Let’s begin with understanding what stock options and employee stock options (“ESOPs”) are.
An option is a contract that allows a buyer the right to buy or sell an underlying asset or financial instrument at a specified strike price on or before a specified date, depending on the form of the option. The strike price may be set by reference to the spot price (market price) of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfil the transaction (to sell or to buy) if the buyer (option holder) exercises the option. An option that conveys to the option holder the right to buy at a specific price is referred to as a call; and an option that conveys the right of the option holder to sell at a specific price is referred to as a put.
The most common type of options in the market are:
- American option: an option that may be exercised on any trading day on or before expiration.
- European option: an option that may only be exercised on expiry.
These are often described as vanilla options.
Other types of options include Bermudan option, Asian option, Barrier option, Binary option, Exotic option etc.
The classification of options is important because, for example, choosing between American or European options will affect the choice for the option pricing model.
In addition to the stock options, companies may also issue stock options to their employees known as the ESOPs. ESOPs allow the employees of a company the right to purchase the employer’s shares at a predetermined strike price and period. There are several common features in which the ESOPs differ from a regular stock option:
- There is usually a vesting period during which the ESOPs cannot be exercised;
- When the employees leave their jobs (voluntarily or involuntarily) during the vesting period they forfeit the unvested ESOPs;
- When employees leave their jobs (voluntarily or involuntarily) after the vesting period they forfeit ESOPs that are out of the money and they have to exercise vested ESOPs that are in the money immediately;
- Employees are not permitted to sell their ESOPs. They must exercise the ESOPs and sell the underlying shares in order to realise a cash benefit or diversify their portfolios. This tends to lead to ESOPs being exercised earlier than similar regular options; and
- There is some dilution arising from the issue of ESOPs because if they are exercised new common shares are issued.
In general, below are the common inputs required in valuing the stock options and ESOPs:
- The stock price is the current market price of the asset. The exercise price (or the strike price) is the price at which an option can be exercised and is usually pre-fixed upon entering into the contract.
- The life (or expected life) of the option.
- The expected dividend yield: Although this does not have a direct impact on the value of options, but it does have indirect impact through the stock price. When the dividend is paid, the stock becomes ex-dividend therefore the stock price will go down which would result in an increase in the put premium and decrease in the call premium.
- The risk-free rate of interest.
- The expected stock price volatility.
- In the case of ESOPs, some additional consideration may be required, for example the exercise behaviour of the ESOP holder, vesting periods and criteria of the ESOP plan and forfeiture record of the ESOPs.
There are in general three ways in valuing the stock options and ESOPs. These are the Black-Scholes option pricing model, the Binomial tree approach and the Monte Carlo simulation. Depending on the situation, one of these could be used.
Company A is a start-up private company which had completed its Series B preference share (“Series B PS”) fund raising at $2 per Series B PS on 1 April 2020. During FY2020, Company A also granted ESOPs to its eligible employees at the end of each quarter in year 2020. Underlying the ESOPs are the ordinary shares of Company A with an exercise price of $1 and expiring at the tenth anniversary from the grant dates. The ESOPs can only be exercised on the next fund-raising or exit event. Company A is required to value its ESOPs at the grant dates for financial reporting purposes (and let us assume these are equity settled ESOPs).
Consideration # 1: Understand the underlying shares
In this instance where the capital structure involves, the ordinary shares, Series A preference share, Series B PS and ESOPs, an equity allocation model needs to be developed to allocate the value across different classes of equity before valuing the ESOPs. Here one should not use the Series B PS price of $2 as a price input to value the ESOPs unless the characteristics of Series B PS and ordinary shares are identical, which is often not the case.
Consideration # 2: Work out various estimates and assumptions
In allocating the value across different classes of shares, certain features of each class of shares and company specific matters/ potential events would need to be considered and modelled, for example:
- What are the likely exit and fund-raising scenarios? Example of exit scenarios are IPO, sale to a PE, trade sale, etc.
- What are the probabilities for such scenarios eventuating?
- When are the scenarios expected to occur?
- What are the payoffs to each type of shareholder in such scenarios?
- How is the liquidation preference (ranking in the case of liquidation) in such scenarios?
Next, in valuing an ESOPs, examples of some estimates or assumptions that need to be considered are as follows:
- What is the expected stock price volatility? Should Company A refer to its comparable companies’ stock price history or benchmark against the relevant stock market index?
- What is the life or expected life of the ESOPs? It is rather common to use a “simplified” method in estimating the expected life of a ESOPs as an input for the Black Scholes option pricing model. However, the “simplified” method may not be appropriate in this case as the ESOPs can only be exercised on the next fund-raising or exit event. Company A needs to consider and estimate the appropriate time frame and probabilities of those events (as such the exercisability of the ESOPs) eventuating.
Consideration #3: Maintain historical exercise and forfeiture records
Company A would maintain historical exercise and forfeiture records. Over time, for example, the use of a “simplified” method may not be appropriate when more relevant detailed exercise and forfeiture records information becomes available. A more sophisticated method such as the Binomial tree approach and Monte Carlo simulation may be more appropriate in valuing Company A’s future ESOPs grant.
Companies should pay attention to the details of the ESOP plan and its value implications when drafting the plan itself. A number of aspects need to be juggled including, employee incentives/ retention, compliance costs and implications (i.e., to fulfil the requirements of financial reporting standards and/ or the tax regime). The ESOPs in the hands of the employee may be taxable depending on the tax status and the jurisdiction. Valuation of the ESOPs can be complicated many times particularly if the implications are not thought through enough before finalising the ESOP plan.
By Nai Siu Loon and Adie Gupta
This article has been authored by Nai Siu Loon, the Co-Founder and Associate Director of Spring Galaxy and Adie Gupta, the Co-Founder and Managing Director of Spring Galaxy. Siu Loon and Adie provide valuation and related advisory services to the corporate sector across the Asia Pacific. Adie is a regular trainer for accounting bodies, business schools, angel networks as well as speaks at various conferences and other forums on valuation and IP.
- Corporate Finance Institute: https://corporatefinanceinstitute.com/resources/knowledge/valuation/option-pricing-models/
- Determining the value of employee stock options (John Hull and Alan White, August 2002)
- How to value employee stock options (John Hull and Alan White, September 2002)
- U.S. Securities and Exchange Commission: https://www.sec.gov/interps/account/sab110.htm