Option pricing models estimate what an option would sell for in the market today (i.e., its fair market value) given the terms of the option and the underlying stock characteristics, including future expectations. The marketplace sets the value of publicly-traded stock, so the value of options to buy this stock can be readily calculated. However, if the company is closely held, stock-based compensation raises a valuation issue. First, the company’s value must be determined by performing detailed financial analysis of the company and of comparable publicly traded companies. Second, the value attributable to the option must be determined.
Traditionally, the Black-Scholes model is the preferred method for determining the value of an option for financial reporting and taxation purposes. The main assumption underlying the Black-Scholes model is that the underlying stock behaves in such a way that future price changes can be modeled by a probability distribution. These modeled future values, along with other variables, are then used to determine the option’s estimated fair market value. These variables include the:
- Underlying stock’s value
- Exercise price of the option
- Underlying stock price volatility
- Dividend expected
- Risk-free interest rate for the option term remaining
- Time until expiration (or the expected life) of the options
For companies with complex capital structures, including multiple rounds of preferred stock, warrants for preferred stock, and common stock options, the determination of the common stock value is a complicated task. Sigma Valuation Consulting has the experience and expertise to arrive at reliable valuations of options and stock based compensation.