However, valuing share options, accounting for them and providing the relevant disclosures can be tricky.

In this article, you’ll learn the most common way to value share option schemes and how Rickard Luckin can help.

What are share option schemes?

Share option schemes like Enterprise Management Incentive (EMI) options and non-tax advantaged options give employees the right, but not the obligation, to purchase shares in a company at an agreed price.

They specify how many company shares an employee can acquire, how much they will have to pay and when they can exercise the option.

They are commonly used to motivate key staff to increase the value of a business before an exit event. Other blogs have covered the benefits of implementing such schemes , which include:

• Attracting and retaining top talent
  
• Giving employees skin in the game
  
• Rewarding employees with equity
  
• Increasing employee engagement

Once options to employees have been granted, companies must account for the schemes. Medium and large companies must provide relevant disclosures regarding the schemes in their accounts.

Accounting for share option schemes

The accounting of share-based payments is dependent on the specifics of the situation. However, the common factor that is needed for all schemes is the fair value of the share options.

But what is the fair value, and how can you determine it?

FRS102 rather blandly defines fair value as the price that would be paid or received for an asset or liability in an orderly market transaction.

In the case of some companies, it may be possible to use market data or recent transactions to determine this. However, for most private companies, it will be necessary to use an alternative valuation methodology.

There are multiple valid methods of determining the value of an option. However, we will only consider the Black Scholes Model in this article, as this is often seen as the most accessible valuation methodology.

Valuing share options using the Black Scholes Model

The calculation pulls together numerous factors to determine the market value, and these key factors are as follows:

• Share price. What is the current value of a share in the company?
  
• Exercise price. What price would the option holder need to pay to acquire the share?
  
• Time. What is the expected time until the option will be exercised?
  
• Risk-free rate. What is the current risk-free rate? This is often considered to be the yield on a Gilt (UK government debt) for a time period matching the period to exercise.
  
• Volatility. By how much is the share price expected to fluctuate during a period?
  
• Dividends. What annual dividends are expected to be paid by the company?

Black Scholes Model calculators are readily available online. However, as with all calculations, there is the issue of ‘rubbish in, rubbish out’.

Even with inputs seemingly as simple as the current share price, which is often determined when issuing the options, consideration needs to be given as to whether to use the pro-rated value of the company or the discounted value of the standalone shares.

As with all things, the key is in the detail. It’s necessary to understand the broader share rights and the terms of the options to understand under what circumstances the options can be exercised to determine what benefit (if any) an option holder would receive.

Another key point to consider is the likelihood of the options being exercisable. Are the options ‘exit-only’, or can they be exercised at any point after they have vested? It’s common sense that identical options can’t be worth the same if they have vastly different likelihoods of being exercised.

Professional advice from Rickard Luckin

The valuation of employee share scheme options is a technical exercise and requires full consideration of the facts and an understanding of how these factors impact on value.

Rickard Luckin has extensive experience in employee share schemes and can help you value share options correctly. We can prepare statutory paperwork to implement the scheme and value your company to establish the tax liabilities that may arise.

Please reach out if you require any advice or assistance in valuing pre-existing share options or setting up an EMI Option Scheme.