The Ultimate Guide to ESOP Valuation

The Ultimate Guide to ESOP Valuation

November 07, 2022 Admin
ESOP Valuation ESOP Employee Stock Ownership Plans Employee Stock Option ESOP’s Valuing ESOP

Employee Stock Ownership Plans (ESOPs) allow businesses to sell part of their company’s shares to employees. ESOPs are provided, in the main, to increase the retention rate in a firm. The idea here is to recognize and reward staff for their commitment and contribution to the company while ingraining a sense of ownership. Employee stock options can provide new possibilities for succession and estate planning, offering closely held businesses a vehicle for continued expansion.  

 

For a startup, ESOP valuation is crucial as the valuation of the organization in its entirety. Companies that offer ESOPs are required to provide ESOPs as an expense in their P&L statement. The provision impacts the determination of distributable profits for factors such as EPS calculation, dividend declaration, MAT payment, and profit determination for senior management remuneration.

 

Valuing ESOPs eventually translates into valuing the entire company. ESOPs need to be treated as an expense in the P & L statement.

 

The valuation is also important for issuing ESOPs over a vesting period (a specified amount of time working with the company) and calculating the required tax that employees must pay. In India, ESOPs are valued using a variety of approaches including income, asset, market, and fair value methods among others.

The Ultimate Guide to ESOP Valuation

Valuing ESOPs

ESOP valuation can be carried out in two ways:

  • Intrinsic Value Method
  • Fair Value Method

Intrinsic Value Method

Intrinsic Value is the measure of the extent to which the market price of the share exceeds the exercise price of the option. In other words, "intrinsic value" is the profit that accrues to employees on account of the higher market value of the shares.

 

Fair Value Method

An ESOP's fair value is calculated using option-pricing models such as the Black-Scholes or Binomial model. The Black-Scholes model is commonly used to arrive out at a fair value of ESOPs, taking into account various factors such as Time Value, Interest Rate, Volatility, Dividend Yield, and so on.

The Black Scholes model factors in various external aspects that affect the value of the ESOPs. The following factors must be considered when calculating the value of ESOP options using Black Scholes:

 

  • The expected life of the option
  • Exercise price
  • The fair value per share
  • Expected volatility of share price
  • Expected dividend yield
  • Risk-free interest rate

Tax Valuation

To comply with applicable provisions of the Indian Income Tax Act, 1961, and the CBDT notification in this regard, ESOP valuation needs to be carried out for determining the value of perquisites taxable in the hands of employees.

 

According to “CBDT Notification No. 94/2009 dated 18.12.2009, 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 the value of the share in the company as determined by a merchant banker on the specified date for the purpose of clause (vi) of sub-section (2) of section 17.”

 

In India, no method is prescribed for unlisted companies. This includes shares of companies listed on foreign stock exchanges, which do not qualify as recognized stock exchanges in India.

 

Merchant bankers can perform the valuation of an ESOP in accordance with Indian Income Tax law. Companies should seek expertise to arrive at an accurate and conclusive value of the ESOP. The initial value could serve as the foundation for future valuation. There are numerous rules and regulations associated with the ESOP scheme. To ensure that there are no adverse consequences, businesses must comply with the regulations.

 

An independent valuer conducts an annual appraisal of the plan sponsor after an ESOP is established. The market price for shares held by employees is influenced by such appraisal. When employees retire or leave the company, the sponsor buys back their shares at the most recent valuation price.

 

When a corporation sells its stock to an employee trust via a leveraged ESOP (a leveraged ESOP entails taking out a loan to buy equity in a firm directly from them or their existing shareholders), the trustee needs to appoint an impartial assessor to determine the business's fair market ESOP value (FMV). Using this valuation as a baseline, ESOP trustees and plan sponsor negotiate the final sale price. The plan sponsor is typically also the participants' employer in most ESOPs. However, the sponsor could alternatively be the employer's parent company.

 

A contributing ESOP is one in which a company issues new shares to an employee trust and is reimbursed for their fair market ESOP price on the contribution date. An independent valuation is performed to ascertain the corporate income tax gain when new shares are issued.

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