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January 13, 2012 Article 2 min read
The valuation of stock options, restricted shares, or other types of equity compensation in private companies can present some challenges. To help you avoid problems, here’s a list of some key factors you should watch for.

One: Dilution

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Total shareholder dilution is not determined by percentage ownership alone. It must also incorporate the combined effect of value dilution created by equity compensation. Dilution in earnings per share is usually not a consideration for privately owned companies.

Tip: Have no value calculated on a fully diluted per share basis.

Two: Option formulas

Don’t forget to change your variables

Modifications are required to standard variables used in option pricing formulas such as the Black Scholes and binomial methods. These changes reflect the special characteristics of options used as equity compensation.

Tip: Adjust the expiration date for the expected term and the current stock price for dilution.

Three: Income adjustments

No double dipping

Costs for equity compensation expense must be adjusted in the income measures used in valuation methods. This applies to valuation methods using multiples such as EBITDA or discount rates.

Tip: Adjust income statement data and have market pricing multiples derived on the same basis.

Four: Tax effects

Remember your Uncle Sam

Don’t forget to factor income tax effects in the valuation. Incorporate the deferral, vesting, and non-cash features and tax benefits generated by certain types of equity compensation.

Tip: Include the present value of any tax benefits to the company based on vesting.

Five: Capital allocation

Put everything in its place

The total business value is allocated across the capital structure including debt, shareholder interests, and equity compensation. This requires capturing the order of preference and co-dependence of the specific capital interests.

Tip: Include a value for equity compensation on the appropriate basis.

Six: Terms and conditions

It’s the little things that can matter most

Differences in the type, restrictions, vesting requirements, performance conditions, gross up, dividends, and other terms of equity compensation can have a significant effect on value. Be sure they are clearly identified and factored into the analysis.

Tip: Know the economic impact of all provisions.

Seven: Standard of value

Keep your eyes on the road

Select an appropriate regulatory standard of value. It’s either fair market value or fair value. The appropriate standard is decided by the purpose of the valuation.

Tip: Don’t blindly assume the two standards mean the same thing.

Eight: Valuation methods

Choose your friends wisely

Select professionally recognized valuation approaches and methods. Use best practices which satisfy regulatory requirements and are appropriate for equity compensation valuation.

Tip: Avoid short cuts and use more than one method whenever possible.

Nine: Discounts and premiums

Watch the bottom line

Adjust the value of individual equity compensation interests for applicable control premiums, minority interest discounts, marketability discounts, or other factors.

Tip: Equity compensation is normally valued on a minority, non-marketable basis.

Ten: Documentation

Be ready to rumble

Have results supported by complete information regarding the data, methods, assumptions, and analysis supporting the valuation. Be fully prepared for any inquiry, review, audit, and questions.

Tip: Have reasonable and complete support for all conclusions.