ESOP Valuation 101: What You Need to Know About Your Stock Options
ESOP Valuation 101: What You Need to Know About Your Stock Options
By - Jeremiah Grant
Last Updated - October 17th, 2023 4:56 AM
Oct 17
ESOPs are a way for your company to reward you with shares of its stock. But how do you figure out what they are worth? That’s where ESOP valuation comes in.
ESOP valuation is the process of finding out the fair market value (FMV) of your ESOPs. It’s not as simple as looking at the share price and multiplying it by the number of options you have.
There are many factors that affect the value of your ESOPs, such as:
The type and features of your options: For example, are they call or put options? When can you exercise them? How long do they last?
The market data and conditions: For example, how volatile is the stock price? What is the expected dividend rate? What is the risk-free interest rate?
The accounting and tax rules and regulations: How are your options classified and reported? How are they taxed when you exercise them?
In this blog, we will cover various topics, such as how to choose the best valuation method and model for your ESOPs, validate the inputs and assumptions for your valuation model, common mistakes and pitfalls in ESOP valuation for private companies, and how you can use an ESOP business valuation service to plan your financial goals, negotiate your salary, and decide when to exercise your options.
As described by the American University Washington College of Law, an Employee Stock Ownership Plan, otherwise known as ESOP, is a tax-qualified retirement plan authorized and encouraged by federal tax and pension laws.
ESOPs are unique retirement plans because:
They must invest mainly in the company’s own stock.
They create trusts that hold company shares for employees, making them part-owners.
They offer tax advantages to both the company and owners who are leaving.
They can borrow money for company projects, even to buy company stock with tax benefits.
ESOPs let a company give its own shares or cash to a trust. This trust holds the shares for employees. When employees leave or retire, they get these shares, and the company buys them back at a fair price.
ESOPs help businesses facilitate their succession planning. It allows company owners to sell their shares and smoothly transition out of their company.
Simply enough, ESOP valuation for private companies is the process of figuring out how much the stock options given to employees through an Employee Stock Ownership Plan are worth.
This valuation is crucial for tax and accounting purposes because it affects how much income tax employees pay when they use these options and how much the company reports as an expense for giving out these options.
It’s also necessary because businesses must follow specific accounting and tax regulations, such as IFRS 2.
How Does An ESOP Work?
ESOP’s inner workings can be quite complicated, due to which it can be quite difficult for some to understand who are unfamiliar with the subject.
So, we have broken down the process into 6 simple steps to make it a bit easier to understand.
Here’s a simplified breakdown of how an ESOP works:
Step 1
The company establishes an ESOP trust.
Step 2
The company can contribute cash to buy shares from existing owners at a fair market value or issue new shares if owners don’t want to sell.
Step 3
If the company lacks cash initially, the ESOP can take out a loan to buy shares while the company contributes funds to repay the loan.
Step 4
Employees receive shares in the trust, often based on their pay. Over time, as they work for the company, they gain more rights to these shares, a process known as vesting.
Step 5
Typically, all full-time employees over 21 can participate in the plan. This means employees become part-owners of the company and may have control and voting rights.
Step 6
When an employee leaves the company, they receive their stock, and the company must buy it back at its fair market value (unless there’s a public market for the shares). Employees usually receive the value of their shares in cash.
ESOPs offer several benefits, including increased productivity, better employee retention, tax advantages, and improved job satisfaction.
They also serve as a financing option for companies by selling their stock to the ESOP, which can then be used to pay off debt and more.
But that is not all. ESOPs offer several other advantages for both companies and employees:
For the Company
Community Stability: They help keep businesses and jobs rooted in the community.
Tax Deductions: ESOP-owned S corporations can avoid income taxes on the portion of the business owned by the ESOP. If the ESOP owns 100%, the company pays no income taxes.
Fair Value for Owners: ESOPs offer a fair market to sell their shares for owners of closely held businesses.
Financing Options: The ESOP can be used to fund growth, acquisitions, or succession plans by issuing new shares or borrowing money through the trust.
Alignment of Interests: Employees become company owners, aligning their interests with shareholders and sharing in profits and losses.
Customer Continuity: Customers interact with the same familiar faces, ensuring continuity in customer relationships.
