ESOP valuation in India: FMV, merchant banker reports and fair value explained

Founders, employees and accountants often talk past each other about ESOP valuation because they mean different numbers. Separating them makes every other conversation easier.

When an employee exercises options, the gap between the fair market value of the share and the exercise price is taxed as a salary perquisite. The company deducts TDS on it.

For shares that are not listed, the Income-tax Rules require the fair market value to be determined by a Category I merchant banker registered with SEBI, as of the exercise date or any date up to 180 days before it. For listed shares, the fair market value is based on the stock exchange price on the exercise date.

This means an unlisted company needs a fresh merchant banker report whenever employees exercise more than 180 days after the last one. Employees will also want this number, because it decides their tax.

The exercise price is the amount employees pay per share. For unlisted companies, it is set in the ESOP scheme approved by shareholders, together with the formula for arriving at it.

Many Indian startups set it at face value. Others use the latest fair market value or a discount to it. A valuation helps the board choose, but the exercise price itself is a policy choice, and it affects both employee upside and the accounting cost.

Companies record share-based payments as an employee expense, spread over the vesting period. Companies following Ind AS apply Ind AS 102. Others generally follow the ICAI Guidance Note on Accounting for Share-based Payments.

The expense is based on the fair value of each option on the grant date, not the share's value. This is usually estimated with an option-pricing model such as Black-Scholes, using the share's fair value, the exercise price, expected life, expected volatility, a risk-free rate and expected dividends.

Auditors look closely at these inputs, especially volatility for an unlisted startup, which is usually taken from comparable listed companies.

If you run ESOPs, plan valuations around these events so they are not a scramble.

Two of the three. The merchant banker FMV, because it decides your tax at exercise. And your exercise price, because it decides what you pay. The accounting fair value of an option matters to the company's books, not to your tax.

Remember that none of these is a sale price. An unlisted share can only be turned into cash through a buyback, a secondary sale, an acquisition or an IPO, and the price there may be higher or lower than the last FMV.