Understanding ESOPs valuation and its importance for the Startups

01-December-2020 by Virtue Ventures

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.

 

ESOPs valuation

 

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 statement.
 
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.

           

Employees advantages

 

Employer advantages

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 flows
  • 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 of ESOPs