ESOP Academy 15: Understanding Company’s Share Price, Valuations, and Dilution

Written By:
Amit Majumder
March 27, 2023

How much are your ESOPs actually worth?

Understanding value of your equity may not be straightforward, especially when you work in an unlisted company. Even for listed organisations, it’s not as simple as looking up the latest share price online and multiplying the number of ESOPs you hold by it. There are other factors that you need to consider. In this blog, we explore how you can understand the true value of your employee equity by introducing new concepts with some oversimplified examples.

Listed Companies

If you work in a company that is listed on an exchange, you might think that things are relatively straightforward. After all, you can easily look up the share price the company last traded at online. Knowing the quantity of ESOPs you hold, you could then calculate the value of your portfolio, right? So, is there anything you need to be mindful of? A couple of things, actually. Let’s run through them.

1. Exercise price (aka strike or grant price) 💲

If you hold options as the underlying equity instrument, this is the price you have to pay to convert your options into shares. You need to take that into consideration to understand if your options are in the money (current price is above the strike price), at-the-money (they are equal), or underwater (meaning current price is lower than exercise price).  Be sure to deduct the option cost when you calculate the value of your holdings to understand how much your resulting shares would be worth should you exercise.

2. FX considerations 💱

Your company may be listed on an exchange in another country. As a result, the share price may be quoted in foreign currency. Naturally, you would need to convert the current values of your ESOPs. You will need to consider the FX rate fluctuations and the fact that the exchange rate you look up online is not that would be used should you sell your shares and move the money into your bank account. You need to consider the FX spread that would be applied and any money movement fees. FX spread is the margin that the service providers make on the buy and sell side of the same currency pair. More on that later.

3. Tax considerations (including withholding) 💰

In most jurisdictions, you will have to also consider how tax will impact your ESOP transactions. Familiarise yourself with the tax regulations that will apply to you (and seek appropriate advice, as required). It is important to understand if your employer has withholding tax obligations, or whether it will be up to you to settle the tax bill separately. Besides income tax, capital gains tax may be applicable. It is helpful to evaluate the value of your holding on both pre- and post-tax basis so you can make more informed budgeting and financial planning decisions.

4. Fees 💵

Transactions in shares of public companies are often facilitated by brokers appointed by your employer. Unsurprisingly, there are associated fees, and these fees are often borne by you, and not your employer (in some cases employers may cover some of the fees). Fees can include both direct charges like exercise fees, administrative charges, sale and transfer fees, brokerage, money movement fees, and indirect fees including FX spread. Be sure to understand what fees may be applicable and how will they be covered – often fees are deducted from your proceeds when you sell your shares, but if no sell is occurring you may receive a smaller number of shares as some may be withheld to cover fees and/or taxes, or you will be required to make a separate payment to your employer out of pocket.

Again, it’s important to understand how the fees will be taken care of as it will impact how much cash and/or shares you will end up with following the transaction.

Illustrative example 👀

You were granted 1,000 options with a $1.00 strike price. They have now vested, and you are considering exercising and selling them. Current share price is $2.50, you will be in the 25% income tax bracket, and you would be subject total transaction fees of $50.00.

Your expected gross proceeds following the exercise: 1,000 * ($2.50 - $1.00) = $1,500. This amount may then be subject to withholding tax, which means only $1,125 will be sent to you. But don’t forget the fee. You now will end up with $1,075 in your bank account. What if you need to move the fund to a bank account in another country? Even if the exchange rate is 1-to-1, you may be “short-changed” due to money movement fees and/or FX spread. Be mindful that when entering into FX transactions, banks and financial service providers will also take a cut (commonly via FX spread), so when calculating, be sure to incorporate that when looking up current FX rate online.

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⚠️ These calculations are general in nature and have been prepared for informational purposes only. This example is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your tax, legal and accounting adviser to discuss your specific circumstances and before engaging in any ESOP transactions or completing your income tax return.

As you can see, a few things to consider. If there is no withholding, you will receive a larger payment, but will likely need to settle the tax bill later directly your local tax authority. Ensure you consider all factors when entering into any transactions.

