ESOP Valuation: Definition, Importance & Requirement – A Complete Guide

Monetary rewards and benefits, incentives, bonuses, and there exist various ways through which an employer can recognize and appreciate employees for their contribution to the organization.

But what if the employee deserves more? 

In recent times, Employee Stock Ownership Plan in India has been gaining much popularity with the startup ecosystem coming to the light.

Nowadays, high-performance employees expect more than just a salary, and the evolution of this mindset has been supported by startups to attract and retain good talent. 

Besides the in-hand salary, employees find ESOP valuation to be an attractive motivation for joining a company. The Employee Stock Option Plan (ESOP) is an employee benefit scheme to reward employees for their excellent work. 

ESOP valuation in India also offers an ownership interest to employees; hence many Indian startups and multinational companies are offering ESOP to encourage a feeling of ownership in the employee.

But the majority of people don’t truly understand what ESOP company valuation essentially means and how it works.

Are you also one of them?

Here in this blog, we decode everything about what is Employee Stock Option Plan, the ESOP valuation process, who can do the ESOP valuation, its pros and cons to its methods and types, and much more.

So, without much ado, let’s dive into ESOP!

WHAT IS ESOP VALUATION?

ESOP stands for Employee Stock Ownership Plan, which is an employee benefit plan that gives employees an ownership interest in the company; this interest takes the form of shares of stock. 

Under this scheme, the employer distributes a certain percentage of the firm’s stock share to eligible employees based on the pay scale, terms of service, and other T&Cs at no upfront cost. 

As per the ESOP contract, employees furthermore get the opportunity of converting their ESOPs to stocks at a predefined rate over a period of time.

The distributed shares of an employee are held in a trust unit for safety and growth until the employee exits the company or retires. When the employee leaves the company, the shares are brought back and returned to the company for further distribution to other employees.

Employee Stock Option Plan is a great opportunity for employees to own equity shares of their company while they are working.

By giving the employees a stake in the company via ESOP Valuation, the employers aim to motivate and inspire the employees to give their 100% for the company’s growth.

ESOP Valuation is typically a facilitator used by startups or private companies to engage, retain & enumerate their employees and get them awarded for being associated with the company.

HOW DOES ESOP VALUATION WORK?

When a company wants to create an Employee Stock Ownership Plan, it necessitates an independent ESOP valuation.

Under an ESOP plan, the employer allows certain stocks to the employee from their trust fund. 

In a sales ESOP, a company’s stock is sold to an employee trust – a trustee employs an independent evaluator to determine the company’s fair market value. 

In a contributory ESOP, a company issues new stakes to an employee trust. On the contribution date, the shares tax deduction for the fair market value is received.

After ESOP formation,  annual valuation is performed by an independent evaluator.

As per the latest rules, ESOPs in India are governed by the Companies Rules, 2014.

According to it, these processes are necessary to be followed by employers while implementing ESOPs for their employees:

STEP 1 – Draft an ESOP plan and get an ESOP scheme prepared through a lawyer. 

STEP 2 – Get the board or shareholders’ approval for adopting the ESOP scheme

STEP 3 – While allocating ESOP to the employees, issue a  ‘Letter of Grant’ that state the number of shares allocated, the vesting period, exercise price, and other details.

When the employee expects to exercise the granted options, an ‘Exercise Application’ will be required. After creating ‘Exercise Application’ the options will be allowed to be converted into shares. 

Once the vesting period ends, the employees can exchange the shares for money at the current market rate.

NOTE – ESOPs are only options and not shares, therefore there is NO need to increase the authorized share capital of the company at the time of ESOP grants. 

TYPES OF ESOP VALUATION:

1. Employee Stock Purchase Plan (ESPP)

2. Employee Stock Option Scheme (ESOS)

3. Restricted Stock Units (RSU)

4. Stock Appreciation Rights (SARs)

WHO CAN DO ESOP VALUATION IN INDIA?

At the time of grant of the option, valuation of the fair value of shares shall be done by a registered valuer. At the time of exercise of the option, the valuation shall be done by the Merchant banker.

Valuation of ESOP in case of Unlisted Companies:

The fair value of shares at the time of “Grant of Option” and “Exercise of Option” shall be done by the registered valuer as per “Guidance note on accounting for employee share-based payment” (Issued 2005).

Income Tax Act, 1961 does not specify any method for computation of FMV of shares but, Section 17 and Rule3(8) of the Act provide that for the purpose of perquisite valuation the FMV of ESOP shall be such value as determined by a merchant banker on the specified date.

“Specified Date” means the date of exercising of the option; or any date earlier than the date of the exercising of the option, not being a date which is more than 180 days earlier than the date of the exercising.

ESOP is an employee benefit plan issued by the company to encourage employee ownership in the company. Under the ESOP plan, the shares of the companies are given to the employees at discounted rates, and any company can issue ESOP.

WHAT ARE THE ESOP VALUATION METHODS?

ESOP company valuation can be performed by two methods.

1. Accounting Valuation
2. Tax Valuation

1. Accounting Valuation:

The accounting valuation is needed for working out the employee compensation cost at the time of ESOP grants which is apportioned over the ESOP vesting period.

There are two methods for accomplishing ESOP Valuations,

• Intrinsic value method 
• Fair value method

2. Tax Valuation:

The tax valuation is needed for determining the value of perquisite taxable in hands of employees, to concede with applicable provisions of the Indian Income Tax Act, 1961.

Points to consider while calculating the value of ESOP options through the Black Scholes model:

• 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

HOW TO CALCULATE ESOP VALUATION?

The formula to calculate ESOP – Employee Stock Ownership Plan

ESOP = TSO * PPS

Where,

• ESOP = Total value of the ESOP (₹)
• TSO = Total No. of stocks offered in the plan
• PPS = Total price per share at the time of receiving the stocks (₹ / Share)

Example of how to calculate the value of an ESOP,

Step 1 – Determine the total amount of stocks, suppose the plan offers 1000 stocks.

