Understanding ESOP Valuation: A Simple Guide

ESOP valuation is the process of determining the fair market value (FMV) of a company's common shares granted to employees through stock options, RSUs, or other equity compensation plans.

Unlike venture valuation, which reflects the price investors pay for preferred stock, ESOP valuation serves a different purpose. 

• Establishing a fair exercise price for employee stock options.
• Valuing common stock separately from investor-held preferred stock, often at a lower price due to differences in rights and liquidity.

Why do companies need ESOP valuation?

ESOP valuation ensures that the FMV is objectively determined for compliance, tax, and financial reporting purposes.

1. Regulatory compliance

ESOPs can be granted at face value, fair market value (FMV), or a discounted price.

However, for unlisted companies, ESOP valuation is mandatory under the Companies Act, 2013, and must be conducted by an IBBI-registered valuer or a merchant banker. This ensures transparency, fairness, and compliance with financial and tax regulations.

2. Taxation

The valuation of ESOPs directly impacts tax calculations for both employees and the company. 

Employees are taxed at the time of exercising their stock options, with the difference between FMV and the exercise price treated as taxable income.

For companies, while the deductibility of ESOP-related expenses has been a subject of litigation in India, courts have ruled that these costs qualify as employee compensation and are deductible under Section 37(1) of the Income Tax Act, 1961. 

Proper valuation ensures accurate tax reporting and strengthens a company’s claim for these deductions.

3. Financial reporting

Under Ind AS 102, Indian companies must account for ESOPs as an expense in their financial statements. 

The cost of stock-based compensation is determined using valuation models like black-scholes or the binomial model. This ensures that companies properly account for employee benefits, providing a transparent view of financial health. 

ESOP valuation in India using a registered valuer or merchant banker

For private companies in India, ESOP valuation must be conducted by an IBBI-registered valuer or merchant banker.

The valuer applies core valuation methods to determine the FMV per share of common stock:

1. Market approach (Comparables method)

The Market Approach values a company by comparing it to similar businesses in the same industry. It relies on financial benchmarks such as revenue multiples, EBITDA multiples, or recent acquisition prices.

This method is useful for late-stage startups and mature companies where industry peers provide clear valuation trends.

2. Income approach (Discounted cash flow)

The income approach estimates a company’s valuation based on its future cash flow potential, discounted to present value. This method accounts for business risk through a discount rate, making it useful for companies with stable revenue and predictable growth.

However, this approach is sensitive to assumptions about future performance, making it less reliable for early-stage startups.

3. Asset approach (Net asset value method)

The asset approach values a company based on its tangible assets, calculated as total assets minus liabilities. This method is typically used for asset-heavy industries such as real estate and manufacturing or for early-stage startups with minimal revenue.

Core valuation methods assess the overall company value, which includes both preferred and common shares. However, preferred shares often have superior rights, such as liquidation preferences, which reduce the value available to common shareholders in the event of liquidation.

Valuation professionals account for this and accordingly allocate the company’s valuation between preferred and common shareholders before determining the FMV per share for common stock.

Companies typically obtain a valuation report before granting ESOPs and update it periodically, especially before major corporate events. 

Black-scholes model for ESOP accounting

While a valuation report from a registered valuer/merchant banker establishes the FMV of shares, companies also need to determine the fair value of stock options for accounting purposes under Ind AS 102.

Ind AS 102 is an accounting standard that requires companies to recognize stock-based compensation as an expense over the vesting period.

This is because FMV reflects only the share price, whereas stock options have additional variables, such as vesting conditions, exercise periods, and market volatility, that impact their value.

The black-scholes model is one of the most commonly used methods for ESOP valuation under Ind AS 102.

Black-scholes calculates the fair value of stock options based on:

• Stock price (determined by a registered valuer/merchant banker)
• Exercise price (the price employees pay to exercise their options).
• Time to expiration (the duration before options expire).
• Volatility (expected stock price fluctuations, often based on historical data).
• Risk-free interest rate (usually linked to Indian government bonds).