How Does Stock Option Valuation Work?

In this article, we will discuss the basics of stock options along with the tools and techniques used to price or value the stock options.

For privately held companies, stock options are the primary form of compensation for employees. It is meant to incentivize employees in order to retain, motivate, and increase productivity. As such, the stock options valuation in private companies is derived with the help of standardized models and formulas. Establishing a stock options model requires a number of assumptions, including the exercise price, stock volatility, and expected term. Hence, careful analysis and calculation are required to determine the theoretical value of stock options. In this article, we will discuss the basics of stock options along with the tools and techniques used to price or value the stock options.

Stock options valuation

Stock options valuation involves estimating the fair value of stock options using a variety of methods. The choices available to companies depend on the company’s particular assets, operations, and business objectives. These approaches and models are developed to yield an estimate that is in line with the company’s core financial statements. Several methods commonly used in determining stock option value are the Black-Scholes Model, Binomial Model, and Monte Carlo Model, which will be discussed in the later part of this article.

Transparency and understanding of the valuation methods used are critical for ensuring the effectiveness of stock option programs. In this context, stock options valuation plays an important role in strengthening the accuracy of financial data. It helps to eliminate potential accounting errors and disagreements during the process of issuing stock options.

Understand stock options

A stock option represents an agreement between the investor and the company that gives the investor the right to buy or sell the underlying shares at a certain price for a particular time period. The methodology for determining the stock options valuation for public companies is different from those for private companies. Stock options are traded on stock exchange platforms, and the value of a stock is determined by the market forces in the case of public companies.

On the other hand, stock options in private companies are in the form of stock-based compensation, thereby referred to as an employee stock ownership plan (ESOP). In this regard, employees are given the right to purchase or sell shares at a specific price over a specific time period. As such, the foundation of stock options in both public and private companies is based on a similar concept.

However, the stock options valuation is totally different in private companies due to the fact that the shares are not publicly traded. As a result, stock options are usually awarded to the employees of private companies as a form of employee compensation, while public companies use stock options as a source of raising capital.

How do stock options work?

Stock options are derivatives instruments that essentially put the right to buy or sell the company’s stock at a certain price for a specific duration of time. In this regard, strike price or exercise price is the amount paid for the stock options at the time of expiration, which serves as a benchmark in determining the stock options valuation. The strike price is generally set at a price representing the fair market value of the company’s shares.

It is essential to note that the option should be exercised within the expiry date. Conversely, if it is not exercised, the option will be void. Furthermore, call options and put options are two basic types of stock options. Call option refers to the right to buy a certain number of shares at a certain price within a certain period of time in the future.

In contrast, the put option means the right to sell a particular number of shares at a specific price within a specified duration. Therefore, stock options are contracts that give the right to buy or sell at a specified price for a specified period of time. So, what are the benefits to value stock options?

Benefits of valuing stock options

Typically, private companies are required to value the stock options because the shares are not publicly traded. Stock options valuation plays a significant role in helping companies to identify and establish benchmarks for their stock options, improve the reliability of financial statements, and make informed decisions. Properly valuing stock options is very critical for the accuracy of financial data, thereby enabling employees to make an informed decision about stock options.

During the process of issuing stock options, companies must be able to establish a reliable method for valuing the options in terms of fair market value. In order to protect the company from errors and fraud, there is a need for a proper stock options valuation. Thus, there is a need to ensure that the valuations are based on the most accurate methods.

When should you value stock options?

Well, at the time of setting up an employee stock option program, companies must ensure that they provide complete disclosure about the fair value of each option, how many options are being granted, and the guidelines for exercising them. This means the valuation should be determined at the beginning of the program, and companies should provide fair and accurate information about the options.

Moreover, stock options valuation must occur on a regular basis once the program has been established. This is because some factors influence the value of stock options, and it is necessary to re-evaluate regularly. But, how to value stock options in private companies?

How to value stock options for private companies?

Now that we have a good idea about how stock options work, let us move on to see how private companies value stock options. The valuation of stock options for private companies is based on various methods and models such as the Black-Scholes model, Binomial model, and Monte Carlo model. Basically, the methods are based on assumptions and variables, which enable us to calculate the stock options valuation

However, each option carries a different risk, and hence, it is necessary to take into consideration all the factors for an accurate valuation. In this context, 409A valuation is one such way to calculate the FMV of a private company’s common stock. Further, the FMV of shares can be used to determine the value of stock options. Hence, a variety of methods and models can be used for the purpose of valuing stock options in private companies.

Tax compliances for stock option valuation

The Internal Revenue Service (IRS) regulates the tax compliances of stock option valuation. As such, companies and employees need to ensure that they follow all the necessary procedures and official rules in order to ensure that they have the right tax compliances. Well, the taxability of the stock options lies in the employee’s hands since it is a form of stock-based compensation that is given to employees by employers. It is essential to recognize that the employer should report the FMV of the stock options to the IRS.

How does a 409A valuation help value your stock options?

A 409A valuation is basically a process that helps private companies to establish the FMV of their stock options, thereby helping them to value their options. You may be wondering how to value the stock options using the 409A valuation. Well, the strike price can be established in terms of the FMV of the shares and thus, it serves as a benchmark for calculating the value of the options. In other words, a 409A valuation identifies the price at which employees can buy or sell their stock options.

Stock options valuation model

The following section will help you understand the employee stock option valuation model and approaches for private companies.

  • Black-Scholes method – The Black-Scholes model of stock options valuation is based on the option pricing formula developed by Fischer Black, Myron Scholes and Robert Merton. Basically, the model is the most popular approach that is used for valuing stock options in private companies, which is based on six variables, including volatility, type, underlying stock price, strike price, time, and the risk-free rate. The BSM Model focuses on the concept of hedging while eliminating the risks involved.
  • Binomial model – The Binomial Model is another approach that can be used for stock options valuation. The theory of the Binomial Model is based on the idea of an iterative procedure that enables the specification of nodes during the time span between the valuation date and the expiration date of options. It is considered a risk-neutral method due to the fact that it is considered a path-independent option, wherein the option cannot be exercised before its due date.
  • Monte Carlo model – The Monte Carlo model is one of the approaches that can be used for the purpose of valuing stock options where experts identify the projection of the share price. As such, the share price is sampled from historical data in the form of random outcomes of the stock price at a particular point in time. This innovative model can be used to value stock options under any level of complexity.
  • Intrinsic Value – The intrinsic value is the difference between the price of the stock and the strike price, thereby enabling one to calculate the stock options valuation based on the price of the underlying stock. Intrinsic value reflects the true value of the stock option at the time of the exercise.
  • Time Value – Time value is the amount of money that is equal to the difference between the option’s premium and the intrinsic value. As such, it is the part of an option’s premium that is attributable to the duration of time remaining till the expiration of the option contract.

How does volatility affect stock options value?

Volatility is the amount of price movement that is seen in a particular asset within a certain period of time. Volatility, however, varies from company to company, and there are certain factors that impact the level of volatility. Generally, the volatility of the underlying stock price impacts the stock options valuation. Therefore, it is essential to understand the components of volatility in order to value the stock options.

Why Eqvista is the best option to value your stock

It is essential to recognize the methods and procedures that are used to value stock options. As you may have noticed, there are several approaches that can be used to value stock options. Therefore, it is essential to choose the appropriate approach that best suits your situation. Eqvista helps companies to value their stock options in a seamless manner. We have a dedicated team of experts that offers support to companies to value their stock options. To know more about how we can value your stock options, contact us today!

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