The Share Based Payments also called Employee Stock Option Plan (‘ESOPs’) are the options offered to the employees by the company. One may ask what is it exactly? It is a form of incentive plan where the employees are given the right to be exercised after completion of certain period (called vesting period) and conditions, to buy the shares of the company at predetermined price or to receive cash depend upon future value of company’s share. The Companies Act, 2013 mandates a minimum vesting period of 1 year.

Issuance of ESOP is a two-way benefit plan as it benefits both the company and the employees. This option plan may lure many employees to stay in the company as it provides the employees a feeling of belongingness and ownership of the Company, which drives them to achieve higher profitability, leading to deliver their best performances. Both the company and the employees get tax-benefit from this option. In an equity settled plan, difference between the market price and the exercise price, for the number of employees to whom the expense is vested upon, is debited to the profit & loss account as an expense, cumulatively over the vesting period. Tax-benefit achieved by issuing the ESOPs can be used to finance the growth of the company. It provides retirement benefits to the employees. The price of the shares to be issued is fixed at the inception itself, which can help the employees find their own growth along with the company’s growth.

Some key terms that one should be familiar with for getting a better understanding of the plan:

• Options: It is a right (not an obligation) to buy the shares of the company.
• Grant date: The date on which the shares are granted and the scheme is approved.
• Vesting date: Date from when the options can be exercised.
• Vesting period: Time period between grant date and vesting date.
• Exercise period: Time period after vesting date during which options can be exercised.
• Exercise/ strike price: The price at which the options are exercised.

Principally, the options offered are CALL options i.e., the right to buy, hence the value of the option can never be zero. The options offered can generally be exercised at any given point of time during the exercise period, and hence are in the nature of American options having some conditions attached with it and are granted IN the money, i.e., the market price is higher than the strike price.

Valuation of ESOP is governed by Indian Accounting Standard 102 ‘Share-Based Payments’ (‘IND AS 102’) for companies coming under the purview of IND AS and ICAI Guidance note-18 for the rest. Ind AS talks about primarily three methods of payment – equity-settled, cash-settled and equity-settled with cash alternative. Most of the time companies use equity-settled method for ESOPs. Equity-settled share-based transactions are valued at the time of issue itself (i.e., Grant date) but cash-settled transactions have to be valued at each reporting date.

There are mainly two methods for finding out the value of the option granted to the employees, such as:

• Intrinsic value method: Intrinsic value of option = Market price of the equity shares – Exercise price
  If the market price is less than the exercise price the option will stand lapsed (making the value of the option zero) as we have already discussed that it is a right of employees and not an obligation.
  
  
• Fair value method: This method undertakes various elements into consideration that Intrinsic Value Method doesn’t account for, such as time value, volatility, dividend yield, etc. This method has been given more preference by the IND AS 102. Under this method, valuation of the options is worked out on the basis of various models such as Black-Scholes-Merton model (‘BSM model’), Binomial model and Monte Carlo model.
  
  

The various models for valuing the ESOPs are as followed:

• Black-Scholes-Merton Model: This model was developed by Fischer Black, Myron Scholes and Robert Merton. In this model the fair value of option is calculated using the 5 functions which are current value of stock, volatility of price of underlying asset in the market, interest rate, strike price and time to expiry of the option. This model is more relevant for European call options. The formula used in this model is as follows:
  C0= S0*N(d1) – E*e-r1t * N(d2) where,
  C0 = The equilibrium value of European call option
  S0 = Price of stock (underlying asset) now
  E = Exercise price
  e = Exponential constant (base of natural log, i.e., 2.7183)
  r1 = Continuously compounding risk-free rate of interest
  t = Time to expiration in years
  N(d) = Value of cumulative normal density function
  
  

As discussed earlier, ESOPs are generally American options, and hence using the BSM model for valuation of ESOPs would not be suitable to determine the value of the call option, which will expire after time t.

• Binomial Model: This model is a more flexible and simpler model as compared to the other complex models such as BSM and Monte Carlo. This model is widely used for valuing American call options. The key assumptions for this model are:
  • The value of the underlying share can move only to two different values in two different directions at a given point of time.
  • Over different time periods, the various nodes are created
  • At every node the value of share and option is calculated
• Monte Carlo Model: Monte Carlo Simulation is a method of probability analysis done by running a number of variables through the model in order to determine different outcomes. This method had his name after a city called Monte Carlo which was famous for casinos, it is relevant because the dice, slot machines and wheels use probability. By this method a range of outcomes are achieved. These outcomes are chosen on the basis of risk-taking appetite. (Is this method used for ESOP? – we generally don’t use monte-carlo for any valuation, it is more of a probability analysis than a valuation)

ESOP accounting and valuation requirements under various Acts:

• IND AS 102: Prescribe mechanics of ESOP and provided for Fair value method for valuation of scheme but is silent about who can do the valuation of the options.
• Guidance note-18: It is only valid for the companies not coming under the purview of the Indian Accounting Standards (companies having net worth less than INR 250 crores). It prescribes that the valuation shall be done by an independent valuer at the time of grant of option for recognition of ESOP cost in the books of account.
• Companies Act, 2013: Provide for various conditions that are to be met for establishing ESOP scheme and issuing shares under such scheme.
• SEBI: Under SEBI guidelines, it prescribes the mechanics to be followed by listed entities for establishing and implementation of ESOP scheme.
• Income-tax Act, 1961: The valuation of options of unlisted companies shall be done by a Merchant Banker at the time of exercise of option. It does not provide or mandate any specific method for valuing the ESOPs.
  
  

Why is it advisable to get the valuation done by an Independent Valuer?

• An independent valuer can achieve a value which is unbiased.
• The company can also have a check on whether the expenses accounted for are actually incurred and that the management of the company shall not indulge in any malpractice while issuing the ESOPs.
• Independent valuers have professional experience and are likely to value the ESOPs appropriately by avoiding any mistakes.

The process of valuation of ESOPs has been refurbished for several times now and in today’s scenario valuing ESOPs has become more logical as it has overcome many challenges such as the method of valuation and accounting treatment. ESOP has become a popular source to attract competitive human resources towards companies and helping retention of their employees thus making it a popular choice for issuance of shares of the company.