Business Continuity: Employees who have an intimate understanding of the business stay on to keep operations running smoothly. This promotes business continuity.
For Employees
Tax Benefits: Employees enjoy tax-deferred growth on their shares until they receive them and may qualify for favorable tax treatment if they roll over their shares to an IRA or another qualified plan.
Motivation and Loyalty: Employee ownership can boost motivation, productivity, and loyalty, as they have a stake in the company’s success and performance.
Job Security: Studies show that ESOP-owned companies are 7.3% less likely to lay off employees compared to traditionally owned firms, providing job security.
Benefits for Owners
Succession Planning Options
One of the primary reasons for establishing ESOP is because it allows us to buy shares from small businesses and provides the business with a succession plan.
Unfortunately, many locally owned small businesses don’t have a succession plan, leaving them without a plan for what happens if the owner or key shareholders decide to step down. Understandably, it creates an undeniable situation for the company, its workforce, and the owners themselves.
In such cases, ESOP helps businesses facilitate succession planning. The founders and main shareholders have the option to sell all of their shares to ESOP, all at once or gradually over time.
This means the change in leadership can happen fast or slow, depending on what the owner wants.
Finding a Buyer
Sometimes, finding someone to buy a small company is hard, even if it’s doing well. Due to this reason alone, the company might close, people lose their jobs, and the community may lose the products or services the company provides.
Even if the company manages to find a buyer, new owners usually get rid of some of, if not the entire staff. So, it still ends up with people losing their jobs in a roundabout way.
Luckily, ESOP solves this problem. Especially rural North Carolina and New York City have benefited from ESOP, as it gave locally owned businesses a way to keep their business afloat even without buyers.
An ESOP:
Keeps the business in the community and saves jobs.
Makes it more likely that employees will keep their jobs because companies with ESOPs are less likely to lay off workers.
Gives a fair price to the person selling the company.
Customers can keep dealing with the same people they’re used to.
Keeps the business running because the people who know it best stay on to run it.
Tax Benefits
If that wasn’t enticing enough, the federal law also offers the owners of small businesses a way to potentially reduce their taxes when they decide to sell their business to an ESOP.
Here are the 3 terms that you need to know:
The company being sold must be a C corporation at the time of the sale.
The ESOP must own at least 30% of the company after the sale is complete. The stocks sold by two or more shareholders contribute to the 30%.
The money received from selling the business needs to be reinvested in stocks and bonds of American companies within a specific time frame. You have 15 months to do this, starting three months before the sale and ending 12 months after.
This “tax-free rollover” is designed to encourage the use of ESOPs and can be a good option for business owners who want to retire while potentially saving on taxes.
The simple answer is yes; it is very important for two main reasons: tax and accounting purposes.
Accounting
ESOP valuations help companies figure out exactly how much they’re spending when giving employees stock options as compensation.
It is really important that companies record this spending in the company’s financial reports over time, typically as an expense.
This makes deciding on the value of these options crucial.
Companies are required to disclose their methods and assumptions for transparency.
Taxation
ESOP valuation for private companies is crucial for tax purposes because it affects the perquisite tax amount that the employees have to pay when they exercise their options.
The perquisite tax is calculated as the difference between the FMV of the shares at the time of exercising them and the exercise price of the options.
And the FMV of those shares is determined by ESOP valuations.
The employees must pay tax on this difference amount as part of their income tax.
Methods of ESOP Valuation
ESOP valuation is a very complex and challenging process that requires professional judgment and expertise. It also requires experts to use various methods and models to get a reliable valuation.
Intrinsic Value Method
Experts use this method to calculate the difference between the market price per share and the exercise price of the option.
This is the ‘imputed gain’ that an employee receives by selling their option.
For example
An employee has an option to buy 100 shares of the company at $10 per share, and the current market price of the share is $15.
The intrinsic value of the option is ($15 – $10) x 100 = $500.
This means that the employee can make a profit of $500 by exercising their option and selling their shares at the market price.
The intrinsic value method is simple and easy to use, but it does not consider the time value of money, the volatility of the share price, or the probability of exercise.
Black-Scholes Method
This is the standard valuation technique that uses a mathematical formula to determine the fair value of an option based on various parameters, such as the expected life of the option, the expected volatility of the share price, the expected dividend yield, the risk-free rate, and the exercise price.
