How to Understand Private Company Stock Options.
Employees are the primary beneficiaries of private company stock options.
Jules Frazier/Photodisc/Getty Images.
Related Articles.
1 Employee Stock Purchase Options 2 Understanding Employee Stock Options 3 What Are the Benefits of Employee Stock Options for the Company? 4 Fair Value Method Stock Options.
Small companies often do not have the financial size to offer potential or high performing employees salaries that are commensurate with their large, publicly traded corporate peers. They attract and keep employees through other means, including by giving them greater responsibility, flexibility and visibility. An additional way is through the offering of stock options. Private companies may also use stock options to pay vendors and consultants.
Stock Options.
A stock option is a contract that gives its owner the right, but not the obligation, to buy or sell shares of a corporation’s stock at a predetermined price by a specified date. Private company stock options are call options, giving the holder the right to purchase shares of the company’s stock at a specified price. This right to purchase -- or “exercise” -- stock options is often subject to a vesting schedule that defines when the options can be exercised.
Employee Stock Options.
Employee stock options typically fall into two categories: outright award and performance-based award. The latter is also referred to as an incentive award. Companies either grant outright awards of stock options upfront or on a vesting schedule. They grant incentive stock options on the achievement of specific targets. The taxation of the two differ. Employees who exercise their outright award options are taxed at their ordinary income tax rate. Incentive stock options are generally not taxed when exercised. Employees who then hold the stock for more than a year will pay capital gains tax on subsequent gains.
Payment for Goods and Services.
A startup or rapidly growing small business needs to conserve cash. A company can negotiate to pay its consultants and vendors in stock options to conserve cash. Not all vendors and consultants are receptive to payment in options, but those who are can save a company a significant amount of cash in the short term. Stock options used to pay for goods and services generally have no vesting requirements.
How It Works: Grants.
A Better Day Inc. authorizes 1 million shares of stock but only issues 900,000 to its shareholders. It reserves the other 100,000 shares to support the options it has provided to its employees and vendors. A Better Day’s current valuation is $1.8 million, so each of the 900,000 issued shares has a book value of $2. The company grants a group of newly hired employees 50,000 options to buy stock at $2.50. These options vest equally over a four-year period, meaning the employees can exercise 12,500 options at the end of each year for years one through four.
How It Works: Exercise.
Two years later A Better Day has grown significantly. It now has a valuation of $5 million. It also has issued another 50,000 shares to support the options that were exercised. The price per share is now the $5 million valuation divided by the 950,000 currently outstanding shares or $5.26 per share. The employees who exercised their stock would have an immediate pre-tax profit of $2.76 per share.
References (4)
About the Author.
Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.
Photo Credits.
Jules Frazier/Photodisc/Getty Images.
More Articles.
How Do I Provide Stock Options?
Incentive Stock Options & the IRS.
The Advantages of Owning Minority Shares of a Privately Held Company.

Private company stock options valuation

The Editor interviews Joan M. D'Uva , Partner in the Litigation Services Group of EisnerAmper LLP.
Editor: Please tell our readers about your work at EisnerAmper.
D'Uva: I am a partner in the Litigation Services Group and have been with the firm for 14 years. I primarily prepare valuations for many different purposes: estate planning and gifting, dispute resolution, financial reporting, financial planning, and buying or selling a business or a particular asset.
Editor: What is Section 409A of the Internal Revenue Code?
D'Uva: Section 409A of the Internal Revenue Code relates to the taxation of deferred compensation. It was part of the American Jobs Creation Act passed by Congress in 2004. A common way for companies to defer compensation to employees is by issuing stock options and stock appreciation rights. In issuing stock in any form, it is important to know the fair market value of the underlying common stock.
Editor: What is considered deferred compensation under these rules?
D'Uva: Under the rules, if an option to buy stock has an exercise price that is lower than the fair market value of the common stock at the date of grant, then the difference is considered a deferred compensation arrangement. This becomes an important factor because there are federal tax consequences under Section 409A for nonqualified deferred compensation at the time of vesting. These rules also apply to a severance situation.
