How to value ESOPS (employee stock option plans)?

Accounting valuation:

It is required to find the employee compensation cost when the ESOP grants itself, that is allocated over the vesting period. There are two methods for the valuation of ESOP:

Intrinsic value method:

It is the excess of the market price of share under ESOP above the exercise price of the option including the upfront payment (if any).

Fair value method:

It is estimated by taking an option pricing model such as the Black Scholes or a binomial model. The Black Scholes model is often used as takes into consideration factors such as time value/interest rate/volatility/dividend yield. These factors are not taken in the intrinsic value method as it may lead to under estimating the employee’s compensation cost.

The external factors that Black Scholes model takes in consideration affects the value of ESOP. On the other hand, the intrinsic value method takes only the internal factors into consideration of the option offered. In order to fid ESOP value by Black Scholes model the variables which are considered are the expected life of the option/exercise price/fair value per share/expected volatility of share price/expected dividend yield/risk-free rate of interest.

Issues in the Black Scholes Model:

1. For valuation purpose, the likely life of the option is considered and not the total life of the option. For calculating the expected life, the average of the maximum life and minimum life of an option is used for every vesting of a particular grant.
2. In case of listed companies, the historical volatility of their own share price is taken. However, there is a problem in computing the volatility of the unlisted companies.

According to Indian accounting guiding norms the unlisted companies must consider volatility as 0 because there is no market price of such companies. This may present incorrect ESOP value. An alternative of this is to consider the historical volatility of the share prices of similar listed companies and consider the expected volatility for the unlisted company.

3. Payment of dividend lowers the share price. The dividend paid in the ESOP period is not accumulated for the ESOP holders. As a result, the dividend is paid before the ESOP may be reduced when computing the ESOP value. Therefore, the companies need to estimate the future dividend yield by using its historical dividend yield.
4. It is considered for calculating whether the interest rate is applicable for the maturity equals the expected life of the options based on the 0-coupon yield curve for government securities or ten-year bonds.

Tax valuation:

It is required for determining the value of perquisite that is taxable for employees in accordance with the provisions of Indian Income Tax Act, 1961 and the notification issued by CBDT.

The Notification No. 94/2009, dated 18-12-2009 issued by CBDT for clause (vi) for sub section (2) of Section 17 states that the fair market value of any specified security/sweat equity share that is not listed in any recognised stock exchange shall have share value in the company as mentioned by a merchant banker on the particular date.

No method for tax valuation is prescribed for the unlisted companies and in India including the companies which are listed on stock exchange abroad.

The ESOP valuation plays a vital role in the success of ESOP scheme. The compensation expense lowers the EPS of the company and the possibility of tax excess pay out by the employees which may cause the ESOP scheme to be unattractive.  

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