DEMYSTIFYING STOCK OPTION VALUATION Increasingly, employee compensation packages include stock options. Family law
lawyers require a determination of the value of stock options for inclusion in the titled spouse’s net family property. This paper provides an overview of the nature of options and how they are valued. A stock option is the right to purchase a stock at a predetermined price (“strike price”) by a certain date (“expiration date”). This type of option is referred to as a “call” option.1 An employee’s options may be vested, or they may not vest until a specified vesting date. Based on Ontario’s Family Law Act, vested and non-vested stock options received during the marriage are considered to be family property. Employee stock options of a publiclytraded company generally are not saleable on a stock exchange. The value of an option is usually calculated using a mathematical technique known as the Black-Scholes formula. An option’s value is comprised of two components. The first component is the intrinsic value, calculated as the difference between the stock price and the strike price.2 The second component is the time premium which accounts for the length of time until the option expires and the possibility of price appreciation during that time period. These components can be best illustrated through the use of an example of a publicly-traded option : Stock Stock Price Strike Price Expiry Date Research in Motion $46.36 (closing price as at May 15, 2001) $40.00 June 15, 2001
The total value of the option as at May 15, 2001 using the Black-Scholes formula is $10.05. The intrinsic value of this option is $6.36 ($46.36 less $40.00) and the time premium is $3.69. The time premium is calculated using the Black-Scholes formula,
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The right to sell a stock at a predetermined price by a certain date is referred to as a “put” option. Should the strike price exceed the stock price, the intrinsic value is $Nil.
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taking into account the underlying stock price ($46.36), strike price of the option ($40.00), time to expiration (one month), risk-free rate of interest (30 day Treasury Bill rate of 4.37%), dividend rate (0%) and volatility (128%).3 By purchasing a stock option instead of the underlying stock, an investor is able to leverage investment capital until the options are exercised. The longer the time period to expiration, the greater the benefit to the option holder. Should the value of the underlying security increase prior to the expiration of the option, the investor profits from the price increase without having to pay the full market price of the stock. On the other hand, should the value of the underlying security decrease prior to the expiration of the option, the maximum loss incurred is the cost of the option. Stock option investors generally prefer options that experience a high degree of volatility since this provides the investor with the opportunity to profit from increases in the stock price with limited downside risk. Thus, higher volatility generally results in greater time premiums. The most common misconception regarding the value of stock options is the belief that if the stock price is trading at a lower price than the strike price, the option value is zero. This situation is commonly referred to as “out-of-the-money options”. Although the option may not have any intrinsic value because the stock price is lower than the strike price, there may be value associated with the time premium component. If the stock price exceeds the strike price, the options are referred to as “in-the-money”. The greater the excess of the stock price over the strike price, the higher the intrinsic value will be relative to the time premium.
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The Black-Scholes calculations can easily be determined by using a computer model.
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In order to use the Black-Scholes formula, the following six factors are required: • • • • • • Underlying stock price; Strike price of the option; Time to expiration; Risk-free rate of interest; Dividend rate; and Volatility.
If the underlying stock and options are publicly-traded, the rate of volatility can be estimated based on either (a) the historical volatility of the stock or (b) the volatility implied by the price of the option if the option period of the employee’s options approximate the exercise period of the publicly-traded options. On the other hand, if the underlying stock is publicly-traded but the company’s options are not publicly-traded, the rate of volatility can be estimated based on the historical volatility of the stock. If the underlying shares are not publicly-traded, it would be necessary to first determine the fair market value of the issued shares and utilize the value per share as the underlying stock price. The volatility of the employee’s options may be estimated by reviewing the historical volatility of publicly-traded companies in the same industry. The Black-Scholes formula determines the value of the option assuming the option has can be freely traded (i.e., no restrictions on transferability, vesting, etc.). Therefore, once the value of the stock option is determined using the Black-Scholes formula, the following discounts may be applied: 1. Discount for lack of transferability of vested and unvested options. Employee stock options cannot be sold or transferred. It is important to review the option agreement and the employee’s employment contract for the conditions required for vesting.
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Discount for risk of non-vesting. This discount considers the risks associated with the possible forfeiture of the options for reasons of termination (voluntary or involuntary), disability or death of the employee prior to the vesting date.
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Discount for risk of forfeiture of the options after the vesting date but prior to the expiry date of the options.
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Discount for the dilution resulting from the exercising of options.
In assessing the discounts for risk of forfeiture, the following factors should be considered : • • • • • Level and career progression of the employee in the organization. Tenure of the employee and the employer’s assessment of the employee. Turnover rates at the employee’s level. Determining what happens to the employee’s options on death or disability. Financial strength of the company and its outlook.
It is possible to utilize an “if and when” approach by having the options held in trust. However, consideration should be given to the possibility that the options may expire and are potentially worthless should the titled spouse voluntarily leave his or her present position. In summary, the valuation of stock options involves the determination of two components of value – intrinsic value and the time premium. Stock options that are valued solely on the intrinsic value may significantly understate the value of the options. In addition, after determining the value of a stock option using the Black-Scholes method, it is important to consider the appropriate discounts.
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Bruce Roher, CA•IFA, CBV, CFE is President of Fuller Landau Valuations Inc. in Toronto. The firm provides a full range of business valuation and financial litigation support services. He can be reached at broher@fullerlandau.com or (416) 645-6526.
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