How are employee stock options (ESOs) valued and why are there different approaches?
A simple way to value employee stock options is to subtract the option price from the current share price and value the option based on that differential. Option (strike) price of $10 means employee has the option to buy at $10 so if the current share price is $15 then every option is worth $15-$10 = $5. Many companies will value employee stock options this way when performing buyouts for new hires and that approach is fine, it is simple and makes sense. In fact the Sharpe Valuation free report will value stock options this way and assign them a simple intrinsic value.
However what if you have a critical candidate that has a significant amount of stock options that are underwater meaning that the share price is currently less than the option price? What if they don’t expire for many years and that candidate does not want to forfeit all of those stock options without compensation? Is that candidate being unreasonable? No, they are not – especially when the stock market or the individual stock price is depressed and they believe it will bounce back. There may be many employee stock options underwater at any given time but that doesn’t mean they have no value and can be ripped up. If the share price increases before the option expires then there is still the potential of significant value.
This is why when valuing employee stock options for accounting purposes or when considering a buyout it is sometimes appropriate to perform a more sophisticated valuation. This will require a mathematical formula (eg. Black-Scholes) taking in to account current share price, option price, time until expiry, time until vesting and share price volatility. Many valuation techniques including the one used by Sharpe Valuation can also take in to account dividend yield, prevailing interest rates, employee attrition data and early exercising prevalence.
These mathematical formulas work by reproducing potential outcomes using all of the available variables and then establishing what the average of all those possible outcomes is to get the valuation. For example high share price volatility and a long window in which to exercise the option will increase the option value for a stock where the price is currently down. This is because if a share price is highly volatile and the time frame is long then it is more likely to hit some good highs (and lows) during that time period meaning the holder of the option has the potential to take advantage of an attractive price and exercise the options for a gain.
Current share Price = $10
Option Price = $15
Time until vesting = 5 years
Volatility = 40%
Approximate Sharpe Option Valuation = $2*
*Based just on 4 metrics above and reasonable assumptions for other variables
Despite being underwater the value of these stock options would be approximately $2 each. If the employee holds 50,000 options that values the entire award at $100,000 so these options should not just be ‘written off’.
If the share price increases dramatically then the Stock Options can clearly become very valuable so employees who have strong belief in the company they work for are always very reluctant to give them up without a ‘fair’ price. Using a black-scholes type valuation methodology is a very ‘fair’ way of valuing stock options that have no or limited value using a simple stock price minus option price valuation.
Many start-ups use stock options as part of their compensation plan for obvious reasons – they don’t cost anything upfront (help preserve cash) but can be a strong motivator for employees. If they become valuable that is only because the company has been successful which is a win-win for management/shareholders and employees. One problem however with valuing stock options for start-ups is that as they are not listed companies establishing the prevailing share price is extremely hard.
If you are enquiring:
- what is the value of my employee stock options (ESOs)?
- how do I calculate stock option (ESO) value?
- how do I calculate stock option (ESO) value for a start-up?
Then do contact us at email@example.com and we would be happy to perform a bespoke valuation for you and provide an accompanying report to help you understand and use the valuation.