Many appraisers may not be aware of just how high the bar for valuing employee stock options (ESOs) was raised with the release of Statement of Financial Accounting Standards (SFAS) No. 123(R) by the FASB and regulations pertaining to IRC Section 409A by the U.S. Treasury. SFAS 123(R) states that “employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments” (italics added).  Many of us have turned to the Black-Scholes Option Pricing Model, but this model was created for publicly traded options and fails to account for the unique characteristics associated with ESOs – especially those of closely held companies.  Consider the chart below:

A more appropriate and a much more flexible approach to valuing options is to use a binomial lattice model.  In fact, only a well executed lattice model can be readily modified to correctly value ESOs, given their unique attributes.  Furthermore, the value of common stock and the value of ESOs must be estimated simultaneously because of the dilutive aspects of the options. If a lattice model is not being used along with a bisection methodology for allocating value, the results may be misleading and the error in valuation can be substantial.

To learn more about the valuation of employee stock options in private firms, read Keith Sellers', Yingping Huang's & Brett King’s (all professors from the University of North Alabama) free article here (originally published in the Business Valuation Update), as well as their article in the Journal of Accountancy here. Also, get some ESO valuation help with these authors’ new Calculator (The BVR/DVA 123R Compliance Calculator™) located at BVMarketData.com.