The Union budget has provided for certain concessions in tax treatment of employee stock option plans (ESOPs) for startups. Globally, ESOPs have successfully aligned interests of employees with that of shareholders (mainly improvement in company’s performance and consequential appreciation in valuation of companies) and have played an instrumental role in success of many startups.

The organisations offering ESOPs are required to provide for ESOPs as expense in profit and loss statement. Providing for ESOPs as the expense has an impact on the determination of distributable profits for dividend declaration, calculation of EPS (earnings per share), determination of profits for senior management remuneration, and payment of MAT (minimum alternate tax). Therefore, it is important that ESOPs are expensed appropriately in the profit and loss statement. Indian Accounting Standards (Ind-AS) require companies to undertake a fair valuation of ESOPs when quantifying ESOPs expense amount. ESOPs fair valuation treatment is followed internationally as well and financial statements in this scenario are better appreciated globally.

For undertaking a fair valuation of ESOPs, either the Black-Scholes model or the Binomial model can be used, which are option valuation models. Simply stated, these models compute the value of the option as the difference between: (a) likely value of the share at the time of exercise of the option as discounted to present value; and (b) the present value of paying the exercise price.

Option pricing models consider a few variables such as the life of the option, exercise price, fair value per share, expected volatility of share price, expected dividend yield and risk-free interest rate for computing the value of options.

Organisations can consider the following for determining each of the variables:

Expected life of the option:

Organisations need to consider the likely life of option and not the total life of the option. So, while a stock option is available to the employee for say 10 years, there exists a possibility that the employee will exercise the stock option at the end of, say 7 years, pay the exercise price, take the shares and then sell the shares in the open market.

It will be challenging for companies (especially startups) to estimate the “expected” life of an option. Here, companies can take guidance from the prescription suggested by the Securities Exchange Commission’s Staff Accounting Bulletin No. 107 of the USA.

Exercise price: Organisations will not face any challenge in determining this variable as the exercise price is normally mentioned in the stock option plans.

Fair value: For listed companies, the share price applicable on stock option grant date should be considered. For unlisted companies (including startups), an independent valuer may be appointed to determine the share value of the company as of options grant date or the value of the share can also be deduced from the recent funding round witnessed.

Expected volatility of share price: While listed companies can consider historical volatility in their own share prices for the period that is same as the expected life of the option, unlisted companies can consider historical volatility in share prices of other listed comparable companies.

Expected dividend yield: Companies are required to estimate the future dividend yield rate (i.e. dividend per share divided by value per share). Here, companies can take a clue from their own historical dividend yield rate or dividend yield rates of listed companies in the same industry. Startups (that need capital for growth for next few years) can consider lower dividend yield rates or even ‘nil’ depending on their capital requirements.

Risk-free interest rate: The current yield rates in government securities (with similar residual maturity as expected life of stock options) can be considered. Data on yield rates in government securities is widely available in newspapers or on the internet.

A rigorous analysis needs to be undertaken to determine each variable used in option pricing models and if required an independent valuer may be appointed by organisations to undertake ESOPs valuation. The value of ESOPs needs to be expensed over the period during which options will vest with the employees.

Sanjeev Krishan is Partner and Leader – Deals at PwC India.

First Published:Feb 19, 2020 6:00 AM IST