Editor: Why should companies be concerned about this?
D'Uva: Whether the company is public or a private, it should be concerned with the IRS rules as to how to set the fair market value of the company's common stock. In the case of a public company where the common stock is traded, there is not as much of an issue, but there are still some rules with respect to what value is used. For a private company the valuation of a common stock can be very complex. In many instances a company issuing stock options may be a startup, often in cases where it doesn't have the cash flow to pay its executives adequate compensation. In such cases the company issues stock options. Many times there may be several classes of stock where outside private equity groups invest, often in the form of preferred stock. Allocating the value between the common stock and the preferred stock becomes quite complex. Importantly, IRS rules need to be adhered to in order to avoid adverse tax consequences.
Editor: How is the strike price of options determined?
D'Uva: The strike price of options should be set equal to or greater than the fair market value of the underlying common stock. There were many different ways in the past that companies have arrived at the strike price. Today it is a common practice for a company to seek the advice of an outside appraisal firm because of new IRS rules.
Editor: I understand these rules were enacted back in January 2005 but didn't take effect until 2008. Why was that?
D'Uva: Section409 was added to the code in January 2008, although it was part of the American Jobs Creation Act passed by Congress in 2004.The cause of the delay in implementation may have been due to the amount of controversy among various companies lobbying for different provisions, especially with regard to the penalties.
My understanding is that the consequences of issuing options as deferred compensation at a below market price can result in the immediate inclusion in income of all deferrals made in the year of noncompliance as well as noncompliance deferrals made in prior years, to the extent the deferrals are not subject to forfeiture. There is a 20 percent excise tax on prior year noncompliant deferrals included in income. Furthermore, there is an interest charge on deferrals from prior years. I understand that some of the states impose taxes in these situations as well.
Editor: Can the board of directors set the fair market value of the company stock?
D'Uva: It is considered a best practice in meeting all IRS rules to engage an outside appraiser. In the past, the board of directors would set a price based on a a formula of multiples or a ratio and really didn't go through all the steps of preparing and performing a business appraisal.
Editor: How is fair market value of a company's stock determined?
D'Uva: In general there are three approaches: (1) the income approach; (2) the market approach; and (3) the asset approach. Within each approach there are several acceptable methodologies. For example, within the income approach one can look to historical income or projected income to determine value. A market approach would entail using market information such as looking at the price of a similar public company stock or looking at the acquisition price of an entire public company by another company. An asset approach would involve evaluating the specific assets, both tangible and intangible, of the company.
Typically this appraisal might be done by an appraisal firm or an accounting firm, who might use at least two of the three methods I described.
Editor: What other methodologies should be used to determine the fair market value of the company's stock?
D'Uva: In addition to the methodologies that I previously described, more complexity comes into the valuation process when you have different classes of stock to which value is allocated. There are other models that are used in allocating values to the different classes of stock. In addition to the three approaches I have referred to, the AICPA has a practice aid for stock issued as compensation that describes allocation of value to the various classes of stock. Some of the more acceptable methods are current-value method, the probability-weighted-expected-return method and the option-pricing method.
Editor: What are the IRS criteria for determining fair market value?
D'Uva: The valuation of the company stock must be reasonable, taking into account the company's specific facts and circumstances. Besides considering the value of tangible and intangible assets, the appraiser should examine cash flows and the present value of future cash flows, market value of similar publicly traded companies and other relevant factors such as discounts for lack of marketability, minority interests or control premiums.
Editor: How often does the company need to get an appraisal of its stock for the granting of options?
D'Uva: According to the regulations, it is considered reasonable to use an appraisal that was performed no more than 12 months prior to the grant date of an option as long as there has not been a significant event that could have changed the value of the business.
Editor: What should a company be looking for in an appraiser?