Private Markets

The above can still apply even if you hold equity in an unlisted company. Companies that are not listed on an exchange tend to have a more complex capital structure with a range of various equity classes. While for listed companies, you can easily look up the share price (which is generally the price of the ordinary shares in the company, or common stock as our friends in the US like to call it), it’s not as straightforward in private markets. So, how do you determine the value of shares in this environment?

Fair Market Value (FMV) obtained via independent valuations 📄

Most of jurisdictions have specific local provisions on how the fair market value (think share price) of ordinary shares should be determined. As an employee, you don’t need to stress too much about the logic and calculations, as valuations methodologies can get extremely complex. What’s important to note, the FMV is often determined by an independent third party as a result of series of comprehensive financial analysis, and that your employer will likely be audited on this. As such, plenty of resources will be committed in order to get this right.

Priced rounds 📊

The above seems overly complicated. Why can’t company’s share price or valuation be simply taken from the most recent announcement of a priced round (i.e. where new investors invested funds into the company)? After all, you often see those news articles saying that Startup ABC raised $X as part of Series A and is now valued at $Y. External investors like VCs often receive preference shares that have different parameters attached to them when compared to ordinary shares, and as a result are not worth the same. You as an employee, are more likely to have entitlement to receive ordinary shares. So whilst priced rounds do reset the valuation of the company, when you see various share prices after the funding round has been completed, be sure check if you are looking at the price of ordinary or preferred shares and ask your employer to help you understand the differences, and how your own holding is impacted as a result.

Future funding rounds and dilution 🚰

What happens when a company raises another round of funding? More money, higher valuation – all must be great? That is not always the case, as down rounds may happen – and something the ecosystem may need to get accustomed to in the near future given the current climate.

Your company’s next funding round could be at valuation that is significantly lower than the most recent one. As a result, the value of ESOPs you hold can go down. Another aspect to consider is that with every new round, more equity is issued to the investors, and existing investors get diluted. Simply put, if there more shares created, your existing stake in the company now represents a smaller portion, all things equal. You need to hope that increase in company valuation offsets the dilutive impact of the new funding round. That’s not always the case.

Concept of dilution is not limited to private equity. In public markets, companies may issue new shares as part of capital raising corporate actions that may have dilutive impact on existing shareholders.

Valuations and transparency 🥷

Unlike the listed environment, where company information is easily accessible by employees and investors, there is plenty of information asymmetry in private markets. The companies don’t have the same disclosure requirements, and for that reason a lot of information is not available to you.

Unfortunately, some companies decide to limit visibility for their employees and are not upfront about the current company’s valuation or share price, so it may be hard for you to truly understand the value of your ESOPs.

This is changing, and we are seeing the trend of more companies appreciating the value of transparency and clear communication with their employees. You should always have a conversation with your employer to understand how and when will the communicate the updates on the company’s share price to you.

How to find FMV information yourself where there is limited communication from your employer? If you receive annual grants, you can derive the FMV trend from your grant documentation. As the grant price for each grant is often set at the current FMV obtained from the independent third-party valuation reports, you can see how FMV has changed from year-to-year by analysing details of your awards.

Understanding the true value of your ESOPs

Not an easy task, unfortunately. First, you need to know what the current price is for the underlying security that you hold (often ordinary shares), which can be tricky in unlisted environment. Then, you need to consider various factors, including option cost, tax, and fees to forecast what is your potential take-home pay out or value of shares you will actually be able to enjoy. And finally, you need to consider the upcoming events and how they might impact the current value – there is both upside potential for further appreciation, as well as downside risk (due to share price fall and/or dilution). Looking up the value of your portfolio in your online equity account is a good start.

With this new knowledge, I hope you can take a further step and evaluate your ESOPs further to truly understand what they mean for you as part of your overall investment portfolio. Don’t be afraid to use this to help you make better decisions – whether you are considering transacting on your equity or negotiating your equity compensation with your current of future employer.

Amit Majumder

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