Valuation of Employee Stock Options

The first step in valuing Employee Stock Options (ESOs) is to determine the current fair value of the company stock. This value is then used to determine the value of the ESOs.

Financial Accounting Standard 123(R) (FAS 123(R)) provides guidance on the valuation of ESOs. The most commonly used valuation methods for options are binomial models otherwise known as lattice models and the Black-Scholes formula. The Black-Scholes option pricing formula is as follows:

Call Value = Stock Price × N (d1) – Exercise Price-rt × N (d2)

Although the formula appears intimidating, it is simply the stock price times a probability less the present value of the exercise price times another probability.

The price of the option is dependent on the following factors:

• The current stock price;
• The volatility of the stock price;
• The risk-free interest rate;
• The time until expiration; and
• The exercise price.

The option price has a direct relationship with the current stock price, the volatility of the stock price, the risk-free interest rate and the time until expiration. The stock price is inversely related to the exercise price.

However, the Black-Scholes model assumes a publicly traded common stock with options that are liquid. Employee stock options differ from publicly traded stock options in four main ways:

• Employees cannot hedge or sell their options;
• ESOs may be subject to vesting requirements;
• ESOs may be subject to involuntary early exercise or forfeiture; and
• Employees tend to exercise ESOs, with the above limitations, earlier then they would be expected to exercise unrestricted options.

Fortunately, FAS 123(R) allows adjustments for vesting requirements, potential forfeiture or early exercise to account for the differences between publicly traded and privately-held employee stock options. The expected term can be measured as the average of the weighted average vesting term and the weighted average original contractual term of the options.

Sack Associates performs valuations for employee stock options (ESOs) in a timely and economical manner.