Step 2 – Determine the price per share of the stock at the time of ownership or sale, suppose the stocks are worth ₹500.

Step 3 – Calculate the total value,

• ESOP = TSO * PPS
• ESOP = 1000 * 500
• ESOP = ₹500,000.00

WHY ESOP VALUATION IS REQUIRED IN COMPANIES?

• To motivate, retain and reward employees that help make a business successful.
• For saving on immediate cash outflow by avoiding the cash compensations as a reward.
• ESOP valuation can be the most practicable option for businesses planning to expand their business.

RULES OF ESOP IN PRIVATE COMPANY:

Rules applicable for offering ESOP in a Private Company in India:

• A permanent employee working in or outside India of the company. For e.g Director of the company or an employee holding an associate company.
• A promoter belonging to the promoter group or a person holding more than 10% of the outstanding equity shares of the company cannot be offered an ESOP.
• ESOP must be approved by the shareholders of the company.
• 1 year of a gap should be there between the grant of option and vesting of the option.
• The option granted to employees is not transferable to other people.
• The details of the ESOP plan must be reported to the Board of Directors in the Director’s Report.
• ESOP register should be maintained to hold information about the option granted to employees.

WHAT ARE THE BENEFITS OF ESOP FOR EMPLOYEES?

The top 3 reasons how employees benefit from ESOP – 

1. Higher profits at lowered rates:

ESOP helps employees gain good stocks at a discounted or say reduced rate. Employees can hold onto these stocks for long-term returns or can sell them to earn profit at a higher market value.

2. Additional Earning Source:

Employees accumulate voting rights in the company by becoming shareholders. While also earning a dividend on their stock ownership which benefits as an additional income.

3. Job Stability:

Because of the vesting periods, employees get job stability which, sequentially, draws close to employee satisfaction.

WHAT ARE THE BENEFITS OF ESOP FOR EMPLOYERS?

The top 3 reasons how employers benefit from ESOP – 

1. Reaching top talent:

ESOP works as a bridge to the gap in remunerating employees during the company’s initial year when the reserves are usually low. 

Employees who believe in the company potential accept the ESOPs as part of their compensation package to acquire the company’s stocks at reduced rates. This helps out in procuring good talent at a reduced initial cost.

2. Increase employee ownership:

When employees have a stake in the company’s ownership, they get ambitious to put in their best actions for maximum productivity. The better the profitability, the better the firm’s stock value and the higher the returns that the employees can acquire. 

3. Employee retention:

ESOPs help in employee retention. As employees are authorized to cash in their stock options only after the vesting period, they tend to stay with a view to encash their stocks. This improves retention and also cuts down attrition rates.

ESOP TAXABILITY:

Taxation Implications of ESOP:

(A) For the Employee:

There are no cash outflows or taxation implications when the options are granted as and when the options are vested in the employee.

The Income Tax Act, 1961 has laid down the following two stages of taxation for employees in respect of shares allotted to them under an ESOP.

Stage 1 – Taxable as Perquisites – Upon allotment of shares after the employee exercises his option on the completion of the vesting period. Upon allotment of shares, the employer will have to compute the perquisite value of ESOP taxable in the hands of the employee under “income from salary” and deduct tax on such ESOP. The perquisite value and the tax deducted thereon by the company would be reflected in Form 16 and Form 12BA of the employee and treated as income from salary in the tax return.

Stage 2 – Taxable as Capital Gains – When the shares allotted to the employee are sold by him. If the company is listed on an Indian stock exchange and shares are held for more than 12 months, it will be considered a long-term capital gain and as per Finance Act 2018, it will be taxed u/s 112A at 10% exceeding Rs. 1 lakh of CG. If shares are held for less than 12 months, it will be considered a short-term capital gain, and profit will be taxed at 15% u/s 111A.

Today, employees in start-ups and unlisted companies are also allotted ESOPs. These shares will be considered short-term assets if held for less than 24 months from the exercise date and taxed according to the respective tax slab. If the shares are held for more than 24 months and sold after this period, these are considered as long-term gains and taxed at 20% after indexation of cost.

In case the employee chooses to not exercise his option, there shall be no tax implication for the employee.

(B) For the Company:

The Issuing Company can claim ESOP cost as a deduction.

The discounts under the ESOP are an employee cost and should be allowed as a deduction over the vesting period, in the hands of the issuing company.

Furthermore, there may also be a situation when ESOP shares are bought back by the Company.

When it comes to a buyback of shares of an unlisted company, the provisions under sections 10(34A) and 115QA of the Income Tax Act shall intervene.

As per section 10(34A), any income arising to a shareholder (including ESOP shares) on account of the buyback of unlisted shares by the company shall be exempt in the hands of such shareholder. Further, as per section 115QA, the tax of 20% shall be paid by the unlisted company on the buyback of its shares.

Therefore, in the hands of the employees, the gain from the buyback of shares by an unlisted company shall be exempt and the company shall be liable to pay buyback distribution tax.

It is to be noted that if the employee sells ESOP shares to a third party instead of the company, then he shall be liable to pay capital gain tax and the company need not pay any taxes, as the transaction happened between an employee and the purchaser.

CONCLUSION

ESOP Valuation plays a significant role in the success of an ESOP scheme. 

My Valuation is a full-service business valuation and advisory firm. With a dedicated valuation team and extensive experience, we help companies with all-around business valuation services.

If you are seeking more clarity about your ESOP valuation, our skilled team and IBBI registered valuers are here to help you out.

So get started and simplify your business valuation with us.

Visit our site to learn more about company valuation services: https://myvaluation.in/