ESOP valuation and the valuation of the corresponding instruments granted needs to be determined for internal and external purposes. This often requires the application of complex financial mathematical models and the associated challenges.
Dominik Konold CEO/founder of Findiy GmbH, specializes in banking and corporate finance. With a background in audit and investment banking, he's a certified Professional Risk Manager and also serves as a lecturer in banking and accounting.
ESOP valuation methods and valuation process
Background of esop valuation process
A crucial point in ESOP (Employee Stock Ownership Plan) valuation in accordance with IFRS 2 and ASC 718 is the selection of a valuation model for annual valuation purposes. The standard explicitly mentions the Black-Scholes-Merton formula (BSM formula) and the binomial model. However, the IASB nor the US department of labour (dol) do not commit itself to one of the two methods. There is still no statement from the IRS on this matter. It rather points out that factors “that knowledgeable, willing market participants would consider when selecting the option pricing model to be used” must be taken into account when selecting the model. This means that other recognized financial mathematical models, such as the Monte Carlo method, should be considered.
Black Scholes Model
When valuation experts decide for or against a particular model for ESOP valuation, it is crucial that all details of the ESOP plan document can be mapped to fulfill the expectations of a plan sponsor regarding a fully fledged valuation report. A fundamental rejection of the BSM formula is not justifiable from both a financial theory and practical perspective. Nor is it possible to make a blanket statement that the binomial model is the superior model to the BSM formula in all cases. However, the standard points out that the BSM formula can only be used to correctly model very simple programs.
This refers to the structure of the formula meaning that early exercise, for example, cannot be taken into account. Due
to the trend towards increasingly complex ESOPs, the rejection of the BSM formula by an appraiser in accounting practice is therefore
understandable.
ESOP valuation report based on Monte Carlo Model and Binomial Model
The Monte Carlo model and various tree models, offer far more flexible approaches to the valuation of ESOP share. The
flexible structure of both methods allows complex contract details to be mapped. One example of this is an index-related performance targets. These features can be modeled using both the Monte Carlo simulation and the binomial model. The possibility of exercising an option early can also be integrated into both models.
Summary
It is not possible to make a general statement regarding a flexibility advantage of the Monte Carlo compared to tree models. Valuation practice shows that in cases of doubt, the model that is best able to depict the situation at hand is preferred. If several models come into consideration, the calculation time as well as the comprehensibility can be used by ESOP trustees as decision criteria. The effort required to develop a suitable model depends largely on the scope and complexity of the respective ESOP. Last but not least, implementation requires an in-depth understanding of financial mathematics and programming skills. In practice, this represents a major challenge for many companies. It is therefore often necessary to call on experienced valuation specialists or tools .
Early exercise within fair market value (fmv) calculation and valuation due diligence
Background and importance for valuation due diligence
In many cases, share options are exercised before the end of the contractual term if the contractual provisions permit
this. Compliance with these provisions is often monitored by ESOP trustees. From a purely financial mathematical point of view, an early exercise of non-dividend shares cannot generally be justified. This is because the employee forgoes the fair value of the option, whereas he could realize both the intrinsic and the fair value of the option by selling it. However, this is not the case for ESOP. In
most cases stock options or stocks cannot be sold or transferred during their term. Therefore the holder only has the opportunity
to generate cash flow before maturity by exercising the option.
Factors determination early exercise in ESOP valuation
The possibility of early exercise within ESOP transactions has to be reflected in the valuation model on the basis of individual factors. In addition to the question about factors determining exercise behavior, it is also crucial how these factors can be taken
into account in the model. Although early exercise can have a significant effect on the option, only a few
studies have dealt with this topic to date. There is little consensus on the factors that determine exercise behavior.
While factors such as leaving the company before the end of the term and the lack of tradability have an obvious
influence on exercise behavior, the effect of other variables require closer analysis. These factors include expected
dividend payments, expected future volatility and past price movements. Individual factors such as financial
situation, lack of diversification or risk behavior also play a decisive role.
