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Eso Model Parameters | General Questions | Volatility Tool Questions | Risk Free Rate Questions | Publicly Traded ESO Model Questions | Privately Held ESO Model Questions

ESO Model Parameters

Term	Definition
Stock Price	The most recent per share closing price of a publicly traded stock on the valuation date. The closely held model does not use this input, instead, it is an output of the model.
Strike Price	The exercise price of the option specified on the option contract.
Risk-free Rate	The interest rate that can be obtained by investing in financial instruments with no default risk. For USD investments, usually US Treasury bills rates are used. The risk-free rate tool provides the appropriate risk-free rate in accordance with FAS 123R. You may use the risk-free rate tool to obtain the appropriate risk-free rate.
Volatility	A measurement used to quantify the risk of the underlying instrument over a period of time. Since option values are forward looking, an appropriate estimation of future volatility is needed (referred to as "estimated volatility" by the FASB in SFAS 123R). You may use the volatility tools to calculate volatilities for both publicly traded and closely held companies. While there is no consensus as to the single best approach for measuring volatility, we provide volatility calculations using two of the most popular methods, namely, GARCH (1,1) and Sample Variance. However, the user must ultimately decide which measure of volatility to use.
Maturity	Refers to the remaining life of the option stated on the option contract. It is expressed in annualized terms.
Dividend Yield	The dividend yield on a company stock is the company's annual dividend payments divided by its market cap, or the dividend per share divided by the price per share. It's expressed as a percentage.
Vesting Period	The remaining time period during which the option cannot be exercised.
Exercise Multiple	a ratio of the stock price to the contractual strike price at which point it is assumed that the option will be exercised prior to maturity. Industry surveys suggest that the value of this parameter is typically between 1.5 and 2.5. This parameter is typically estimated by calculating the median of ratios of stock prices to strike prices using historical data.
Exit Rate	The annualized rate of turnover for a particular category of employees. You can estimate this parameter using historical data.
Value of Total Common Equity	An input of the model for closely held companies. The value of total common equity should be determined by appropriate business valuation methodologies. Your value of total common equity should not reflect future cash flows resulting from exercise of options. The software will determine the probabilities of exercise of the options and the present value of resulting cash inflow.

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General Questions


SFAS 123(R) requires that employee stock options (ESO) be measured at fair value.


FAS 123(R) is the Financial Accounting Standards Board statement on share-based payments and addresses expensing stock options and other equity awards to an entity's employees.


SFAS 123R does not prescribe a specific option valuation model. Rather, it states that "a lattice model (for example, a binomial model) and a closed-form model (for example, the Black-Scholes-Merton formula) are among the valuation techniques that meet the criteria required by this Statement for estimating the fair values of employee share options and similar instruments." However, SFAS 123R clearly states that the appropriate method to use depends on the "substantive characteristics of the instrument being valued." Since most ESOs include characteristics such as vesting schedules, anticipated employee turnover and the possible early/sub-optimal exercise of the option, it is almost always more appropriate to use a lattice approach.


The program implements the Hull-White model to value employee stock options for public companies. To value the employee stock options for closely held companies, the model uses the same basic methodology as the public company model. However, certain modifications handle the interactions between stock values and option values. Given a total equity value, The BVR/DVA ESO 123R Compliance Calculator™ iterates through possible stock prices using a bisection method, until the total value of stocks and options is equal to the total equity value.


To the best of our knowledge, this is the only online calculator that is suitable for valuing ESOs in privately held businesses as it takes into account specific factors that distinguish ESOs in closely held firms from publicly traded stock options (e.g. vesting schedules, anticipated employee turnover and the possible early/sub-optimal exercise of the option, etc.). If alternative software asks for share value, as opposed to the total value of equity, it is an unmodified model suitable only for valuing ESOs for publicly traded companies.


Yes. An employee share option is a type of barrier option. Like all barrier options handled by binomial or trinomial trees, an accurate solution may not be possible if the barrier (in this case the exercise multiple times the strike) is very close to the spot price. In this case, changing the exercise multiple slightly will usually fix this issue.


Yes. The BVR/DVA ESO 123R Compliance Calculator™ can handle this situation. Just treat each vesting period as a different category of options. For example, let us assume you have a total of 10,000 shares of options, then 2,500 will have 1 year vesting, 2,500 2 year vesting and so on. So you need to input 4 categories of options when you use the Calculator. The sum of the values of the 4 categories will be the valuation of the options.

