This is part of the CanCan's ESOP Series by Katherine Lui. For our previous deep-dive article on ESOP, please  click here.

You may have heard about how an ESOP, or Employee Share Option Plan, can be an effective way to incentivise workers and increase the value of your company, but there is a lot more to uncover behind what an ESOP is and how it works. Although they can have many benefits, if ESOPs are structured poorly, it can spell disaster for your business, coining them the title, Easy to Structure but Open to Problems.

To start with, an ESOP is an Employee Share Option Plan where a business will compensate its employees by allowing them to buy shares of the company at a discounted price. Assuming that your business continues to grow in the coming years, this plan can greatly encourage workers to do their best because employees take on the same interests as other stakeholders, hoping for the success of the company. For a better understanding of what an ESOP is, read our earlier article here.

Despite an ESOP appearing simple to setup and execute though, it is easy for business owners and entrepreneurs to fall prey to some common traps. When avoiding these problems, a few important aspects of ESOPs must be considered:

• The valuation of the company
• How and when to grant shares
• Tax Implications
• Critical items on the actual ESOP

The Valuation of the Company

Because I have hands-on experience working at IPOs, being a founder at a PE firm, supporting as an advisor to the VC firm on Target’s financial position, and being a founder of a tech company myself, I have come across many different situations and businesses. Every time I meet with an entrepreneur as their acting CFO, they ask me how much their company is worth, and every time my answer depends on the same factors: who is buying their shares and why are they are buying them.

The valuation of a company is usually set by the external parties who are considering an investment in the company, and at CanCan, our consultants do their best to calculate an estimate for the value of the company and present it to those external parties. We typically estimate a company’s value using three different approaches, the discounted cash flows method, comparison to similar companies, and benchmarking with recent deals.

The discounted cash flows method uses a model with business assumptions to project the development of the company over the next few years and estimate how much free cash flow the business will generate. Using the estimated cash flow, we can then estimate how much the company is worth today.

Although this is one of the most complicated ways to estimate the value of a company, it provides comparatively more accurate and reliable estimates. For some deals that are significant in size, companies will also employ a third-party valuation company to sign off on a report, explaining how a certain value was found with one or a combination of the different methods.

To better understand how the valuation of a company depends on who buys their stock and why, let’s look at a simplified example:

The owner of a business that has 50,000 customers is currently looking for an automated tax filing software to speed up his monthly work. He recently came across an opportunity to invest in a new startup that is building an automation software. In this situation, the business owner is likely to value the start up highly because of his expertise in the area whereas someone who has no desire or need for automation software may value the startup lower.

Understanding the value of your company gives you a solid foundation to build from when establishing an ESOP for your employees, so you can be confident that your plan will benefit your workers and still help your business grow. Be on the lookout for the next part in our series discussing different areas business owners can improve when forming an ESOP where we will consider how and when to grant shares. If you have any questions regarding your company's ESOP, please don't hesitate to reach out to Katherine directly: k at cancangroup dot com