How to Value Stock Options

Posted 9 Apr 2001 at 22:55 UTC by Bram Share This

Many of you will one day receive a significant chunk of your pay as stock options. Most people guess how much stock options are worth by rank speculation, usually assuming 'a lot'. Now that the stock market is well and truly busted, you may be interested in a more sober approach.

The question is, how much are your stock options worth to you? Someone else might value them quite differently, but you aren't that person, so it doesn't matter.

The following is a good rule of thumb, followed by an explanation of all the values in it.

(current value - (strike price * discretion factor)) * risk factor * liquidity factor

current value

Chances are, some investors have already put money into the company, and you should use their valuation. For example, if an investor put in a million dollars and got a tenth of the company, that gives the company an estimated value of ten million dollars, so if you get half a percent of it, that's worth $50,000.

If there's been no such investment, take the amount of money which has been put into the company so far and multiply by what's been accomplished. A multiplier of one is normal, two is rather generous.

strike price

The strike price is how much you'll have to pay to get your stock. It's set at the time stock is granted, you should ask what it is.

discretion factor

You don't always spend the strike price, because sometimes it winds up being higher than the stock price. The discretion factor ranges from zero for 'mars or bust' investments to one for shares of bundles of cash.

risk factor

An option's value isn't based on upside potential, it's based on average expected money you can get from it. Greater risk makes it worth less. The risk factor varies from zero if you're just barely going to be able to retire some day to one if you're already set for life and the rest is gravy.

liquidity factor

Money which you can spend now is worth more to you than money you can spend later. Liquidity factor varies between zero if you're on the verge of not being able to make mortgage payments to one if you should be saving more anyway.

An employer might tell you 'you should sign up here, because we're going to IPO/get acquired in a month and your stock options will be worth a fortune'. You should view this as possible insider information. Often it's bullshit, but some people really have gotten rich this way.

If you become rich on paper from options, remember that it's all funny money until it vests - your paper fortune could evaporate just as quickly as it appeared.

Holding onto stock one minute past vesting date is an investment decision, not an act of loyalty. Don't leave all your savings in a single investment just because that's how it happened to be given to you.

-Bram Cohen

other factors to consider, posted 10 Apr 2001 at 08:20 UTC by dalke » (Journeyer)

There are for options from pre-IPO companies. I still haven't worked in a public company.

1 in 10 funded startups are successful, another 1 in 10 are "the living dead". That means 8 of 10 funded startups fail. I've been at 2 of those 8 so far. What this means is use a risk factor of 0.2 unless you have good reason to choose otherwise.

Companies nearly always have an IPO share price of around $15 +/- $10. Granted, they may go up or down from that but an estimate of $15/option is reasonable. On the other hand, most companies exit by getting bought - not going public.

Remember to include the effects of dilution. This doesn't really come into play when going public (the $15/share) but is important if the company is being sold.

If you do become one of the successful, or hope to, read Tog's story How I made a small fortune at Apple Computer (out of a much, much larger one).

Lottery tickets, posted 10 Apr 2001 at 18:05 UTC by DrCode » (Journeyer)

Yes, that's how I view stock options: as a gift of lottery tickets. It's a nice benefit, but not one you should take in lieu of the salary that you should be paid.

The idea behind options is that you, the employee, will do a better job if you feel that you have some ownership in the company. And there is truth to this. However, stock prices don't always correlate with a company's performance; and there are many events that you and your employer have no control over which can make your options worthless.

One final bit of advice: If you do get lucky, and have options that have become worth something, and if they're 'qualified' options, it can make sense to purchase the shares and hold them. This is because you won't be taxed immediately when you buy the shares; and if you hold them for a year, you'll pay at a lower 'long-term capital gains' rate. (Of course, this only applies in the US.)

Dalke:, posted 10 Apr 2001 at 20:08 UTC by mblevin » (Journeyer)

It would be foolish to seriously consider that the average IPO price is about $15 when valuing your options. The $15 average price is a psychological price used by the underwriters that is perceived by investors as room-to-grow-but-not-a-penny-stock. The stock will be split or reverse-split just before IPO to make the valuation of the company match the about-$15 range, and your options will be revalued accordingly. This makes the datum of "most stocks IPO at about $15" to be useless when valuing your current pre-IPO options.

I Have Little Regard for Stock Options, posted 10 Apr 2001 at 22:54 UTC by goingware » (Master)

While I know people who have done well with stock options, the one company whose options have vested for me (Live Picture) is now bankrupt. (Read my resignation from Live Picture.)

You should be aware that when you sign up for stock options, you may well be putting your future into the hands of shortsighted fools. My advice is to not settle for a salary less than you would be comfortable taking if there were no options on the table. It really may be in your best interest to not take stock options because then you won't hesitate to walk when you see that the company is being mismanaged.

It has been my experience that the some of the worst people a company can have behind it are the venture capitalists who are responsible for its funding. They will get some crazy idea into their heads as to how the company can appeal to The Street or to a potential buyer and lead it from a well- thought-out plan and straight down a path into heartbreak and financial ruin.

Read all about it in:

Taxes!?, posted 12 Apr 2001 at 00:28 UTC by bodo » (Master)

When considering if you are going to buy your options taxes are important too. As far as I understand you have to pay tax for the difference between strike price and current value right away no matter if you company is public or if you'll ever be able to sell your shares (please correct me if I'm wrong, I was very stunned about this...).

Another issue is what kind of stock you get, common or preferred. This becomnes important when your comany gets aquired before it is public. The purchase price may cover the preferred stock, but your common stock optiones may get voided....

I'm in this situation right now and don't think that I'm purchading my options.

Closer to reality, posted 12 Apr 2001 at 15:33 UTC by sopwith » (Master)

Wishful "personalized" formulas notwithstanding, there are widely accepted formulas for valuing option contracts, Black-Scholes being the most well-known one. Do a web search and run the numbers through if you want a more universal method of valuing your options.

As for valuing pre-IPO options, I believe there is a formula that the SEC requires private companies to use in valuing their stock; talk to your CFO for details. Just assuming "$15" is a crapshoot.

As far as exercising in-the-money options and holding the resulting stock goes, the poster forgot that while you may save ~5-15% in taxes, you are placing your money at risk, and that risk may very likely exceed 5-15% by an order of magnitude. Unexercised options, on the other hand, place you at zero financial risk. I am continually amazed by the people who use a maximum tax gain of 19% (39% highest possible short-term capgains tax - 20% long-term capgains tax) to justify losing much more than 19% on their bagholdings^H^H^H^Hinvestments.

I would suggest that anyone doing financial planning, whether or not it involves stock options, consult a certified financial planner. Odds are that they know how to play the game better than you do. They might not be always right, but odds are that they can provide insights and plan strategies that you would never have thought of.

(Apologies to those not interested in USA taxation - them's all I knows.)

Worth?, posted 17 Apr 2001 at 12:50 UTC by dancer » (Journeyer)

I assume that stock options are worth nothing, and do not accept them. When told that they are worth 'at least $X', I insist that $X be added to my salary instead. If options lower my salary package by $X then I'm entitled to have that value instead, right? Otherwise the figure is a lie.

Thus far, I have always come out ahead of my coworkers who took the options, most of which collected exactly nothing for their possession.

Only one person I've ever worked with who took options ever made any money, and only once. This does not mean there aren't a lot out there who do well....But this is my opinion, right?

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