At Leadenhall, one of the topics we often get queries on is option valuations. It can seem like a complicated topic, so we thought we would take the time to answer some frequently asked questions and hopefully give you a better level of understanding.
What are options valuations?
Rather than assuming anything, let’s start with giving a general overview of what option valuation is and what can make it complex.
An option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset (usually shares of a company) at a specified strike price (exercise price) prior to or on a specified date, depending on the type of the option. There are some other financial instruments that have embedded option features such as convertible debt or preference shares.
A company (listed or unlisted) might grant options or performance rights to its employees under its employee incentive plan or under its remuneration package. These options would need to be valued for accounting and potentially for tax purposes.
A variety of pricing models exist for valuing options and the selected pricing model should reflect the features and complexity of the instruments being valued. The most commonly used option valuation models are:
- Black-Scholes Option Pricing Model (simple model, we give it away as a tool you can use in this spreadsheet)
- Binomial Option Pricing Model (also in the same spreadsheet, different tab)
- Monte Carlo Simulation (more complex, we have developed our own proprietary tool to do this and have a simplified version in the same spreadsheet to help understanding how the model works).
Depending on the terms of the options, and vesting conditions set by a company, valuation of the options could be complex. For example, in some situations the number of options that an employee gets would depend on the relative share price of their company compared to a basket of several other companies. This is when the Monte Carlo Simulation is needed.
Why is it important to get your options valuations right?
If an entity grants performance rights (performance rights have similar features to an option) or options to its employees, the entity is obligated to abide by the terms of the contract if options are vested.
According to Australian Accounting Standard Board 2 (AASB2) and International Financial Reporting Standards 2 (IFRS 2) share-based transactions like granting performance rights or
options by an entity, should be stated at ‘Fair Value’ on the financial statements of the entity.
AABS 2 / IFRS 2 requires an entity to reflect the effects of share-based payment transactions in its profit or loss and financial position, including expenses associated with transactions whereby options are granted to employees.
Financial statements of an entity would be misleading if share-based transactions are not valued properly. Furthermore, an option valuation also might be required for tax purposes.
Not only does a valuation need to be undertaken, but the auditor also needs to be satisfied with the valuation. We’ve assisted many clients with option valuations after their auditor raised concerns about previous providers. This process wastes time and money and is frustrating for the financial controller.
When do you need an expert for options valuations versus DIY?
Do you need an expert to complete an option valuation or can you do it yourself (DIY)? Well, this largely depends on the complexity of your situation, and what level of capability you have in-house.
Depending on vesting conditions (the conditions that should be met to enable the option owner to exercise the options), an option valuation could be simple or complex. For example, a simple vesting condition which is usually used by an entity is continued employment for specific period of time. This can be accomdated by the free tools we offer.
However, when the vesting conditions/terms of the options are more complex, more analytical and quantitative methods (such as the Monte Carlo Simulation) need to be applied and an expert with experience in complex option valuations may be best placed to ensure you get a rigorous outcome.
What information do you need to do an options valuation?
Before valuing an option, you’ll need to be aware of vesting conditions. The primary information required for the valuation of options are:
- Grant date and expiry date of the options
- Spot price of the underlying share (fair value of underlying share if it is not listed) on the grant date
- Strike price of the options
- Vesting conditions/other terms of the options
- Reasonable assumptions about prospective volatility of the underlying share (this should be done by the expert).
Gathering the required information prior to bringing on an expert to complete your options valuation can make the process faster, easier and potentially less costly.
What makes a good options valuation?
Using an appropriate method is critical. It is also useful to agree the approach with your auditor before undertaking the valuation.
Due to complexity of options, some companies might underestimate or overestimate the value of the options or performance rights issued to their employees, which could result in significantly skewed business results and reporting.
Tools and resources
We offer some free options-related tools and resources on our website – click here and they are under ‘Valuation tools.’
Still have questions?
We’re happy to help. Just contact us and we will get one of our options valuation experts to contact you about your specific situation.