Valuation of ESOP

Employee Stock Option Plan (ESOP) is a plan in which a company offers company stocks to its employees on a discounted rate based on their performance. An employee has a right to avail this option but is not obligated to invest in this scheme. The objective of ESOP is to motivate the employees to enhance their performance by creating a sense of belongingness and ownership among the employees.

#Valuation of ESOP

The accounting valuation of ESOP is done to find the employee compensation cost i.e. the price at which shares are offered to the employees under this scheme. There are two methods through which ESOP does valuation:

1. Intrinsic Value Method
2. Fair Value Method

#Intrinsic Value Method

Intrinsic Value is the value of profit that the employee gets as compared to the market value of the shares offered. It is the measure of the excess of the market price of the share over the exercise price offered by the company for the option. The exercise price includes the administrative cost that is incurred for exercising these options. This can be understood from the following example:

If the market value of a share is Rs 100 and it is offered to the employees under ESOP scheme at Rs 60, then the intrinsic value of the share becomes Rs 40 (Rs 100 – Rs 60). However, if it was vice versa i.e. market price was Rs 60 and ESOP price was Rs 100, then these options would not have been exercised by the employees and would have lapsed.

#Fair Value Method

The fair value method is a more appropriate method to calculate the value of ESOP as it considers factors like time value, interest rate, volatility and dividend yield which are ignored in the intrinsic value method. The Fair Value Method uses following models to calculate the value of stock options:

1. Black-Scholes Model
2. Binomial Model
3. Black-Scholes Model is most preferably used for accounting valuation of ESOPs.

#Black Scholes Model

This model considers the various external factors that affect the value of ESOP. It uses variables which are ignored by intrinsic value method like expected life of the option, exercise price, fair value per share, expected volatility of share price, expected dividend yield and risk-free interest rate. Therefore, this method is mostly used to calculate the value of stock options.

#Limitations

This model has certain limitations:

It takes likely life of option (i.e. average of maximum life of options and minimum life of options) and not the total life of options for the calculation of value.

For listed companies, volatility of their shares in previous years is taken into consideration but it is not possible to consider volatility of unlisted companies as they have no market price of their shares. For such companies, volatility of similar listed companies is considered for calculations.

Payment of dividend reduces the market price of a share. Dividend paid during ESOP period can thus reduce the ESOP value of the option. The companies are thus required to estimate future dividend yield rates for the purpose of calculation of ESOP value.

The risk free rate being considered for calculation is based on the zero-coupon yield curve for government securities or 10-year government bonds.

#CONCLUSION:

ESOP valuation plays a significant role in the success of any ESOP scheme offered by a company. The discounted rate of the options offered to the employees reduces the earnings per share of the company and can reduce the returns on investments ratio for the shareholders. Also, if the tax liability of employees increases due to very low value of options as they are valued as perquisites for taxation, the scheme becomes unattractive for them. Thus, proper planning and pricing of ESOPs is very important and should be done with utmost care.

-Shweta Gupta, Founder, and CEO, MUDS