Valuation is an emerging field for the CA fraternity. Increasing number of financial instruments being issued by the Indian corporates, coupled with emphasis on the theme of fair value under Financial Reporting standards has contributed to the growth of this field. Employee Stock Options (“ESOP”) are one of the prominent instruments used in the corporate and start-up world to attract, retain and motivate the high skilled and talented personnel of the business. ESOP motivates the employees to drive the performance of the organization, resulting in maximization of shareholder’s value and thereby align the employees’ interest with that of the organization. In this article, I discuss the valuation aspects of ESOP issued under the Companies Act, 2013.
ESOP Contractual Framework
ESOPs are issued by means of a written agreement with the employees. Some of the significant terms generally used in these agreements are as follows-
- Grant Date: means the date fixed by the Company or the Board, to be the date on which the scheme is extended to any employee. The date would be specified in the offer letter issued to the employee.
- Vesting: The process by which the employee becomes entitled to receive the benefit of the grant made to him.
- Vesting period: This is the period during which the vesting of ESOP takes place.
- Vesting date: The date on which the employee becomes entitled to receive the shares under the option.
- Exercise Price / Strike Price: Amount which the employee is required to pay to receive the shares under the option.
- Exercise Period: The period during which the employee is eligible to exercise his right to receive the shares under the option.
- Exercise Date: The date on which employee exercises his right to receive the shares.
- Lock-in Period: This is the period from the date of allotment of shares, during which the employee is prohibited from selling the share. This is specified in the offer letter issued to him.
Regulation and Accounting of ESOP
ESOP are issued under the ESOP scheme (“ESOS”) formulated by a listed company in accordance with SEBI ESOS Guidelines and by an unlisted company in accordance with Rule 12 of Companies (Share Capital and Debentures) Rules, 2014. The accounting treatment of ESOP issued by an Ind-AS compliant company is governed by Ind-AS 102 ‘Share Based Payment’, whereas companies complying with Companies (Accounting Standards) Rules, 2006 shall apply ‘Guidance Note on Accounting for Employee Share-based Payments’ issued by ICAI for ESOP accounting.
As per IndAS 102 “Share Based Payment” paragraph 10 the general rule for accounting for shared based payment transactions is as follows:
For equity-settled share-based payment transactions, the entity shall measure the goods or services received, and the corresponding increase in equity, directly, at the fair value of the goods or services received, unless that fair value cannot be estimated reliably. If the entity cannot estimate reliably the fair value of the goods or services received, the entity shall measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted.
Since, the fair value of services rendered by employees cannot be estimated reliably, fair value of equity instruments granted is used to recognize the employees’ expense in the financial statement.
Valuation of ESOPs
During the lifetime of an ESOP scheme, valuation is required upon the following events
1.Equity Settled ESOPs
- Upon the grant date
- On the date if there is any change in the terms and conditions of the scheme
- Upon the exercise of the options by the employee
2. Cash Settled ESOPs
- Upon the grant date
- On the date if there is any change in the terms and conditions of the scheme
- On each reporting date
- Upon the exercise of the options by the employee
Approach for valuation of options
The thought behind the valuation of option is that an option’s worth exists on account of the following factors:
- The intrinsic value; and
- The time value (the extrinsic Value)
The intrinsic value of an option is a function of difference between the fair value of the underlying share and the strike price of such underlying share. Time value is the risk premium required by the option seller, to provide the option buyer the right to buy/sell the stock up to the date of option expiry. Time value of options is a function of volatility of underlying share and the option’s time to expiration. Therefore,
Value of Options = Intrinsic Value + Time Value.
All option pricing models take into account, as a minimum[1], the following inputs/ factors:
(a) the exercise price / strike price of the option;
(b) the life of the option;
(c) the current price of the underlying shares (as on the date of valuation);
(d) the expected volatility of the share price;
(e) the dividends expected on the shares; and
(f) the risk-free interest rate for the life of the option.
We now discuss these factors individually.
1.Exercise price of the option (K):
This is the price at which, the option-holder is eligible to exercise his right to buy the underlying shares of the company. It is mentioned in the ESOS agreement.
2. Life of the option (t):
This is also known as time to expiration or time to maturity/exercise of the option. The period from grant date till the exercise date is the life of the option.
3. Current price of the underlying shares (S):
Current price is the price prevailing as on the date of valuation. For listed entity, current price can be obtained from the stock exchange, whereas for unlisted entity, it is the fair value of equity shares to be determined by the registered valuer in as per the requirements of the Companies Act 2013.
4. Volatility of the shares price (σ):
Expected volatility is a measure of the amount by which a price is expected to fluctuate during the life of the option. The measure of volatility used in option pricing models is the annualized standard deviation of the continuously compounded rates of return on the share. Volatility is typically expressed in annualized terms that are comparable regardless of the time period used in the calculation, for example, daily, weekly or monthly price observations.
