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Knowledge Center » Business » VALUATION OF ESOPS


What is an ESOP?
Employee Stock Option Plan (ESOP) is a plan through which a company awards Stock Options to the employees based on their performance. An employee stock option is a call option meaning that under an ESOP the employees have the right and not an obligation to buy the shares of the company on a predetermined date at a predetermined price. The objective of ESOP is to motivate the employees to perform better and improve shareholders' value. Apart from giving financial gains to the employees, ESOP also creates a sense of belonging and ownership amongst the employees.
How is ESOP Valuation done?
(A) The Accounting Valuation

The Accounting Valuation is needed for working out the Employee Compensation Cost at the time of ESOP Grants Itself which is apportioned over the vesting period of ESOP.
There are two methods of doing ESOP Valuations-

1)  Intrinsic value method
”Intrinsic Value” is the excess of the market price of the shares under ESOP over the exercise price of the Option (including upfront payment, if any) Example: - A company grants an ESOP to its employees whose current market price (CMP) of the share is Rs 100 which can be exercised after 2 years for Rs 70. In this case the intrinsic value of options shall be Rs 30/- (100 – 70). However if the CMP was Rs.50 instead, there would be no intrinsic value of the option since the exercise price is more than CMP and in this case options could not be exercised and instead stand lapsed.

2)  Fair Value Method
The fair value of an ESOP is estimated using an option-pricing model  like, the Black-Scholes or a binomial model. For undertaking fair  valuation of ESOPs, the Black-Scholes model is mostly preferred as it takes into account the various other factors like Time Value, Interest Rate, Volatility, Dividend yield etc. These factors are not considered under Intrinsic Value method which may lead to under estimation of Employee Compensation Cost. The Black Scholes Model considers various external factors that affect the value of the ESOP whereas the intrinsic value method considers only factors internal to the Option offered. To compute the value of ESOP options through Black- Scholes the following variables have to be considered:-
•  Expected Life of the option
•  Exercise price
•  Fair value per share
•  Expected volatility of share price
•  Expected dividend yield
•  Risk-free interest rate

Key Issues in Valuation of ESOPs through Black-Scholes Model

Issue 1: - Expected Life or Total Life of the Option
For the purpose of valuations we need to consider the likely life of option and not the total life of the option. For calculation of Expected life it is recommended to use the Average of the Maximum life of option and the Minimum life of option for each vesting of a particular Grant.

Issue 2: - Volatility of Unlisted Companies
For listed companies historical volatility in their own share prices is taken, the problem arises on how to compute volatility of unlisted companies. Indian accounting guidance norms recommends unlisted companies to consider volatility as zero since there is no market price of the unlisted companies. This may however lead to incorrect value of the ESOPs. An alternative for computation of the Fair Value of an ESOP option of unlisted company is to consider historical volatility in the share prices of other similar listed comparable companies should be considered and taken as the expected volatility for the unlisted company.
Issue 3: - Divided Yield
Payment of Dividend reduces the price of a share. Dividend paid during the ESOP period is not cumulated for ESOP holders; therefore dividend paid before the ESOP is exercised may be reduced while computing ESOP value. Thus companies are required to estimate the future dividend yield rate (i.e. dividend per share divided by value per share). The company’s historical dividend yield rate can be used to estimate its expected future dividend yield.

Issue 4: - Risk-free interest rate
The Risk free rate being considered for the calculation is the interest
rate applicable for a maturity equal to the expected life of the options
based on the zero-coupon yield curve for Government Securities or 10
years Government bonds.

B) Tax Valuation
This valuation is required to determination of value of perquisite taxable in hands of employees, to comply with applicable provisions of Indian Income Tax Act, 1961 and notification issued by CBDT in this respect. Notification no. 94/2009 dated 18.12.2009 issued by CBDT, wherein it is provided that for the purpose of clause (vi) of sub-section (2) of section 17, the fair market value of any specified security or sweat equity share, being an equity share in the Company not listed at any recognized stock exchange, shall be such value of the share in the company as determined by a merchant banker on the specified date. No method prescribed for unlisted companies in India. This also includes shares of companies listed on overseas stock exchange as the Overseas Exchanges do not qualify as the Recognized stock exchanges in India.

ESOP Valuation (both for accounting of “Compensation Expense” by company and for perquisite Tax payable by the employees) plays a significant role in the success of any ESOP scheme. The compensation expense reduces the EPS of the company and the possibility of Excess Tax payout by employees may turn the ESOP scheme unattractive. Thus proper planning of ESOP is inevitable.