Model incorporation and valuation due diligence
Once the factors have been identified, the next step is to integrate them into the valuation model. The model is
regularly not based on the actual term of the option but on the expected term. This means that an estimate is made of
the probable exercise date (“expected life” method). As this method is based solely on management estimates, the
applicability of the method is questionable.
Hull and White consider the possibility of early exercise by taking into account a ratio covering the share price and
the exercise price of the option in an adjusted binomial model. Early exercise occurs if the stock price at a certain
point in time is higher than the target price which is determined by the ratio. Brisley and Anderson compare the cash
flow on exercise with the BSM at each possible exercise date in the binomial model.
Summary
To date, no standard approach has been established for mapping early exercise in the context of share option valuation. As the models developed to date are based on different variables for modeling early exercise. In practice the approach should be selected for which reliable and plausible estimates of the underlying variables can be made.
Effect of Expected volatility when determining fair market value
Background
The expected volatility represents the degree of fluctuation of the share return during a period. Formally, this risk
parameter can be defined as the annualized standard deviation of the steady returns of the share. Volatility represents
one of the strongest parameters influencing the level of the option price.
The particular significance of volatility for the measurement of ESOP is underlined by the FREP’s
reference to the problems involved in determining volatility in practice in its 2006 examination report. In practice,
volatility tends to be set too low. Given the demonstrably high influence of volatility on the option price, this is not
surprising. Nevertheless, a careful estimate of this factor is essential in the valuation of share options in the
context of accounting in accordance with the standard.
Concepts of volatility measurement included in an ESOP
IFRS 2 deals in detail with various factors that must be taken into account:
- Implied volatility
- Historical volatility
- Tendency of volatility to return to its long-term average.
In principle, the use of implied volatility is to be preferred, as it is based purely on market data and leaves hardly
any scope for ESOP valuation. However, in the case of companies for which no options are traded on the market, implied
volatility cannot be used. In this case, the historical volatility must be taken into account. In many cases, this means
that the average historical volatility over a period that generally corresponds to the remaining term
of the option is used for the expected volatility. A problem that frequently arises is the calculation of historical
volatility for newly listed companies. In this case, the standard recommends “longest period for which trading data is
available”.
Challenges with historical volatility in ESOP valuation report
For unlisted companies, on the other hand, historical volatility cannot be used for estimation purposes. In both cases, the standard stipulates that the volatility of comparable companies (a so-called peer group) should be taken into account when estimating the expected volatility. However, a comparison of the volatilities of listed companies shows that historical volatility does not necessarily correspond to the volatility actually occurred. It can be seen that over a period of 8 years, the volatility estimated using historical volatility deviates from the volatility that actually occurred by an average of 9.8%. It is worth noting that the mean of the maximum deviations of the 30 companies is 54.7%.
Fair Value of company’s value & business valuation
Background for business valuation
The valuation of the company’s fair market value should be performed on the basis of market prices, if such prices
are available [IFRS 2.16]. Prices are available regularly for public companies. If such prices are not available, a valuation technique should be used to estimate “the price that would have been received for the equity instruments at the measurement date in a transaction between knowledgeable, willing parties […]. The valuation technique must be consistent with generally accepted valuation
techniques. It also must take into account all factors and assumptions that knowledgeable, willing market participants
would consider. [IFRS 2.17]
Challenges within business valuation and private companies
When applying the standard in the context of unlisted companies, prices based on market transactions are naturally not available; accordingly, suitable methods must be used for estimation. In practice, discounted cash flow (DCF valuation) or more general present value methods and multiple method (multiples) are frequently used. DCF methods are based on the payment surpluses of integrated corporate planning. These are discounted to the valuation date using a discount rate appropriate to the risk and term. In the multiple method, the value is determined on the basis of financial parameters of comparable listed companies. Both methods have advantages and disadvantages, which should be taken into account in the decision-making process. The following table outlines the main advantages and disadvantages of both methods.
| Pros | Cons | |
| Multiple |
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| Discounted Cashflow |
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