D'Uva: You want to see that the person has credentials in the business appraisal area. Business valuation isn't a licensed profession but a credentialed profession. One of the more highly regarded credentials is that issued by the American Society of Appraisers, which designates qualified appraisers as ASA or accredited senior appraiser. The AICPA also has an appraisal designation referred to as the ABV, accredited in business valuation, an accreditation only issued to CPAs who have passed an exam and demonstrated experience and knowledge in the area of business appraisal. Those would be the types of credentials that a company should be looking for in addition to asking about the person's experience and possibly asking for references.
Editor: What is the difference between the fair market value of common stock for 409A purposes and the fair value of common stock for financial reporting purposes (Accounting Standards Codification topic 718)?
D'Uva: Companies are required to account for and disclose stock options that fall under the definition of share-based payment arrangements, the terminology used under ASC topic 718, and the standard of value referred to as fair value. For Section 409A purposes the standard of value is fair market value. The methodologies for options and financial statement values are similar. One would consider the same three approaches - the income, market or asset approach - as well as discounted cash flow and capitalized earnings, but the difference would actually be in possibly some of the assumptions that are made because the Section 409A valuation is actually a valuation made from the perspective of the individual owner of the stock, while the ASC 718 valuation is made more from the perspective of the company. It is possible that some of the assumptions might be different. In an ASC 718 valuation some of the parties whom you might consider as market participants may not be the same participants as in a Section 409A valuation. But for the most part, the valuations are going to be the same, and often you can use the same appraisal for both purposes.
Editor: What is acceptable to the company's auditors?
D'Uva: The auditors are going to look for a well-documented report, something that follows appraisal standards. They are going to be looking for documentation of all the assumptions that are made, not just that the methodologies follow professional appraisal practice, but that the assumptions are logical and supported, that they are based on factors that make sense and that the person who is issuing the opinion is a person who has the credentials, the experience and the knowledge to issue such an opinion and reach such conclusions.
Editor: What measures are used in valuing the preferred stock as compared with the common?
D'Uva: Generally speaking, there isn't a rule of thumb. The rights and privileges of the preferred shareholder are factors in determining the value of the stock, such as whether preferred stock is convertible, whether the preferred shareholder is entitled to a dividend, whether dividends are cumulative, and what the liquidation preferences are. If there has been a recent round of preferred stock financing of the subject company, you can use that information in a model to try to back-solve for the value of the common stock. Using that approach the appraiser must still make certain assumptions based on his or her judgment.
Editor: What factors can ensure that the valuation process will be an efficient and timely one?
D'Uva: The most important thing is for the appraiser to gain access to the information that he or she needs in a timely fashion by conferring with the most knowledgeable persons in a fairly concentrated period of time. Getting material in one undertaking in order to analyze all the pieces together is most helpful.
Please the interviewee at joan. duvaeisneramper with questions about this interview.
Law Business Media, 104 Old Kings Highway North, Darien, CT 06820.

How do I value the shares that I own in a private company?
Investopedia.
Share ownership in a private company is usually quite difficult to value due to the absence of a public market for the shares. Unlike public companies that have the price per share widely available, shareholders of private companies have to use a variety of methods to determine the approximate value of their shares. Some common methods of valuation include comparing valuation ratios, discounted cash flow analysis (DCF), net tangible assets, internal rate of return (IRR), and many others.
The most common method and easiest to implement is to compare valuation ratios for the private company versus ratios of a comparable public company. If you are able to find a company or group of companies of relatively the same size and similar business operations, then you can take the valuation multiples such as the price/earnings ratio and apply it to the private company.
For example, say your private company makes widgets and a similar-sized public company also makes widgets. Being a public company, you have access to that company's financial statements and valuation ratios. If the public company has a P/E ratio of 15, this means investors are willing to pay $15 for every $1 of the company's earnings per share. In this simplistic example, you may find it reasonable to apply that ratio to your own company. If your company had earnings of $2/share, you would multiply it by 15 and would get a share price of $30/share. If you own 10,000 shares, your equity stake would be worth approximately $300,000. You can do this for many types of ratios: book value, revenue, operating income, etc. Some methods use several types of ratios to calculate per-share values and an average of all the values would be taken to approximate equity value.