The formula is:
C=S⋅N(d1)−X⋅e−rT⋅N(d2)
where:
C is the fair value of the call option
S is the current market price of the share
X is the exercise price of the option
T is the time to maturity of the option
r is the risk-free interest rate
N(d) is the cumulative normal distribution function
d1 = σTln(S/X)+(r+σ2/2)T
d2 = d1−σT
σ is the standard deviation of the share price
For example
Suppose an employee has the option to buy 100 shares of the company at $10 per share, and the current market price of the share is $15.
The option expires in one year, and the risk-free interest rate is 5%. The standard deviation of the share price is 20%, and there are no dividends.
The fair value of the option using the Black-Scholes method is:
C = 15⋅N(0.8413)−10⋅e−0.05⋅N(0.4013)
C = 15⋅0.7997−10⋅0.9512⋅0.6554
C = 5.99
This means that each option is worth $5.99, and the total value of 100 options is $599.
The Black-Scholes method is widely used and accepted, but it has some limitations, such as assuming constant volatility and interest rate, ignoring early exercise and vesting conditions, and requiring complex calculations.
This is a more flexible method that can account for changes in the exercise price and other factors over time.
It involves building a binomial tree that shows the possible outcomes of the share price at different points in time and then calculating the present value of each outcome.
The binomial tree has two branches at each node: one for an upward movement (u) and one for a downward movement (d). The probability of each movement (p) is calculated using:
p=u−derΔt−d
where:
Δt is the time interval between each node
r is the risk-free interest rate
u and d are calculated using:
u=eσΔt
d=e−σΔt
where:
σ is the standard deviation of the share price
The value of each node is then calculated by discounting the expected payoff from exercising or holding the option at that node using:
V=e−rΔt(pVu+(1−p)Vd)
where:
Vu and Vd are the values of the upper and lower branches
V is the maximum of zero or the intrinsic value of exercising or holding
The value of the option at each node is then compared with its intrinsic value to determine whether it is optimal to exercise or hold.
The value of the option at time zero is then obtained by working backward from the final nodes to the initial node.
For example
Let’s say that an employee has an option to buy 100 shares of the company at $10 per share, and the current market price of the share is $15.
The option expires in one year, and the risk-free interest rate is 5%. The standard deviation of the share price is 20%, and there are no dividends.
The binomial tree for the option with four-time intervals is shown below:
![Binomial tree]
The value of the option at each node is calculated as follows:
This means that each option is worth $5.86, and the total value of 100 options is $586.
The binomial method is more flexible and realistic than the Black-Scholes method, but it also requires more data and computation, and it may not converge to a unique value.
Monte Carlo Simulation
This simulation-based method generates a large number of random scenarios for the share price using Microsoft Excel or any other similar program and then computes the average value of the option across all scenarios.
The share price at each time interval is simulated using:
St=S0e(r−σ2/2)t+σWt
where:
St is the share price at time t
S0 is the initial share price
r is the risk-free interest rate
σ is the standard deviation of the share price
Wt is a standard normal random variable
The payoff of each option at maturity is then calculated by comparing the share price with the exercise price and then discounted to the present value using:
Pt=e−rTmax(ST−X,0)
where:
Pt is the payoff of the option at time t
T is the maturity of the option
X is the exercise price of the option
ST is the share price at maturity
The value of the option at time zero is then obtained by taking the average of all payoffs across all scenarios.
For example
Suppose an employee has the option to buy 100 shares of the company at $10 per share, and the current market price of the share is $15.
The option expires in one year, and the risk-free interest rate is 5%. The standard deviation of the share price is 20%, and there are no dividends.
In this case, the Monte Carlo method simulates 10,000 scenarios for the share price and then calculates the payoff and value of each option as shown below:
![Monte Carlo simulation]
The value of the option at time zero is then:
C = V0 = Average (Ptforallt) = 5.87
This means that each option is worth $5.87, and the total value of 100 options is $587.
Stages of ESOP Valuation
ESOP valuation for private companies happens at different stages when an independent business appraiser is evaluating the FMV of the company shares held by the ESOP trust.
