ESOP Compensation During Economic Distress – Valuation Aspects

1. Chander Sawhney
FCA, FCS, Registered Valuer (IBBI)
“ESOP Compensation during
Economic Distress – Valuation
Aspects”
Webinar
21th May, 2020

2. I. Stages in ESOP implementation
II. ESOP Valuation
III. Guidance under AICPA practice Aid
on ESOP Compensation
IV. Considerations in Option Pricing
Models
VI. Q&A
Agenda

3. Formulation of Incentive
Plan
Grant
Vesting
Exercise
Sale
Commercial Legal Financial
Formulation of
Strategy to
Compensate
Employees
Generation of
Future Cash
Flows
Inflow of Funds
Amortization of
Compensation
Cost
Section -45 read with
Section – 49(2AA) of
Income Tax Act, 1961
Calculation of
Capital Gain
Perquisite
Valuation
Section -17 (2)(vi)
Income Tax Act, 1961
read with CBDT Not. No
94/2009 and Rule 3(8)(i)
of Income Tax Rules
1962
Accounting
Valuation
Sec 62(1)(b) of
Companies Act, 2013 +
Rule 12 of Companies
(Share Capital and
Debenture) Rules, 2014
and SEBI (Share based
Employee Benefits)
Regulations, 2014
Vesting
Period
Exercise
Period
Lock in
Period
Exit
Stages in ESOP Implementation

4. • Options give rights but not obligations
• Valuation is of Underlying Instrument
• Options can be European or American as per their expiry date
• Options can be Call Options or Put Options
 ESOP are Call Options with right to buy the underlying Shares on a predetermined date
at a predetermined basis of price.
 Ind AS 102 / ICAI Guidance Note 18 (2005 edn.) gives guidance on Accounting and
Valuation aspects of ESOP
ESOP – Key Terms

5. Accounting compensation cost Tax on Perquisites
Intrinsic Value Fair Value
Market Price
(-)
Exercise Price
Option Pricing Model
(Black Scholes /
Binomial)
Listed Company on
Recognized Stock
Exchange
Unlisted Company
Average of Opening
and Closing Market
Price on Exercise
Date / Last Closing
Price
Valuation only by a
SEBI Registered
Merchant Banker
Shares of companies listed on foreign
stock exchange also require Valuation
by Merchant Banker.
• Measurement of ESOP (Equity Settled) at Grant Date
only unless terms of grant is modified later.
• Apportionment of Compensation cost over Vesting
period
• Cash Settled ESOP measured at each reporting date.
• Measurement on Exercise Date
ESOP Valuation

6. Valuation
Approaches &
Methodologies

7. Basis of Valuation
The Practice Aid states that the basis of value for measuring privately-held company
equity securities issued as compensation should be that of a minority,
nonmarketable interest in a privately-held-company.
It guides to apply the Fair Value principles for this Valuation
Fair Value is defined as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date under current market conditions
Guidance under AICPA Practice Aid on ESOP Compensation (2013)

8. Guidance for Estimating Fair Value
The Practice Aid summarizes the three valuation approaches (Income, Market, and
Asset) described in ASC 820 that may be used to value a company and its equity
securities.
The Practice Aid states that the following should be considered when determining
the appropriate valuation approach:
•The company’s stage of development;
•The company’s capital structure (ie, simple or complex); and
•The availability of recent transactions involving the company’s own
securities.
For a company with a complex capital structure, value would be ascribed to the
various classes of equity, which requires understanding the economic and control
rights associated with each class using Waterfall methodology (Backsolve Model).
Guidance under AICPA Practice Aid on ESOP Compensation (2013)

9. ESOP Valuation is Minority in Nature. Advisable to apply Comparable Trading
Multiples approach, consider Book Value. DCF also applied in practice with
appropriate discounts.
Adjustments may be required for Lack of Control (DLOC) and Lack of Marketability
(DLOM)
There are many factors to consider in deriving a DLOM, including
•Prospects for liquidity;
•Restrictions on transferability of equity securities by the holder;
•% stake & level of Employees/Management
• Blackout Period
• Covenants of ESOP Scheme
Guidance under AICPA Practice Aid on ESOP Compensation (2013)

10. Key variables in valuation of options through Black Scholes model
(a) The exercise price of the option;
(b) The life of the option;
(c) The current price of the underlying shares;
(d) The expected volatility of the share price;
(e) The dividends expected on the shares (if appropriate); and
(f) The risk-free interest rate for the life of the option.
Under the Fair Value method, Option Pricing models are applied to calculate the call price of
options which is the compensation cost per option. The benefit of this model is that besides
the market price, it takes into consideration certain additional factors which have an impact
on the Option Value.
Considerations in Option Pricing Method

11. The variables that influence the fair value of call option and the impact of
changes in those underlying variables on the option value are presented below
Underlying Variable Change in Variable Change in Option Value
Exercise Price
Market Price
Current Expected Dividend Yield
Risk free Rate of Return
Expected Option Life
Volatility of the stock
Impact of change in Variable and Call Option Value – Black Scholes Method

12. Chander Sawhney
Chartered Accountant & Registered Valuer (IBBI)
FCA, FCS, B.Com (H)
M: +91 9810557353
E: chandersawhney@gmail.com