ESOP & Its Purpose
ESOP or Employee Stock Ownership Plan is a magnificent incentivizing tool in the hands of companies and start-ups. Through this, a company offers shares of the company to deserving employees holding key managerial positions, on a predetermined date and price.
As the name suggests, ESOP is call option and hence, it is not binding on the employee to buy the shares. But it is almost always willingly lapped up by the employees as apart from substantial economic benefit, it also grants security, sense of belonging, and feeling of ownership.
In return, the companies are able to retain competent professionals long-term, and also attract new talent. The employees who are bestowed with ESOPs stay greatly motivated and work full heartedly towards the growth of the company.
How Are Shares of ESOP Valued Annually?
When it comes to the valuation of shares of a public ltd. company, it is quite simple, as it is registered with the public stock exchange, and is traded every day. The real issue is with private companies and start-ups, that are not listed and these are the ones which award their employees with ESOPs most of the time.
Getting to value unlisted stocks is a little complex as they are not registered with any stock exchange. The regulations demand that an ESOP shall value its shares annually to determine the Fair Market Value (FMV). FMV is the price a share would command if traded in the open market, i.e., the price acceptable to a willing buyer and a willing seller.
In order to determine a genuine annual price of ESOP, the company hires a third-party independent valuation firm which will judiciously follow the mechanism to work it out.
Steps Followed to Find out Annual Value of the Shares:
Step 1: The valuator gathers information about all the aspects of the company including its historical and prospective financial figures.
Step 2: Next, the valuator holds meetings with the management and discusses the past performance as well as future expectations. This helps him get an insight into the decision making and approach of the company.
Step 3: Thereafter, the valuator gets to serious working out, making calculations based on the gathered information. Side by side, he writes a detailed report giving out a step-by-step description of how he reached the conclusive value. The report has an in-depth description of the working of calculations for transparency and once completed, it is sent to the company.
Step 4: Finally, a meeting between the management and valuator takes place to satisfy any doubts or queries about the value decided.
Methods Used for Value Determination
The valuation firm can use any or all of the three approaches to find out the fair value of the ESOP shares:
- Income approach
- Market approach
- Asset approach
It is quite common that a valuator uses at least two approaches to determine the value of the share and then compare and contrast the results to come to a final conclusion.
The income approach is most commonly used by the valuators in determining ESOP share value, followed by Market approach. The least used method for this purpose is Asset approach.
The entire process is a bit complicated but professional valuation firms are competent to do it!
Substitute of ESOPs
Compliances that varied regulatory bodies demand for ESOPs are quite a few and in addition, the taxation norms are also cumbersome. Paperwork and accounting work is extensive for ESOPs and these are the reasons because of which companies are adopting ‘Phantom Stocks’. It demands no physical transfer of shares, as well as no compliances, are required, giving lots of flexibility to the companies.
“Phantom Shares have trumped over ESOPs due to their flexibility & ease of handling; with no actual shares exchanging hands, the management prefer it!”
-Shweta Gupta, Founder and CEO, MUDS