Employee Stock Option Plan (ESOP) is a scheme through which a company awards its Stock Options to their employees based on their performance and designations. 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.
As the business are still recovering from the Covid pandemic impacts in-line with the easing of lockdown restrictions, one of the major challenges face by the businesses today is Employee Compensation Cost when the revenues have already taken a huge hit. Some of the common ways business are dealing with this problem is Layoff, furlough and salary cuts, which often makes the remaining employees:
- Loose trust in the employer,
- Feel Insecure and uncertain about his financial prospects,
- Reduce employee morale,
- Less efficient and productive.
This might also result in businesses losing unexpected opportunities due to unavailability of manpower.
In this situation, Employee Stock Options can be the efficient way using which the company can defer the compensation cost of permanent employees. The businesses can pay the employees in equity rather than wholly in cash, which the businesses are facing shortage of in recent times. ESOP Schemes can benefit the business by:
- Minimizing attrition by providing additional reward,
- Steer employees towards organization’s vision,
- Liberty to Channelize funds in other priority area,
- Derives unparalleled Employee Loyalty,
- Increasing employee retention,
- Attract employees who can be potential assets to the organization.
Along with saving cash, ESOP Schemes also provide motivation to the employees in reviving the business by providing them a sense of ownership and directly relating their reward with the success of the business. ESOP Schemes are one of the best ways for Startups use to compensate their employees, aligning their vision with the company’s vision.
Such changed circumstances are forcing the businesses to relook at the traditional employee compensation practices and consider share based compensation of employees through ESOPs.
“ESOP Valuation, both for accounting of compensation expense by company and for perquisite tax payable by the employee, plays a significant role in the success of any ESOP scheme.”
- Accounting Valuation
The accounting valuation is required 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 – Intrinsic value method & Fair value method
- Intrinsic Value Method
“Intrinsic Value” is the excess of the market price of the share 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 INR 100, which can be exercised after 2 years for INR 60 as per scheme. In this case, the intrinsic value of options shall be INR 40 (100 – 60).
However, if the CMP was INR 50 instead, there would be no intrinsic value of the option since the exercise price is more than CMP and in this case options cannot exercised and instead it lapsed over the period of time.
- Fair Value Method
The fair value of an ESOP is calculated using an option-pricing model like, the Black-Scholes or a binomial model. For performing fair valuation of ESOPs, the Black-Scholes model is mostly preferred as it takes into account the various 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 calculate the value of ESOP options through Black Scholes the following 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 like of 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 the 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 companies’ historical volatility is the share price of other similar listed comparable companies, which should be considered as the expected volatility for the unlisted company.
Issue 3:- Dividend 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.
ESOP valuation is required for 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 is already emerging as a preferred way of employee compensation due to its numerous benefits, especially for cash deficient and startup companies, it is only natural that more and more companies are adopting it. 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 and valuation of ESOP is inevitable.