Black-Scholes Valuations

USES FOR BLACK-SCHOLES

The Black-Scholes formula is used for a wide variety of financial decision making that requires derivatives or hedging.

In this course, we are more concerned with its use for the valuation of employee stock options.

The Black-Scholes formula can be used for:

• personal employee reasons
• AND
• corporate reasons

Employee Uses

There are a number of personal reasons why employees want to know the value of their stock options, particularly those that have not yet vested. Simply using the current market value isn’t sufficient in most cases.

• Taxes. The employee may need to calculate the values to compare them with other income sources OR to make tax plans if exercising stock options soon.

• Estate planning. In an estate-plan review, it would be necessary to place a value on all stock options. This may also include evaluation for estate-tax purposes or transfers of stock options to others or a charity.

• Divorce. The value of stock options can be a contentious point in a divorce situation. The parties need to establish the value of all unexercised options as of a set date. Various U.S. courts handle stock options differently when they are a part of the property to be divided in a divorce. The basic question is whether options are compensation to the employee or assets of the employee.

  Which valuation method to use is a continual question, but an intrinsic method is usually relied upon. An extrinsic method may be approved for options that are not yet vested. That method is most often Black-Scholes.

• New job opportunities. If an employee leaves a company for another employer, unvested stock options and stock options for which there is currently a blackout period are usually forfeited.

  There are two advantages to knowing the value of these options:

  1. to analyze whether the new job is worth the change

  2. as a negotiating tool with the proposed employer

  Employees often look only at the number of shares they have and compare that to the number of shares being offered by the prospective employer. But the two sets of options may have very different potential values.