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Volatility Tool Questions


While there are no specific guidelines as to the number of years or the frequency of the historical data to use in the calculation of volatility, it is generally more appropriate to use monthly or annual data for privately held companies. For public companies, daily or monthly data may be more appropriate. Realize that it is the future volatility of the underlying shares that should be input into the model. Thus, if more recent volatility is expected to continue over the life of the option, then the more recent years' stock price data should be used. If future volatility is expected to decrease in the future, then using more historical data may be more appropriate.


This program uses data from the Dow Jones.


Price data can be gathered for up to 30 years from the current date.


The market cap ranges are defined by Dow Jones.


These represent index codes by Dow Jones.


You may enter up to as many as you want symbols.


No. The volatility tool only works with ticker symbols for companies traded on U.S. stock exchanges.

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Risk Free Rate Questions


Yes. Using the Treasury Yield Curve, the appropriate risk-free rate is calculated.


1990


U.S. Department of Treasury


We recommend that the user select the program-calculated rate. This is because the appropriate rate is the expected risk-free rate over the life of the option. This can only be done by extrapolating forward rates from the yield curve. However, if the user wants to assume a constant risk-free rate over the life of the option, then they may do so by selecting the user provided risk-free rate option.

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Publicly Traded ESO Model Questions


Select the appropriate stock symbol, then determine the number of years of historical data you wish to use, then the frequency appropriate for the specific company option being valued. The program retrieves the stock price data, then, using returns, calculates the standard deviation.


The option maturity is the time until the option expires, or must be exercised. The vesting period is the time the holder of the option must wait before they can exercise the option. For example, an option may be granted to purchase stock at any point over the next ten years. However, there may be a vesting period of three years before the holder can exercise the option.


A specific company will have data on the historical exercise of employee stock options. Some employees may decide to exercise the option when the stock price is twice the value of the strike price. Others may wait until the stock price is 3 times the value of the strike price. Still others may exercise at different multiples. Thus a weighted average of the historical stock price to exercise price should be used to determine this value.


Similar to the Exercise Multiple, historical data on the percent of employees that leave the company before their options are vested. That is, what percent of employees are terminated or quit before they are actually allowed to exercise the options they were granted.


Just as the value of common equity and the value of options must be determined simultaneously due to the dilutive effect of the options, newly granted options also have a dilutive effect on both the stock value and on previously granted options. That is, all of the equity component values (common shares and all outstanding options) must be valued simultaneously. This becomes a relatively complex calculation when multiple options are outstanding.

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Privately Held ESO Model Questions


Non-public companies have no historical price volatility by which to estimate expected volatility. For these companies, SFAS 123R provides for two alternative sources of volatility information: 1. If can identify similar public companies: If a company can identify similar public companies, it should use their historical price data to help determine expected volatility. 2. If unable to identify similar public companies: If no similar public companies can be identified, one should identity and use the volatility of an appropriate industry or sub industry index (see example at paragraph 139 of SFAS 123R). Our volatility tool will calculate volatility using either approach. However, in either case, one must use subjective judgment to identify either appropriate similar companies or an appropriate index. FASB has determined that the choice of estimating future volatility requires professional judgment which cannot be prescribed, so it is up to the individual performing the valuation to determine (and support) which data and approach is most appropriate for the specific options they are valuing. In all cases, SFAS 123R cautions that companies should be consistent in this and all critical inputs.


This must be determined by the appraiser using appropriate valuation techniques as prescribed by the IRS or FASB.


The option maturity is the time until the option expires ¨C or must be exercised. The vesting period is the time the holder of the option must wait before they can exercise the option. For example, an option may be granted to purchase stock at any point over the next ten years. However, there may be a vesting period of three years before the holder can exercise the option.


A specific company will have data on the historical exercise of employee stock options. Some employees may decide to exercise the option when the stock price is twice the value of the strike price. Others may wait until the stock price is 3 times the value of the strike price. Still others may exercise at different multiples. Thus a weighted average of the historical stock price to exercise price should be used to determine this value.


Similar to the Exercise Multiple, historical data on the percent of employees that leave the company before their options are vested. That is, what percent of employees are terminated or quit before they are actually allowed to exercise the options they were granted.


Just as the value of common equity and the value of options must be determined simultaneously due to the dilutive effect of the options, newly granted options also have a dilutive effect on both the stock value and on previously granted options. That is, all of the equity component values (common shares and all outstanding options) must be valued simultaneously. This becomes a relatively complex calculation when multiple options are outstanding.


Yes - dilution affects both the value of the common shares and the value of existing options when new options are granted. This is because there are now new potential stockholders. Unless your option valuation model can simultaneously allocate value to stocks and all ESOs, it will yield incorrect ESO values for closely held companies. This, in turn, will result in incorrect stock valuations.

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Last updated: 06/18/2013