Author: Upasak Shah
Featured On: BVIUK Website
The option pricing method is widely used for equity allocation in privately held companies with multiple classes of stock.
The option pricing model (“OPM”) relies on financial option theory to allocate value among different classes of members’ equity based upon a “claim” on value on the expected date of exit. Under the OPM, the values of the various classes of shares are estimated as the net value of a series of call options, representing the present value of the expected future returns to the shareholders at a series of exercise prices that coincide with the liquidation and conversion preferences of the holders of preferred and ordinary shareholders.
The popularity of the OPM stems from its ability to avoid complex, subjective assumptions and that it is not limited by a discrete set of scenarios. The need for a limited number of assumptions/inputs and the potential full distribution of possible outcomes covered in an OPM make it suitable for valuing option-like payoffs such as common stock, warrants, and preferred share interests. OPM considers the various rights and preferences mentioned in the stockholder agreements that would affect the distributions to each class of equity upon a liquidity event, including the level of seniority among the classes of equity, dividend policy, conversion ratios, and cash allocations.
This article explores the nuances of equity allocation, focusing on the Option Pricing Method tailored for privately held companies with a simple capital structure. Read more on: https://www.bviuk.com/post/equity-allocation-using-option-pricing-method-for-privately-held-companies
