Valuation of ESOP

An option provides the holder with the right to buy or sell a specified quantity of an underlying asset at a fixed price (called a strike price or an exercise price) at or before the expiration date of the option.

Employee stock option is one of the important options very know in the startup space for remunerating key personnel of startups.

Employee Share Options Plan ('ESOP') is an option provided by a company to its employees. These options provide an option for the employees to purchase the company's shares on future dates at a pre-determined price.

Variables Impacting Option Valuation

The value of an option is determined by a number of variables relating to the underlying asset and financial markets, some of these variables are as under:

• Current value: Options are assets that derive value from an underlying asset. Consequently, changes in the value of the underlying asset affect the value of the options on that asset.
• Variance in value: The buyer of an option acquires the right to buy or sell the underlying asset at a fixed price. The higher the variance in the value of the underlying asset, the greater will be the value of the option and via-a-versa
• Dividends: The value of the underlying asset can be expected to decrease if dividend payments are made on the asset during the life of the option.
• Strike Price: A key characteristic used to describe an option is the strike price. In the case of calls, where the holder acquires the right to buy at a fixed price, the value of the call will decline with an increase in the strike price.
• Time to Expiration on Option: Options become more valuable as the time to expiration increases. This is because the longer time to expiration provides more time for the value of the underlying asset to move.

Option Pricing Models

The following option pricing models are widely used for the purpose of valuing an option.

1. Black-Scholes Model
2. Binomial Model
3. Monte Carlo Simulation Model

FAQs about the ESOP Valuation