Valuing Early Stage and Venture Backed Companies

CHAPTER 4

Application of the Option-Pricing Method in Allocating Enterprise Value

The option-pricing method is one of the most commonly used methods for allocating the aggregate enterprise value to the early stage company’s various equity classes, including common stock. This method models the common and preferred stock as call options on the company’s enterprise value. The claims on future distributable assets (i.e., enterprise value) depend on the rights and preferences of the company’s preferred stock as opposed to its common stock. By modeling the common stock as a call option, the common stockholder is, in essence, given the right but not the obligation to buy the residual underlying enterprise value at a certain exercise price. Of course, in reality, the common shareholder really doesn’t have the right to “buy” anything because the common stock is already owned. Nonetheless, modeling it as an option provides a similar economic construct as a true option since, if the company isn’t successful, the “option” (i.e., the common stock) will expire worthless. The residual value available to the common stockholders is determined by an option analysis, described farther along in this chapter. Essentially, the residual value to the common stock is the remaining amount after the preferred stock liquidation preference and other participatory rights are measured.

As is the case with many early stage, venture-backed companies, the common stock options granted to employees are often considered ...