It is important to estimate the effect (if any) that outstanding stock options (call options for the purpose of this article) would have when performing a business valuation for a privately-held company. A business valuation under the fair market value standard of value, which indicates an arm’s length price between a hypothetical willing buyer and seller without compulsion to buy or sell, would consider the cash received by the company from any options that would be exercised on the hypothetical sale date (i.e., the valuation date).
Key Valuation Considerations
After discovering that the company being valued had outstanding stock options on the valuation date, the first step is to thoroughly read and understand the company’s stock option plan document. All stock option plans are unique and it is important to understand the rights and terms associated with the stock options. Other key factors to consider include:
- Options Outstanding – Total options outstanding includes all options granted less previously exercised, expired and/or forfeited options.
- Exercise Price – It is important to identify the exercise price(s) of the options granted and determine how the price(s) was calculated. Understanding the key assumptions used to calculate the price can offer useful insight into the current valuation analysis.
- Likelihood of Exercise – If the option is “out of the money” (the exercise price is above the stock price identified in your current valuation analysis) on the valuation date, it is assumed that the outstanding options would not be exercised, and would thus not impact equity value. If the option is “in the money” (the exercise price is below the stock price identified in the valuation), it is more probable that the option will be exercised in the hypothetical sale of the company; however, forfeitures must be taken into account. Although it is very difficult to predict option forfeitures, management can be a good source to help estimate any options that may not be exercised. Historical forfeiture rates should also be considered and discussed with management. Barring any extraordinary restrictions in the stock option plan, it can normally be assumed that vested options that are in the money would be exercised in a potential sale of the company; unvested options that are in the money are subject to potential forfeitures.
The total outstanding options on the valuation date, adjusted for potential forfeitures, are multiplied by their respective exercise prices to obtain the total cash that would be received by the company. This amount is then added as an adjustment to the company’s equity value.
Schneider Downs has significant business valuation experience. For more information about Schneider Downs’ business valuation and other business advisory services, please contact Joel Rosenthal at 412.697.5387 or email@example.com or Tom Claassen at 412.697.5330 or firstname.lastname@example.org.
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