For listed entity, historical volatility of share price can be easily calculated using the historical prices. For unlisted / newly listed entity, the valuer could consider the historical or implied volatility of similar listed entities in same industry.
Where extraordinary event takes place in the share price, the effect of such event shall be eliminated for calculating the volatility. For example, the effect of share split, failed takeover bid or other major restructuring shall be eliminated for calculating the volatility.
5. Expected dividend on share (d):
While calculating expected dividend on share, historical dividend payout and Article of Association of the company along with other available information should be considered. For the purpose of option pricing models, generally a dividend yield is calculated.
Further, expected dividend should be considered into the model, only when the employee is not eligible for dividend during the vesting period. On the other hand, if the employee is entitled to receive dividend during the vesting period, then no adjustment shall be made for expected dividends in the model.
6. Risk-Free interest rate (r):
Typically, the risk-free interest rate is the implied yield currently available on zero-coupon government issues of the country in whose currency the exercise price is expressed, with a remaining term equal to the expected term of the option being valued. For Indian companies, 5-year government bond yield / 10-year government bond yield may be used depending upon the life of the option which should be commensurate with the maturity of the bond.
Valuation Date
As per Ind-AS 102, measurement date or valuation date is the date at which the fair value of the equity instruments granted is measured. For transactions with employees and others providing similar services, the measurement date is the grant date. Therefore, grant date shall be considered as the valuation date for ESOP valuation assignments.
Valuation models
In case of valuation of options, following models are used:
1.Binomial Lattice Model.
2. Black- Scholes Merton Model.
3. Monte-Carlo Simulation.
For the purpose of valuing ESOP, Binomial Model and Black-Scholes Model are widely used. We now discuss these models.
Binomial Model
Binomial Model is the most popular model amongst the lattice-based models of option pricing. This model traces the key underlying variables of the option over discrete time nodes. At each node, the possible price of the underlying asset is mapped, which can be upwards of a multiple of a certain factor (“u”) or downwards multiple of a certain factor (“d”) from the previous price node. This is also known as binomial tree.
The factors u and d are calculated using the stock volatility and time gap from previous node. At the final node, the option value is calculated, which is the intrinsic / exercise value at the final node. Thereafter, option value at each previous node, beginning with penultimate node till the first node, is calculated by discounting the expected value of payoff at succeeding node by risk-free rate. The aforesaid expected value is probability-weighted option values at the succeeding node. The risk-free rate is reduced by dividend yield in case of a dividend paying stock. In this manner, option value at the first node is computed, which is also known as the “binomial value”.
Variables under Binomial model for every node is calculated as follows
- Up factor, u= e^(σ.√t)
- Down factor d=1/u
- Probability of up movement p_u= (e^((r-δ).t)-d)/(u-d)
- Probability of down movement p_d=1-p_u
Where,
σ = Annualized volatility of the underlying share;
t = time between current node and next node;
δ = dividend yield;
r = risk-free interest rate; and
e is the exponential function
Binomial model takes into account, the possibility of early / pre-mature exercise by the option holder and therefore, this model is more suitable for the valuation of American options.
Black-Scholes Model
Black-Scholes model values the option in a continuous time frame. It assumes that continuously compounded rate of return on stock are normally distributed with a constant mean and variance. This determines the price of an option by calculating the return an investor gets less the amount that investor has to pay, using log-normal distribution probabilities to account for volatility in the underlying asset.
The Black-Scholes-Merton formula subtracts the present value of exercise price multiplied by the probability that the option would be above the strike price at maturity, from the current stock price multiplied by a probability which is equal to zero if the stock is below the strike price but is a positive value representing the stock’s value if it’s above the strike price.
The Black–Scholes-Merton formula of value for a European styled option is as under:
C(S,t)= S.e^(-δt).N(d1 )-K.e^(-rt).N(d2 )
where;
C(S,t) = Price of the option as on valuation date, expressed as a function of current stock price and time to expiration,
S = Current stock price
K = Exercise price / Strike Price
r = risk-free rate of government bond of a similar maturity as of option’s time to expiration
t = time to expiration i.e. the time period between grant date and exercise date
N(d) is the cumulative standard normal probability distribution of d1 and d2, where d1 and d2 are calculated as under:
d1=(ln(S/K)+ (r – δ +σ^2/2).t)/(σ√t)
d2=(ln(S/K)+ (r – δ-σ^2/2).t)/(σ√t)
where,
σ = volatility of the stock
δ = dividend yield of the stock
ln () is the natural logarithm
[1] Paragraph B6 of Appendix B to Ind-AS 102.
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