Valuation of ESOP

Employees Stock Option Plan (ESOP) is a tool used by management to remunerate employees and also to retain them since it helps in creating a feeling of partial or limited ownership in the company which further  improve employees morale and satisfaction. For this, the company creates an ESOP pool. These ESOPs can be  Equity Settled or Cash Settled. Grant of ESOP’s are required to meet various regulatory compliances.

The cost of granting ESOP is an estimated expense measured on its grant date, booked over the vesting schedule and incur only when eligible employee exercises them. However, any modification in the terms of ESOP’s granted results in increase in the fair value of equity instruments granted, which will result in  incremental fair value at the date of modification as recognised in addition to the grant-date fair value.
Since Grant of ESOP’s are linked with performance criteria of both the employees and the shareholders which ultimately participate towards the increase in overall value of the Company, hence terms of the ESOP scheme should be carefully translated while deriving fair value of ESOP’s granted.

Important parameters to evaluate:
Equity price per share
Exercise Price
Vesting schedule
Volatility
Risk free rate
Dividend Yield
Option pricing method to use