It is that part of the year when a lot of unlisted startups are finalising their books of accounts for ESOP Expenses

This is governed by Guidance Note on Accounting for Sharebased Payments issued by ICAI, 2020 / Ind AS 102/ IFRS 2/ US GAAP ASC 718

Under the Black Scholes Model, the variables that influence the Fair value of the option are:

•           Exercise Price

•           Fair value of Shares / Market Price

•           Current Expected dividend yield

•           Risk free rate of return

•           Expected option Life

•           Volatility of the stock

Generally, the key things to watch out for are

1. Are you adopting the right value for Fair value of Shares

1. Date of Valuation

The framework says that the valuation of options will be as on the grant date- so one has to clearly map the valuation matrix during the entire year, if grants have happened throughout. Often for practical purposes, auditors allow a Valuation report as on 30^th September i.e. middle of the year; to be used for the entire year

• Implied Equity value from CCPS

CCPS Issuance prices are Level 1 inputs and the most preferred in the Fair Value Hierarchy (Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date)

The question is how do we get the implied Equity Value?

A lot of companies have a view that they can consider issuance price of CCPS as the fair value of equity- assuming 1:1 conversion ratio. In other cases, they assume an standard number, say 15%, based on judgement i.e. equity will be 15% lower than CCPS- which essentially has no rational

But the key questions remain that CCPS as a class of instruments needs to be valued higher than equity because of superior rights such as anti-dilution clause, liquidation preference. So preferably an exercise of applying the OPM Backsolve method should be followed.

• Apply DLOM on the value of equity

Since the ESOP Plans usually carry restrictions around transferability of the shares, the fair value of equity to be considered for BSM should be adjusted for DLOM.

• Chaffe: Black-Scholes-Merton put option
• Longstaff: lookback put option
• Finnerty: average-strike put option
• Ghaidarov: average-strike put option

Chaffe is a widely accepted method for this  

• The right view on Expected Attrition

The ESOP costs to be booked should be adjusted for e. The higher the attrition rate, the lower will be the cost to be charged to P&L – hence the CFO would be happy to have the attrition number to be optimised

Ind AS – 102 – Share-based Payment does not specifically mandate the method for calculating attrition and hence it is open to wide interpretation

If you go by the historical attrition, you can take the annualised value of average Monthly Attrition i.e. Exits during April / ( Opening + Closing ) /2 , Exits during May / ( Opening + Closing ) /2 ….

Else, you can take Exits during April-March / ( Opening of April + Closing of March) /2

If we take a cue from AS 15 and Ind AS 19, one needs to make an assumption about how many people are expected to leave the service of the employer in future. So, its a futuristic assumption and not about the past. The past experience should only be used as a guide to set the assumption. So, let us say the past attrition was 20% but now the company has a Retention Scheme in place, it can jolly well expect that attrition be only 10%.

The attrition number is also to be adjusted for any redundancies planned in the future, say layoffs in a startup that are planned

And then match the expected attrition for whether it matches with the attrition assumed in the Gratuity and Leave Encashment actuarial reports.  Auditors generally check for that

• Graded Vesting

When the options have a graded vesting schedule (for example, 25% vesting each year over four years), they should be treated like multiple grants and the fair value of each grant is amortised over the respective vesting period (the separate grant approach). Practically it needs some care to code it properly

• Volatility

Best to source from listed peers else the industry averages

• Interest Rate

Interest rate that is adopted should not be discrete but be continually compounded i.e. YTM of a Zero-Coupon Bond for the given tenure

• Dividend Yield

This is an important point of judgement- what is the management’s expectation on the expected dividend. In a loss-making startup, it is assumed to be zero.  You could average their historical dividend yield (typically zero) with the average dividend yield of a relevant and comparable peer group.