ESOP: Employee Stock Option Plan Valuation
In this article, we will discuss employee stock options, the reasons why these are used by companies as a form of compensation and the key factors in determining their valuation. Our earlier article discusses the overview of ESOP valuation.
According to various news reports, there has been a massive increase in the number of corporate executives having compensation packages up to eight figures. Naturally, it would seem as if the employee stock option is something that only such well-off corporate executives can take benefit of. However, this is not the case.
Many startups and young technology companies offer employee stock option plans, along with other deferred pay packages, as a part of their remuneration package. Being a form of compensation, employee stock options can have an impact on an organization’s net worth, and can also lead to a favourable business valuation. Therefore, to completely comprehend how these stock options may affect your net value, it is crucial to have a holistic understanding of stock options and their functioning.
Understanding Employee Stock Options
Generally, an employee stock option is a kind of equity-based financial instrument granted by a company to its employees and executives, which gives its holder the right to buy or sell the company’s shares at a specified price— exercise price or strike price— at some later date.
There are two types of such options:
- Call Option: An option that gives its holder the right, but not the obligation, to buy company stocks at the exercise price at a later date, and
- Put Option: An option that gives its holder the right, but not the obligation, to sell company stocks at the exercise price at a later date.
Companies typically grant call options to their employees as part of their compensation plans. Hence, it is important to understand what a call option is. Let’s discuss through an example:
Let’s assume ABC Ltd. — a Singapore plastic recycling company— gives its employee, Charles, 100 shares of the Singapore company as a call option at an exercise price of $18. Now Charles has the right, but not the obligation, to exercise his option by buying 100 shares of ABC Ltd., at a later date, for a total cost of $1800. Even if the actual share price of ABC is greater than the exercise price at which Charles has been granted the option, he will still exercise his option at the pre-determined price i.e. $18.
Reasons why Companies Use Employee Stock Options as a Form of Compensation
One of the most significant reasons why Singapore companies (especially startups) offer call options as a medium of compensation is to create harmony among the drivers of motivation for both the employees as well as the business owners. The prime objective of a business owner, in a corporate environment, is to ameliorate the company’s valuation, more specifically, its business valuation, by maximizing future profits. By granting call options to its employees, the company incentivizes them to perform better with the view of maximizing profits of the business. Consequently the growing revenues and overall business performance would positively affect the business valuation, and thereby the value of their call options (becomes stronger). However, to understand this completely, it is necessary to look into factors that determine the value of call options.
Determining Call Options Valuation
The complete method to determine the value of call options may be a complex one. However, we can continue with the previous example to help you understand in a simple manner.
Let’s consider the same scenario where Charles has 100 call options of his employer’s, ABC Ltd., shares with an exercise price of $14. For the call options to have high valuation or be considered “in the money”, it would be necessary that the current rate at which ABC’s share is being traded is greater than the predetermined rate at which Charles has already been granted the share. For example, if the current share price of ABC Ltd. is at $15 per share, then Charles would be at a benefit to exercise his right at the rate of $14 per share, earning a profit of $1 for every share.
On the other hand, if the current share price of ABC Ltd. is at $13 per share, then Charles would not be at an advantage to exercise his right of call options at an exercise price of $14 per share because, at this rate, he would be at a loss of $1 for every share he buys. In this case, Charles’s option to exercise his right to buy the company’s share at $14 per share, though currently being bought for $13 for every share, would be considered “out of money”.
Therefore, to determine the value of a call option, it is crucial to consider the likelihood of, and the extent to which, the option will be in the money. However, there may be other determinants that need to be considered in the valuation of call options. The following table shows other key determinants:
| Increase in Determinants (ceteris paribus) | Impact on Call Option Valuation |
| Current Stock Price per share (Actual) | Increases |
| Exercise Price | Decreases |
| Stock Price Volatility | Increases |
| Expiration Date to Exercise | Increases |
| Interest Rates (Risk-Free) | Increases |
Even though the above guidelines to fix the value of employee stock options are a good start to understanding the process of stock valuation, the determination of the exact value of employee stock options is a complex process in itself.
We specialize in providing valuation of employee stock options and various other forms of deferred compensation methods. If you are looking to get a valuation of your stock options, or are confused with the intricate process of employee stock option valuation, contact us today.
