Companies grant employee stock options (ESOs) as a form of compensation to align the incentives of employees and shareholders. In addition to aligning incentives, ESOs enable companies to compensate employees without an immediate cash expenditure. Historically, companies did not recognize an expense for granting ESOs, as accounting standards only required employers to expense the intrinsic value on the grant date (i.e., the excess of the underlying stock price over the exercise price). In 2004, the Financial Accounting Standards Board (FASB) changed its accounting standards to require employers to recognize an expense based on the fair value of ESOs. As a result, it is critical to employ stock option valuation methodologies that comply with the revised accounting standard and accurately recognize the special characteristics of ESOs.
Valuing the Option: Two Commonly Used Models
The Black-Scholes Model
The Black-Scholes Model is a mathematical model that is frequently used by market participants to estimate option value. Although the derivation of the model is complex and can be difficult to comprehend, its application to calculating option value is relatively simple to implement. The value of an option is dependent on several parameters under the Black-Scholes model: (i) current underlying stock price; (ii) exercise price of the option; (iii) expected life of the option; (iv) volatility of the underlying stock; (v) risk-free interest rate; and (vi) expected dividends. The Black-Scholes Model is the most commonly used option-pricing model because of the formula’s ease of use and few required assumptions. The model is widely accepted for the valuation of publicly traded options, as it requires simplifying assumptions for the characteristics of employee stock options, such as a single estimate of expected life.
The Binomial Model
The Binomial Model is a lattice model that estimates the value of an option based on assumed price changes of an underlying instrument over successive periods of time. The model is based on a binomial probability distribution, which assumes two possible outcomes in each period: an upward price movement or a downward price movement, each with a certain probability. Underlying stock prices are projected over the expected life of the option at each individual measurement period and then discounted back to present value to determine the option’s value. The Binomial Model is intuitively easier to understand and can directly accommodate more variation in assumptions than the Black‑Scholes Model. Unlike the Black‑Scholes Model, the Binomial Model can be adapted to reflect the expected early exercise behavior of ESO holders.
Although both of these models are commonly used in ESO valuation, the methodology used in practice will depend on the specific terms and provisions of the ESO. Consult with a financial professional to determine the appropriate valuation methodology for valuing your ESO.
Making Use of A Professional Stock Option Valuation
ESO valuations are often subject to after‑the‑fact scrutiny performed by the company’s auditors, the IRS, or the SEC. As a general principle, an outside reviewer is likely to place the greatest reliance on and have the highest confidence on an appraisal that has been prepared by an independent valuation firm. Appraisal Economics has extensive ESO valuation experience and would be glad to be of assistance.