Black-Scholes Valuations

What is the Value of an Option?

Options are risky. The value of employee stock options can vary from zero to enormous amounts of money.

Stock options often comprise more than half of the compensation reported for top executives.

Let's take a look at some of the situations that affect the value of a stock option…

Being underwater

If the market price is lower than the strike price, then the option is said to be underwater. The value of the option is zero and there’s no reason to exercise the option.

Remember: With an employee stock option, it isn’t necessary to exercise the option on the exact date it becomes vested.

In many companies, when it appears that the market price of the stock won't rise enough to get the stock option above water, the company cancels current stock options and re-issues them with a lower strike price. This practice is often criticized as it can create a no-lose situation for the executive and promote high-risk behavior.

Being above water

Being above water is the most desirable situation. It makes sense to exercise the options when they are above water.

The value of the options is the current market rate less the strike price and any applicable brokerage fees.

Lack of a market

Start-up and privately owned companies often offer stock options. Unless the company engages in an Initial Public Offering (IPO), however, the options have little value since there is no market for the stock. Companies usually issue these stock options in anticipation of an IPO, and the strike price is set quite low.

A successful IPO can produce extremely valuable stock options.

Q: Can the stock options be exercised without the company going public?

A: Yes, in some cases. But the employee will be required to invest money to exercise the option only to find that there may be no market in which to sell it.

Not yet vested

This is the most difficult situation in which to set a value to a stock option.

There are a couple of approaches:

• Say that the stock option has no value before the vesting date. This makes sense, since you don’t know whether the market value will ever exceed the strike price.
• Use the current market value. This is an uncertain measure at best because the value at the date of vesting may have little to do with current market value.

More complicated and mathematical techniques are required to get beyond guessing. This is the function of the Black-Scholes model.