Valuing Employee Stock Options

Lessons from History

The Origin of First Employee Stock Ownership Plan

The origin of the Employee Stock Ownership Plan/Scheme [ESOP/ESOS] can be traced back to Mr. Louis O. Kelso, an economist and lawyer who created the ownership plan to ensure an ownership transition of Peninsula Newspaper Inc. from its aged founders to their chosen employees and managers. Kelso belonged to the school of thought with the proposition that employees are the ones responsible for a company\'s success and know the operations throughout, and accordingly, the company\'s own employees should be the owners. However, this ownership would come with a catch, in order to purchase any ownership in the company, the employees would have to use their own retirement funds to pay for the shares. The solution to this problem was created in the form of the world first ESOP in the year 1956.

Prior to the genesis of this plan, the owners had majorly only two options:-

1. Option 1: Sell the business to competitors.
2. Option 2: Sell the portion of the business to key employees and redeem the remaining shares.

Both of these options had significant disadvantages related primarily to brand identity, higher leverage, and tax inefficiencies. Further, employee ownership wasn\'t an unheard concept, as prior to Kelso\'s creation of the ESOP there were many public and private companies that had significant employee ownership to increase morale and productivity through the medium of the \"Stock Bonus Plan\" primarily investing the shares of the company.

Survival and Defensive Tool

The year 1979 witnessed the application of the ownership plans to ensure that failing companies survived wherein the stocks that the ESOP acquired were paid from the negotiated salary reductions instead of employee contributions from current or accumulated profits. The major candidates for this survival plan were the Chrysler Corporation, Weirton Steel, and United Airlines. However, it is important to note that the majority of the salary-reduction ESOPs failed and were approved by a majority vote of all the participating employees after full disclosure of the financial situation.

During the 1970\'s stocks of many publically traded companies became undervalued which eventually led to hostile takeovers. In order to prevent this, \"poison pills\" were invented which have many facets but the primary objective would be to deter takeovers by increasing the shareholding of all the shareholders except the acquirer and extinguishing the control they would have obtained normally. The poison pill took effect in the situation of an acquirer gaining controlling interest in the subject company and was litigated extensively in Delaware courts, as well as federal and federal district courts. ESOPs can be used as a defensive tool by issuing shares representing 20-30% of the outstanding share capital to block any incoming votes on the resolution for takeover.

Accordingly, ESOP\'s fared much better in dissuading hostile takeovers than the poison pills along in protection shareholder value. For countries like Japan, nearly 90% of the publically traded firms offer stock options for the employees to participate in although the overall employee holding percentage is miniscule.

Employee Stock Options in India

The credit for introducing ESOPs to the Indian landscape is held by Wipro which introduced the scheme in 1985. Thereafter, many public IT Companies brought employee ownership plans into the mainstream media by creation of salaried millionaires and billionaires. The old taxation legislature offering tax exemption both at the time of exercise of options and sale led to the inherited value of ESOP being incredibly higher than the base salaries. The taxation laws would be amended in the early 2000s but that would not dampen the lustre of stock options for the employees.

The government sector companies would soon jump on the bandwagon with Maruti Udyog Limited becoming the first PSU to introduce ESOP in 1990s in the form of a trust called \"Employees Mutual Benefit Fund\" which operated along the likes of mutual funds by churning employee savings to be utilized by the fund for investment in shares, stocks, debentures or other financial instruments of the company.

Based on the positive feedback of the scheme, the Department of Public Enterprises, Government of India issued guidelines for other PSUs to develop similar schemes for their employees.

Retrospective on Indian Startups

Following the funding boom of 2021 where startups raised more than $41.4 Billion for 1,579 deals which overshadowed the combined deal value of the last three years, many of the startups gravitated to buyback of Employee Stock Options for reward sharing. Further, the employee sentiments towards cash salary took a backseat as many were negotiating substantial ESOPs and less cash payment as part of their tech package, ESOPs being the major differentiator from the average salaries in the market.

This table represents the summary statistics of the buyback value of ESOPs for FY-24

Table 1: Startup Buyback Trends for FY2

Valuation Nuances

The first step in valuing stock options is to determine the value of the underlying equity value of the company. The inherited value of a company\'s stock depends upon a number of factors inter alia, nature of the industry, product offerings, level of competition, intangibles/patents held, government regulations, and director efficiency. All of the aforesaid factors translate into turnover, margins and cash flow to the business, which will ultimately serve as inputs to the valuation exercise.

The three fundamental approaches to valuation are Cost Approach, Income Approach and Market Approach, with Income Approach being the widely used and scientific approach.

