Understanding ESOP Valuation: Why it is Crucial for Startups?

During tough times, a startup that has recently begun its journey can turn weak enough to start bleeding from various places. The human resource department is one such critical area. In situations like these, many startups consider ESOPs as a substantial option to hold their high-performing employees back.

Offering ESOPs involves awarding stock options to employees based on their performance. They help retain employees to a certain extent. However, it is crucial for startups to evaluate them regularly and for various purposes, one of which is compliance. Let’s look at a few aspects related to it.

What are ESOPs in India?

At the outset, let’s understand the concept of ESOPs in India. Employee Stock Option Plan, also termed ESOP, is an incentive given to employees of a particular company to buy or subscribe to its shares at a predetermined price for the future. In other words, ESOP is a plan, wherein the company awards stock options to employees based on their performance. An employee stock option is termed a call option. It refers to employees having the right but not the obligation to buy the company’s shares on a pre-decided future date at a pre-decided price.

ESOPs aim to encourage employees to perform better and enhance the company’s shareholders’ value. It offers monetary gains to employees and creates a sense of ownership, increased responsibility, and belongingness among employees. Now, let’s see why ESOP valuation is necessary for startups.

Why is ESOP Valuation Necessary?

According to the Indian Income Tax Law, only a SEBI Registered (Cat-I) Merchant Banker can do ESOP/ Sweat Equity valuation to determine the prerequisite tax payable that is in the control of the company’s employees and decision-makers. Now, let’s answer why ESOP valuation is important for startups.

For a startup, ESOP valuation is crucial as the valuation of the organization in its entirety. Companies that offer ESOPs are required to provide ESOPs as an expense in their P&L statement. The provision impacts the determination of distributable profits for factors such as EPS calculation, dividend declaration, MAT payment, and profit determination for senior management remuneration.

Hence, startups must expense ESOPs appropriately in the P&L statement. As per Ind-AS, companies must undertake a fair ESOP valuation while quantifying the ESOP expense. The compensation expenses reduce the startup’s EPS. On the other hand, employees paying excess tax may fade out the purpose and the value of the ESOP scheme. So, startups must plan ESOPs carefully and have them evaluated regularly to ensure the ESOPs serve their purpose and prove mutually beneficial.

ESOP enables prospective shareholders to gain minority stakes. In that case, it is necessary to evaluate ESOP by applying minority valuation methods. If you consider a particular control methodology, you must provide appropriate discounts, the basis of observation and experience-based evidence, and case-related facts.

ESOP Valuation with Valuation India

Valuation India is an authorized startup ESOP valuation company headquartered in Pune. The company works with various startups across diverse business domains and employs the most appropriate ESOP valuation techniques. Connect with Valuation India at +918530064848 or write to info@valuationindia.co.in.

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