The Authors: Dr. Keith Sellers is the La Grange Eminent Scholar of Business Valuation, Professor of Accounting and Director of the Center for Research and Education in Business Valuation at the University of North Alabama (UNA). Dr. Yingping Huang is an Assistant Professor in the Department of Computer Information Systems at UNA. Dr. Brett King is an Assistant Professor and the State Farm Professor of Risk Management at UNA.
See the article “Valuing Employee Stock Options for Closely Held Companies” posted at our Free Downloads page.
While the valuation of employee stock options (ESOs) has been an issue in numerous tax cases and matrimonial disputes, the level of sophistication and accuracy of the models used by appraisers has not historically received close scrutiny. However, with the release of Statement of Financial Accounting Standards (SFAS) No. 123R by the FASB and regulations pertaining to IRC Section 409A by the U.S. Treasury the bar has clearly been raised.
The Black-Scholes Option Pricing Model (BSOPM) is the most widely recognized option valuation model. Developed formally in 1973, the BSOPM helped give rise to an enormous market for publicly traded options. While the formal derivation of the model is quite complex, the calculations involved in the model are very straightforward. A much more flexible approach to valuing options is to use a binomial lattice model. This approach is related to the BSOPM in that the BSOPM is a continuous-time version of a very simple lattice model. The key advantage of a lattice model is that it provides much greater flexibility because it is constructed in discrete time periods. The BSOPM does not capture the impact on value of ESO-specific variables such as vesting, employee turnover and early exercise. In addition, the BSOPM is used to value non-dilutive options whereas ESOs dilute the shares of the underlying company stock. Because of this dilution, the value of both stock and ESOs are affected and they can only be determined simultaneously as is done in a binomial lattice model—the BSOPM does not do this.