DCF analysis is also a popular method for equity valuation. This method utilizes the financial properties of the time-value of money by forecasting future free cash flow and discounting each cash flow by a certain discount rate to calculate its present value. This is more complex than a comparative analysis and its implementation requires many more assumptions and "educated guesses." Specifically, you have to forecast the future operating cash flows, the future capital expenditures, future growth rates and an appropriate discount rate. (Learn more about DCF in our Introduction to DCF Analysis .)
Valuation of private shares is often a common occurrence to settle shareholder disputes, when shareholders are seeking to exit the business, for inheritance and many other reasons. There are numerous businesses that specialize in equity valuations for private business and are frequently used for a professional opinion regarding the equity value in order to resolve the issues listed.
This question was answered by Joseph Nguyen.
Notman, Derek.
Putting a value on private equity is not as easy to do as securities listed on listed exchanges. Typically, a private company will have completed a valuation to determine how much the company is worth, thus giving a value for each share. There are so many variables on how to value a private company that it is difficult to determine an accurate share price.
Ask the management team or board if there is one what the most recent valuation was, this will give you an idea of what your shares are worth, but keep in mind this can change quickly.
Clark, David.
The simplest method of estimating the value of a private company is to use comparable company analysis (CCA). To use this approach, look to the public markets for firms which most closely resemble the private (or target) firm and base valuation estimates on the values at which its publicly-traded peers are traded.

Valuing Private Companies.
While most investors are versed in ins and outs of equity and debt financing of publicly-traded companies, few are as well-informed about their privately-held counterparts. Private companies make up a large proportion of businesses in America and across the globe; however the average investor most likely cannot tell you how to assign a value to a company that does not trade its shares publicly. This article is introduction to how one can place a value on a private company and the factors that can affect that value.
Private and Public Firms.
The most obvious difference between privately-held companies and publicly-traded companies is that public firms have sold at least a portion of themselves during an initial public offering (IPO). This gives outside shareholders an opportunity to purchase an ownership (or equity) stake in the company in the form of stock. Private companies, on the other hand, have decided not to access the public markets for financing and therefore ownership in their businesses remains in the hands of a select few shareholders. The list of owners typically includes the companies' founders along with initial investors such as angel investors or venture capitalists.
The biggest advantage of going public is the ability to tap the public financial markets for capital by issuing public shares or corporate bonds. Having access to such capital can allow public companies to raise funds to take on new projects or expand the business. The main disadvantage of being a publicly-traded company is that the Securities and Exchange Commission requires such firms to file numerous filings, such as quarterly earnings reports and notices of insider stock sales and purchases. Private companies are not bound by such stringent regulations, allowing them to conduct business without having to worry so much about SEC policy and public shareholder perception. This is the primary reason why private companies choose to remain private rather than enter the public domain.
Although private companies are not typically accessible to the average investor, instances do arise where private firms will seek to raise capital and ownership opportunities present themselves. For instance, many private companies will offer employees stock as compensation or make shares available for purchase. Additionally, privately-held firms may also seek capital from private equity investments and venture capital. In such a case, those making an investment in a private company must be able to make a reasonable estimate of the value of the firm in order to make an educated and well researched investment. Here are few valuation methods one could use. (For a related reading, see Why Public Companies Go Private .)
Comparable Company Analysis.
The simplest method of estimating the value of a private company is to use comparable company analysis (CCA). To use this approach, look to the public markets for firms which most closely resemble the private (or target) firm and base valuation estimates on the values at which its publicly-traded peers are traded. To do this, you will need at least some pertinent financial information of the privately-held company.
