Companies use stock options as a form of employee compensation for a number of reasons. An option is a form of compensation, the value of which increases as the company is more successful. Thus, the incentives of an option-holding employee are aligned with those of the shareholders of the company. Also, the granting of stock options does not require an immediate cash expenditure by the company. This can be important to a cash-strapped start-up enterprise trying to attract top flight talent.
Valuation of Options – When is it Required
Generally speaking, an employee stock option should be valued when it is granted. There are two reasons for this.
First, an employee stock option is a form of employee compensation. Therefore it is necessary to know the value of the option granted as compensation in order to properly record and account for employee compensation expense. This is required under generally accepted accounting principles (GAAP). Details can be found in FASB Statement of Financial Accounting Standards No. 123R (also known as FAS 123R or FASB 123R).
The second reason employee stock options need to be valued is because of the income taxation of deferred compensation. Section 409A of the Internal Revenue Code, among other things, imposes income tax penalties on an individual who receives an employee stock option which has an exercise price which is lower than the fair market value of the underlying stock on the date of grant. When a company issues an employee stock option it must know the value of its stock so that it can avoid setting the exercise price on the option too low, thus creating a tax liability.
How are Stock Options Valued
The value of a stock option depends chiefly on four variables. They are:
- The exercise price of the option
- The price of the underlying stock on the valuation date
- The remaining life of the option (time ‘til expiration)
- The volatility of the price of the underlying stock
The higher the price of the underlying stock is in comparison to the option’s exercise price, the greater the value of the option. The option’s value is also higher the greater the length of its remaining life, and also is higher the greater the volatility of the price of its underlying stock.
The relationship of the value of an option to these four variables is typically captured in an arithmetic formula known as the Black-Scholes Model. This model is widely used for valuing options, particularly those of the “plain vanilla” variety, which have no exotic features such as variable exercise prices. For more complicated options, analysts use other approaches such as the “lattice method” (typically a binomial method) and the “Monte Carlo simulation” method.
Valuing the Options of a Private Company
The four variables discussed above are readily available for a public company. The exercise price and remaining life are set forth in the option itself. The price of the underlying stock is readily known from the public market, and the volatility can be calculated from the price history of the stock.
When the subject company is a private company, however, the process becomes more complicated. It becomes necessary to perform a company valuation in order to determine the price of the underlying stock. The volatility, also, must be determined by alternative means, as there is no stock price history from which to calculate it. Sometimes the appraiser will use the volatility of other comparable companies to estimate the volatility of the subject company.
Importance of a Concurrent Valuation
The option valuations described above are often subject to after-the-fact scrutiny. This review can be 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 appraisal specialist, and done reasonably concurrently with the actual issuance of the options. An example of this thinking can be found in the section of the IRS § 409A Regulations having to do with option valuations, which are summarized here.
Private early-stage companies frequently use employee stock options to foster energy and enthusiasm in their employee team. The procurement of regular professional valuations of employee stock options as they are issued can prevent a variety of accounting and regulatory headaches for the company and its employees down the road. Hempstead & Co. has extensive experience in valuing stock options, and would be glad to be of assistance.