, and payment of MAT (minimum alternate tax). So, it is
important that ESOPs are expensed appropriately in the profit and loss
Indian Accounting Standards (Ind-AS) require companies to
undertake a fair valuation of ESOPs when quantifying ESOPs expense amount. The
process of ESOPs valuation is followed internationally as well and financial
statements in this scenario are better appreciated globally.
For arriving at a fair valuation of ESOPs, either the
Black-Scholes model or the Binomial model can be used, which are option
valuation models. Simply stated, these models compute the value of the option
as the difference between: (a) likely value of the share at the time of
exercise of the option as discounted to present value; and (b) the present
value of paying the exercise price.
Option pricing models consider a few variables such as the
life of the option, exercise price, fair value per share, expected volatility
of share price, expected dividend yield, and risk-free interest rate for
computing the value of options.
Organizations can consider the following for determining each of the variables:
Expected life of the option:
Companies need to consider the likely life of option and not the total life of
the option. It will be challenging for companies to estimate the “expected”
life of an option.
Exercise price: Companies will
not face any challenge in determining this variable as the exercise price is normally
mentioned in the stock option plans.
Fair value: For listed companies,
the share price applicable on stock option grant date should be considered. For
unlisted companies, an independent valuer may be appointed to arrive at the
share value of the company as of options grant date or the value of the share
can also be deduced from the recent funding round.
Expected volatility of share
price: While listed companies can consider historical volatility in their own
share prices for the period that is same as the expected life of the option,
unlisted companies can consider historical volatility in share prices of other
listed comparable companies.
Expected dividend yield:
Companies are required to estimate the future dividend yield rate (i.e.
dividend per share divided by value per share). Here, companies can take a clue
from their own historical dividend yield rate or dividend yield rates of listed
companies in the same industry.
Risk-free interest rate: The
current yield rates in government securities (with similar residual maturity as
expected life of stock options) can be considered.
> Getting a stake in the
> Receiving an additional source of income
> Having the option to join ESOP with other retirement plans
> Can avail wealth benefits by selling profitable shares that were acquired at a lower rate
Of course, along with employees, employers will also be benefited
from an ESOP as mentioned below.
- Tax benefits
- Leverage employee’s morale urging
them to perform better in their day-to-day tasks
- Help in improving business cash
- Boosts employee retention and
thereby lowers the employee turnover rate
- Savings on director remuneration
for a private limited company as a part of salary by offering a certain portion