After the identification of the stock price, the intricacies of option valuation can be explored. The employee stock options are derivative instruments whose values are contingent upon the price of the underlying stock price of the company. The option is a right but not an obligation to purchase a company\'s stock at a specific price for a specific period of time for a specified quantity. These enable the employees to share in the value generated by the company via an appreciation in the stock price at a minimized risk by not owing the stock directly till the time option is exercised by the employee.

The option is generally vested to a particular employee after fulfilment of certain conditions which are primarily limited to performance, company valuation, milestones, capabilities, and profitability. After the options are vested, they must be exercised within a specific period of time known as the exercise period. The exercise period is generally one to three years for a listed company and event/milestone based for private companies. Options can be exercised by payment of exercise price or strike price which is significantly cheaper than buying the stock outright by paying full price.

An employee will exercise the stock options if the price of the company\'s stock is greater than the exercise price. However, in the scenario where the stock price has fallen and is lower than the exercise price then the option will lapse and will expire worthlessly.

Employee Stock Option Valuation Methodology

The Black-Scholes Option Model was formulated in 1973 by Fisher Black and Myron Scholes for the valuation of a marketable call option on non-dividend paying stocks and is used for the valuation of options that can be exercised in the event of expiry. Another option valuation model is the Binomial Lattice Method which is utilized for the valuation of options that can be exercised anytime throughout the exercise period. Employee options employed by the startups or private companies are only exercisable at specific dates like European options, linked to either revenue milestones, initial public offerings or buyouts, and the issuing companies do not declare any dividend during the exercise period making the Black-Scholes the appropriate model for use in this circumstance.

The valuation model outputs the fair value of a call option based on inputs such as the price of the underlying share, exercise price, risk free rate, volatility, and time to expiration of the option. The model has been adjusted by experts to account for dividend paying stocks, different expiry of options, as well as for pricing warrants.

Formula for computation of fair value of a call option exercisable on expiry

Call Value $= S \\times N(d_1) - Ee^{-rt} \\times N(d_2)$

Where:
$S$ = Stock price
$E$ = Exercise (strike) price
$N(d_1)$ & $N(d_2)$ = Value of cumulative distribution functions of the standard normal distribution, $d_1$ and $d_2$ evaluated
$d_1 = 1 / \\sigma \\sqrt{t} [log(S/K) + (r + \\alpha^2 / 2)t]$
$d_2 = d_1 - \\alpha \\sqrt{t}$
$ln$ = Natural logarithm
$r$ = Short-term Risk-free rate (continuously compounded)
$t$ = Time to expiration, in years
$e$ = Exponential function
$\\sigma$ = Annual standard deviation of return (usually referred to as volatility)

The derivation of the model is complex and has many variable components, brief explanation on the major drivers is provided below:-

1. Stock Price and Exercise Price: The value of an employee option is directly proportional to the price of the underlying company\'s share. However, a higher exercise price will lower the value of an option since the employee will have to pay more to acquire the right to purchase shares at a discount. A typical ESOP Plan accounts for a different tier list of exercise prices depending on the employee designation and hierarchy.
2. Risk-Free Rate: The risk-free rate for the purpose of the Black Scholes Option Pricing Model is the Yield to Maturity (YTM) on a sovereign government bond that has the maturity period equivalent to the term of the option. For Indian companies, 364-Day Treasury Bill (Primary) Yield is relevant and used for calculations. However, the risk free rate used is a continuously compounded rate of return, that is, the natural log of $1+i$, where i is the annual rate of interest. The higher the risk-free rate, the higher the value of an option.
3. Time to Expiration: This refers to the exercise period available to the employees to exercise the option and purchase the shares. The longer the exercise period the more valuable the option becomes due to the effect of time value of money. The period is expressed in years or a fraction of a year in the computation.
4. Volatility: The degree to which the price of a particular stock changes during a fixed period. Volatility is measured as the annualized standard deviation of the daily price changes of a stock if the stock is listed on a stock exchange. If the company stock is not listed, then the volatility of stocks of listed comparable companies can be used as a proxy. The proxy method is also relevant in cases where the stock is thinly traded and does not have sufficient reliable trading volumes during the relevant period.
5. Natural logarithm: The natural logarithm, the standard normal cumulative distribution function, and the exponential function are all mathematical constants.

Valuation Adjustments for Private Companies

The options granted by private companies are bundled with additional characteristics such as liquidity risk and volatility risk. In order to adjust for limited marketability of option discount for lack of marketability is considered appropriate and the volatility computation for private companies is subject to the greater degree of error and is inherently challenging. These are discussed in detail below:-

Discount for Lack of Marketability

Since neither the stocks nor the options of private companies are listed on any stock exchange, we need to assign a discount for lack of marketability (DLOM) to arrive at the fair value of employee options. In the published study conducted by the members of The Put and Call Brokers and Dealers Association (PCBDA) in \"The Wall Street\" Journal from March 1965 to March 1973, a total of 5700 PCBDA options were compared to their derived Black Scholes Option values.

