ESOP Valuation System: Why it is So Important for startups

Companies that offer employee stock option plans are required to include employee stock option plans expenses in their profit and loss statements. Including employee stock option plans as an expense affects the calculation of distributable profits for dividend declaration, the calculation of EPS (earnings per share), the calculation of profits for senior management remuneration, and the payment of MAT (minimum alternate tax). As a result, it is critical that ESOPs are properly expensed in the profit and loss statement. When quantifying employee stock option plans expense amounts, Indian Accounting Standards (Ind-AS) require companies to conduct a fair ESOP Valuation. The fair ESOP Valuation treatment of employee stock option plans is also followed internationally, and financial statements in this scenario are more appreciated globally.

The Black-Scholes model or the Binomial model, both of which are option valuation models, can be used to perform a fair ESOP Valuation. Simply put, the value of the option is computed as the difference between (a) the likely value of the share at the time of option exercise as discounted to the present value; and (b) the present value of paying the exercise price.

Organizations can take this into consideration when determining each variable:

The expected life of the option:

Organizations must consider the likely life of the option rather than the total life of the option. So, if an employee has a stock option that is exercisable for 10 years, there is a chance that the employee will exercise the stock option at the end of 7 years, pay the exercise price, take the shares, and then sell the shares on the open market.

Estimating the "expected" life of an option will be difficult for businesses (particularly startups). Companies can take advice from the Securities and Exchange Commission's Staff Accounting Bulletin No. 107 of the United States in this regard.

Exercise price: Organizations will have no difficulty determining this variable because the exercise price is typically stated in stock option plans.

Fair value: For publicly traded companies, the share price on the grant date of stock options should be considered. For unlisted companies (such as startups), an individual valuer may be designated to evaluate the company's stock value as of the opportunity grant date, or the share value can be inferred from the most recent funding round witnessed.

Presumed share price volatility: Unapproved company should consider historical volatility in asset values of many other mentioned similar firms, whereas listed companies can acknowledge historical volatility in their very own equity prices for about the same period as the option's entire life cycle.

Predicted dividend yield: Companies must forecast their dividend yield rate in the future. Companies can learn from their own historical dividend yield rate or the dividend yield rates of other publicly traded companies in the same industry. Startups (that require capital for growth over the next few years) can recognise lower dividend yield rates and even 'nil,' relying on their capital needs.

Average yield rates in government bonds (with similar residual maturity as average lifespan of stock options) can be taken into account as the threat interest rate. Data on government bond yield rates is readily accessible in publications and on the website.

A strenuous analysis must be performed to evaluate each variable used in option ESOP Valuation methods, and companies may appoint an impartial valuer to value ESOPs if necessary. The value of employee stock option plans must be expensed over the period in which the employees' options will vest.