How to Value Stock Options in Non-Public Companies

Companies use stock options to attract and retain employees. A stock option contract gives an employee the right to exercise the option and buy the underlying share at a fixed price, known as the strike price or grant price, within a certain period. According to attorneys Peter Barnes-Brown and Diana Espanola, Section 409A of the Internal Revenue Service tax code specifies that the fair market value of a private company, and thus its stock and stock options, should be determined using a reasonable valuation method.

Instructions

1. Compute the value of the company's tangible and intangible assets. Tangible assets include cash, stock and bond investments, inventory, equipment and buildings. Intangible assets, such as patents and copyrights, are difficult to value because there is usually no market for them. The cost of developing the intangible asset could be one valuation method, asset valuation consultant Kelvin King suggested in an article hosted on the World Intellectual Property Organization's website.

2. Get the value of a recent arm's-length transaction involving the sale or transfer of ownership interests in the company. For example, if a 10 percent ownership interest was sold for $1 million, the company is worth $10 million ($1 million x 10).

3. Use the valuations of comparable companies. For example, if a competitor half your size in terms of sales was recently acquired for $1 million, a rough valuation for your company might be $2 million ($1 million x 2).

4. Find the present value of anticipated future cash flows. This method involves a financial modeling concept known as discounted cash flow, in which estimated future cash flows are discounted or brought back to the present using a discount rate. The formula for the present value is CF / (1 + i)^n, where CF is the future cash flow; "i" is the discount rate, which can be the risk-free 90-day Treasury bill rate plus a suitable risk premium; and "n" is the number of discounting periods. If you assume a constant cash flow going out into the future, the present value formula simplifies to the constant cash flow divided by the discount rate.

5. Calculate the value of a stock option. It is the market value of the private company determined using one of the reasonable methods divided by the total number of authorized shares and stock options.

Tips & Warnings

• Unlike options that trade on the Chicago Board Options Exchange, employee stock options cannot be traded or transferred. Employee stock options have a vesting period, which is a waiting period before they can be exercised. According to the Congressional Budget Office, this waiting period ranges from two to four years.

References

• U.S. Securities and Exchange Commission: Employee Stock Options Plans
• Morse, Barnes-Brown & Pendleton; Stock Option Pricing by Private Companies: The New Valuation Environment Under 409A; Peter Barnes-Brown and Diana Espanola; March 2008
• World Intellectual Property Organization; The Value of Intellectual Property, Intangible Assets and Goodwill; Kelvin King
• Creative Academics; Discounted Cash Flow Calculator; John Kish

Resources

• Congressional Budget Office: Accounting for Employee Stock Options