The stages of ESOP valuations are:
Initial formation
When the ESOP is first established, the appraiser determines the value of the shares that are sold to the ESOP trust by the existing owners or issued by the company as new shares.
Annual Update
Every year, the appraiser updates the value of the shares based on the latest financial and non-financial data available.
Contribution
Whenever the company contributes to the ESOP trust in cash or shares, the appraiser determines the value of the shares allocated to the ESOP participants’ accounts.
Distribution
Whenever an ESOP participant retires, terminates employment, dies, or becomes disabled, the appraiser determines the value of the shares that are distributed to the participant or their beneficiary.
Repurchase
Whenever an ESOP participant exercises their put option to sell their shares back to the company or the ESOP trust, the appraiser determines the value of the shares that are repurchased.
Termination
When the ESOP is terminated or dissolved, the appraiser determines the value of the shares that are liquidated or transferred to another entity.
As we have said before, ESOP valuation involves significant challenges and risks, such as complexity, uncertainty, volatility, compliance, litigation, etc.
Therefore, it is essential to avoid common mistakes that can undermine the validity and reliability of ESOP valuations.
Some of these common mistakes are:
Improper Due Diligence
The valuation report should demonstrate and document that the appraiser conducted sufficient due diligence to understand the company’s historical performance, financial situation, corporate structure, legal agreements, and any pending or threatened litigation.
The appraiser should also research and analyze the industry and market conditions that affect the company’s value.
If all the factors are not accounted for, the fair market value of the shares can be questioned, and the whole process can result in a moot exercise.
Unsupported Forecasts
The company’s projections are a driving force of the business appraisal.
The appraiser should scrutinize the projections and test their reasonableness and consistency with historical trends, industry benchmarks, and economic outlooks.
They should also consider different scenarios and sensitivities to account for uncertainty and volatility.
If they use unsupportable projections, it can result in unrealistic and inflated valuations.
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The ESOP plan design should reflect the objectives and needs of both the selling shareholders and the employees.
This means that the plan design should consider factors such as vesting schedules, repurchase obligations, distribution policies, voting rights, etc.
It should also be compatible with the valuation method and model used to value the ESOP shares.
If done incorrectly, a faulty plan design can create operational and financial problems for the company and the ESOP.
Overvaluing and Overleveraging
The ESOP valuation for private companies should not overestimate the value of the company or underestimate the risks involved in the transaction.
It should also take into account the impact of debt financing on the company’s cash flow and profitability.
Overvaluing and overleveraging can result in excessive debt service, reduced employee benefits, lower shareholder returns, and increased regulatory scrutiny.
Neglecting the Tax Impact
The ESOP valuation should always consider the tax implications of the transaction for both the selling shareholders and the company.
Additionally, it should also comply with the tax rules and regulations applicable to ESOPs, such as Section 409A, Section 1042, Section 280G, etc.
Neglecting the tax impact can result in unexpected tax liabilities, penalties, or disqualification of the ESOP.
ESOP valuation is not a one-time thing. You need to update it regularly to reflect changes in the factors that affect it.
ESOP valuations are important for both accounting and tax purposes, as well as for your compensation and motivation.
It can help you plan your financial goals, negotiate your salary, and decide when to exercise your options.
It is not an easy task, but it’s worth it. It can help you understand and appreciate the value of your ESOPs.
However, it also involves a lot of challenges and risks, such as complexity, uncertainty, volatility, compliance, litigation, etc.
That’s why you should seek advice from qualified experts who have experience and knowledge in ESOP valuation for private companies.
But where do you find such an expert?
We at Arrowfish Consulting can help you with that. Our team of professionals offers industry expertise with 20+ qualifications and over 200 years of collective experience in ESOP valuations and business valuation as a whole.
But you don’t have to take our word for it. We are offering you a free initial consultation, which you can schedule by simply contacting us. Schedule your free consultation, meet our team, discuss your requirements, and decide for yourself.
Jeremiah Grant
Jeremiah Grant is the Managing Partner of Arrowfish Consulting. In addition to acting as a primary liaison for many of the firm’s engagements, He primarily focuses on business valuation and economic damages expert witness assignments, in addition to forensic accounting and insurance claims analysis.
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