For instance, if you were trying to place a value on an equity stake in a mid-sized apparel retailer, you would look to the public sphere for companies of similar size and stature who compete (preferably directly) with your target firm. Once the "peer group" has been established, calculate the industry averages. This would include firm-specific metrics such as operating margins, free-cash-flow and sales per square foot (an important metric in retail sales). Equity valuation metrics must also be collected, including price-to-earnings, price-to-sales, price-to-book, price-to-free cash flow and EV/EBIDTA among others. Multiples based on enterprise value should give the best interpretation of firm value. By consolidating this data you should be able to determine where the target firm falls in relation to the publicly-traded peer group, which should allow you to make an educated estimate of the value of an equity position in the private firm.
Additionally, if the target firm operates in an industry that has seen recent acquisitions, corporate mergers or IPOs, you will be able to use the financial information from these transactions to give an even more reliable estimate to the firm's worth, as investment bankers and corporate finance teams have determined the value of the target's closest competitors. While no two firms are the same, similarly sized competitors with comparable marketshare will be valued closely on most occasions. (To learn more, check out Peer Comparison Uncovers Undervalued Stocks .)
Estimated Discounted Cash Flow.
Taking comparable analysis one-step further, one can take financial information from a target's publicly-traded peers and estimate a valuation based on the target's discounted cash flow estimations.
The first and most important step in discounted cash flow valuation is determining revenue growth. This can often be a challenge for private companies due to the company's stage in its lifecycle and management's accounting methods. Since private companies are not held to the same stringent accounting standards as public firms, private firms' accounting statements often differ significantly and may include some personal expenses along with business expenses (not uncommon in smaller family-owned businesses) along with owner salaries, which will also include the payment of dividends to ownership. Dividends are a common form of self-payment for private business owners, as reporting a salary will increase the owner's taxable income, while receiving dividends will lighten the tax-burden.
What's important to remember is that estimating future revenue is only a best guess estimate and one estimate may differ wildly from another. That is why using public company financials and future estimates is a good way to augment your estimates, making sure that the target's sales growth is not completely out of line with its comparable peers. Once revenues have been estimated, free cash flow can be extrapolated from expected changes in operating costs, taxes and working capital.
The next step would be to estimate the target firm's unlevered beta by gathering industry average betas, tax rates and debt/equity ratios.
Next, estimate the target's debt ratio and tax rate in order to translate the industry averages to a fair estimate for the private firm. Once an unlevered beta estimate is made, the cost of equity can be estimated using the Capital Asset Pricing Model (CAPM). After calculating the cost of equity, cost of debt will often be determined by examining the target's bank lines for rates at which the company can borrow. (To learn more, see The Capital Asset Pricing Model: An Overview .)
Determining the target's capital structure can be difficult, but again we will defer to the public markets to find industry norms. It is likely that the costs of equity and debt for the private firm will be higher than its publicly-traded counterparts, so slight adjustments may be required to the average corporate structure to account for these inflated costs. Also, the ownership structure of the target must be taken into account as well as that will help estimate management's preferred capital structure as well. Often a premium is added to the cost of equity for a private firm to compensate for the lack of liquidity in holding an equity position in the firm.
Lastly, once an appropriate capital structure has been estimated, calculate the weighted average cost of capital (WACC). Once the discount rate has been established it's only a matter of discounting the target's estimated cash flows to come up with a fair value estimate for the private firm. The illiquidity premium, as previously mentioned, can also be added to the discount rate to compensate potential investors for the private investment.
As you can see, the valuation of a private firm is full of assumptions, best guess estimates and industry averages. With the lack of transparency involved in privately-held companies it is a difficult task to place a reliable value on such businesses. Several other methods exist that are used in the private equity industry and by corporate finance advisory teams to help put a value on private companies. With limited transparency and the difficulty in predicting what the future will bring to any firm, private company valuation is still considered more art than science. (To learn more, see For Companies, Staying Private A Matter Of Choice .)