Why your ESOP needs a valuation

An option plan looks simple on paper: employees get the right to buy shares later at a price fixed today. The difficulty is the word "price". Accountants need a value for the option. Tax authorities need a value for the share when the option is exercised. Investors want to see that grants were not priced to favour insiders. One documented valuation, done properly at each grant round, answers all three.

Three reasons you need it

Step one: value the share

A private company has no market price, so the share value has to be built. The usual methods are:

• A recent funding round. The best evidence, if it was at arm's length and recent. But the price investors paid was for preference shares, with liquidation preferences and other rights. Ordinary shares, which is what options are over, are worth less.
• Allocating equity value across share classes. The option pricing method "backsolves" the total equity value from the last round, then allocates it between preference and ordinary shares according to their rights. For an early-stage company the ordinary share often comes out at 30% to 60% of the preference price.
• Discounted cash flow or market multiples, for companies with revenue history and a credible plan.
• Net assets, only for very early or asset-heavy companies.

Using the preference price as the ordinary share value overstates the expense and the employees' tax. Using a value far below it, without support, invites challenge.

Step two: value the option

The option itself is valued with a pricing model. Black-Scholes is standard for simple service-vesting options. A binomial model handles early exercise better. Options that vest on a market condition, such as an exit valuation, usually need a Monte Carlo simulation.

A worked example

A company closes a Series A at S$2.00 per preference share. Allocating the implied equity value across share classes puts the ordinary share at S$0.80. The board grants 100,000 options at an exercise price of S$0.80, vesting over four years, with a six-year expected term. Assume volatility of 55% from listed peers and a risk-free rate of 2.5%.

Black-Scholes gives a fair value of about S$0.43 per option, or about S$43,000 for the grant. That is expensed over the four-year vesting period, adjusted for expected leavers. Had the company used the S$2.00 preference price as the share value with a S$0.80 strike, each option would have been valued at about S$1.48, more than three times the expense, and the grant would look "in the money" to every reader of the accounts.

Illustrative figures only. Real valuations depend on the rights attached to each share class and the plan terms.

Singapore tax for employees

Gains from employee share options are generally taxable as employment income in Singapore. For options, the gain is usually measured at exercise: the market value of the shares minus the exercise price. Where shares are subject to a selling restriction, the taxable point moves to when the restriction lifts. The employer reports the gains each year in its employment income submissions, so it needs a share value at each exercise date, not only at grant.

Foreign employees who leave Singapore, or who stop working here, are treated as having exercised unexercised options shortly before they leave, and tax is computed on that deemed gain, unless the company tracks them under IRAS's approved tracking arrangement. Plan this before the first foreign employee leaves: see IR21 tax clearance.

Employees abroad

• India: the employee is taxed at exercise on the fair market value minus the exercise price, with the value set under Indian rules. See ESOPs for Indian employees.
• United States: options granted below fair market value can trigger penalty taxes for the employee, so US staff usually need a valuation that meets US standards before each grant.

Where one plan covers several countries, keep the valuation dates and methods consistent, and record any differences required by local rules.

When to revalue

• At each grant round, if the last valuation is more than about 12 months old
• Immediately after a priced funding round, a secondary sale, or an acquisition offer
• After a major event: a large contract won or lost, a pivot, a down round
• Before a liquidity event where employees will exercise in bulk

Mistakes we see in due diligence

• Grants priced off a two-year-old valuation after a large funding round
• No expense recognised because "the options are worthless until exit"
• Board minutes that approve grants without recording the share value or how it was set
• Different values used for the accounts, Singapore payroll and Indian payroll, with no reconciliation

Keep the valuation report, the model and the board minute together for each grant round. When investors arrive, that file answers most of their questions on the plan.