The study concluded that the illiquidity discount for in-the-money call options was 22% from the Black-Scholes Values, and the discount for out-of-the money call options was approximately 45%. Further, for the purpose of financial reporting valuations, adjustment for lack of transferability is made by adjusting the term or exercise period of the option rather than discounting the option value.

Table 2: Factor Leading to Discount for Lack of Marketability

Adjustment for Lack of Control

Employee holdings typically do not result in a controlling stake in the company and accordingly, the employee should not be paying more than the fair price that a willing buyer will pay for non-controlling/minority interest. The employees will neither individually nor as a group will influence the dividends, listing/unlisting decisions, issuing or buying stock, directing management as well as their salaries. Accordingly, in this scenario, the company share price will be discounted for minority interest for input to the option valuation model. The adjustment for lack of control stems from the doctrine that a potential acquirer would be willing to pay extra for a controlling stake assuming all the other factors are constant. Control premium for the majority shareholder necessitates a minority discount for the minority shareholder.

However, certain companies can provide cumulative voting to minority shareholders, elect small shareholder directors representing employee claims and certain minority shareholders can form a voting block and thereby achieve a substantial position. Accordingly, such shares with cumulative voting powers will command a smaller discount for lack of control than the other shares without cumulative voting and other factors being equal.

Control as well as its lack thereof, does not have a demarcated dividing point and constitutes a spectrum from pure minority interest position to 100% controlling interest.

Levels of Ownership

As per empirical studies, the control premium ranges from ~29.0% to ~53.9% and the implied minority discount is within the range of ~22.5% to ~35.0%. The discount is applied directly to the fair value of equity derived at the first step itself and not at the option value level.

Minority Discount is computed as per the following formula:-

Discount for Lack of Control = $1 - 1/[1+\\text{Control Premium}]$

Table 3: Levels of Ownership

Put Rights and Potential Buyers

A put is a contractual right but not an obligation to sell the ownership interest at one\'s own discretion to a third party for consideration under pre-determined events/circumstances, essentially creating a ready market for the transaction where there was none. Private companies can put provisions in the ESOP Plan that would allow the participants to sell the shares to the company in the event of retirement, disability, or death. The acquired share on the exercise of the option can either be redeemed or recirculated in the common ESOP Pool. Existence of Put Rights can significantly reduce the discount for lack of marketability to be applied.

Similarly, potential buyers or acquisition interest by a major buyer can impact the discounts for lack of marketability. However, there have to be past trends or activity of acquisition by buyers for consideration in the fair value computation.

Initial Public Offering

An upcoming public listing can provide a market for the sale of shares exercised by the option holders. A prospective IPO without any concrete plan in place would not warrant any reduction in the discount, and it is problematic to offset the discount for only director intentions or aspirations. However, if the company founders are adamant on the company being private for the foreseeable future, this would require the discount for lack of marketability to be increased and adjusted accordingly.

Further, the magnitude of discount for lack of marketability depends on historical performance, the extent of losses, high leverage, and restrictive transfer provisions in the ESOP Scheme.

Empirical Tests and Pricing Errors

The Black Scholes Option Valuation Model is revolutionary but not without its faults. Research has been conducted to discuss the 1972 Black and Scholes Study as well as the subsequent studies to compare the price of publically traded options with its derived value based on model inputs. The initial studies discovered that there were statistically significant differences between the expected results and the actual market price, although the difference was not economically important due to trading costs. Other researchers propounded that there were significant deltas for long-term options that were significantly in or out the money. Authors like N. Gassel and J. Legras have argued that the difference can be attributed to the change in implied volatility of the underlying stock as the standard Black Scholes Model assumes constant volatility. Shmuel Hauser and Beni Lauterbach published a research paper in 1997 by observing 20,000 warrant price observations by testing five warrant pricing model.

They concluded that a dilution-based model remained the most reasonable and economic model although another model, the Constant Elasticity of Variance Model [CEV] based on constant elasticity of variance generated the lowest average pricing observation, and the degree of error is within normal valuation tolerances, as depicted in Table 4.

Table 4: Average Pricing Errors by Time to Expiration and the Degree of In or Out of the Money

Conclusion

Employee stock ownership plans are increasingly drawing the attention of founders as well as employees who prefer stock options to their cash salaries by delaying instant gratification for the sake of immense value in the foreseeable future. Evidence from the Indian Stock Buyouts suggests that the stock options are thriving and more importantly, there is a ready market for the vested options other than the popularised dream of public listing. However, stock options are not a path to be ventured upon nonchalantly and without conviction but demand an understanding of the valuation which not only determines value creation but also its many variables which can impact the price exponentially and many times dramatically.