Valuing Share Options in Private Companies: Methods and Audit Considerations
Introduction
Many private companies use share option schemes to attract, motivate and retain key employees. Whether the scheme involves EMI options, growth shares, unapproved options or management incentive arrangements, the company will generally need to determine the fair value of the options for accounting and financial reporting purposes.
Under FRS 102 Section 26 (and IFRS 2 where applicable), share-based payments are typically measured using the fair value of the equity instruments granted. As private company shares are not publicly traded, determining that fair value can involve significant judgement. This paper outlines the principal valuation methods and the evidence companies should retain to satisfy their auditor.
- Black-Scholes Valuation Model – Valuing Share Options in Private Companies
The Black-Scholes model is the most commonly used option-pricing methodology for straightforward share option arrangements.
The calculation typically considers:
- Current share value.
- Exercise price.
- Expected option life.
- Share price volatility.
- Risk-free interest rate.
- Dividend yield.
Advantages
- Widely accepted by auditors.
- Relatively straightforward to apply.
- Suitable for many standard employee option schemes.
Limitations
- Originally developed for listed shares.
- May require adjustments for private company characteristics.
- Less suitable for complex performance conditions.
For many owner-managed businesses, Black-Scholes remains the preferred valuation methodology.
- Monte Carlo Simulation – Valuing Share Options in Private Companies
Monte Carlo modelling is often used where options contain market-based performance conditions.
Examples include:
- Exit valuations.
- Share price targets.
- Investor return hurdles.
- Total shareholder return measures.
The model assesses thousands of possible outcomes before estimating a fair value.
Advantages
- Suitable for complex incentive arrangements.
- Captures uncertainty and probability-based outcomes.
Limitations
- Requires specialist expertise.
- More costly to prepare and review.
- Greater audit scrutiny.
- Binomial (Lattice) Models – Valuing Share Options in Private Companies
Binomial models evaluate multiple future share price paths and incorporate varying exercise behaviours during the option term.
Advantages
- More flexible than Black-Scholes.
- Can better reflect employee exercise patterns.
Limitations
- More complex to prepare.
- Usually only justified for larger or more sophisticated schemes.
- Enterprise Value-Based Approaches – Valuing Share Options in Private Companies
Many private companies begin by determining the value of the underlying shares before applying an option-pricing model.
Valuation techniques commonly include:
- EBITDA multiples.
- Earnings multiples.
- Discounted cash flow analysis.
- Recent investment rounds.
- Third-party share transactions.
The resulting share value is then used within an option valuation model.
Advantages
- Reflects the economics of the specific business.
- Commonly used by valuation specialists.
Limitations
- Dependent upon forecasts and assumptions.
- May involve significant professional judgement.
- Compensation-Based (Remuneration Shortfall) Approach – Valuing Share Options in Private Companies
Early-stage and cash-constrained businesses often recruit employees on salaries below prevailing market rates, with the expectation that share options will compensate for part of the remuneration package.
For example:
- Market salary: £120,000
- Actual salary: £80,000
- Annual remuneration shortfall: £40,000
Management may argue that the value of the options granted approximates the value of the remuneration sacrificed.
Advantages
- Simple and commercially intuitive.
- Particularly relevant for start-ups and founder-led businesses.
- Can provide evidence of management’s intentions when designing a remuneration package.
Limitations
- Generally not regarded as a standalone fair value methodology under FRS 102 Section 26 or IFRS 2.
- Does not directly measure the value of the underlying equity.
- May not reflect future growth potential, liquidity restrictions or option terms.
In practice, auditors will normally regard this as a corroborative or reasonableness-check methodology rather than a primary valuation technique. It can, however, be particularly useful where the company wishes to demonstrate that a valuation derived using another method is commercially sensible.
For example, if a Black-Scholes valuation indicates that an option grant is worth approximately the same amount as the remuneration sacrificed by the employee over the vesting period, this may provide supporting evidence for management’s valuation conclusion.
Adjustments Commonly Required for Private Companies
Unlike quoted companies, private companies often need to consider:
Lack of Marketability
Private shares cannot generally be sold easily. A discount may therefore be appropriate.
Minority Holdings
Small shareholdings may be less valuable than controlling interests.
Vesting Conditions
Performance targets and service conditions may affect value.
Leaver Provisions
Options that lapse on resignation or dismissal may require adjustment.
These adjustments should be based on evidence and not arbitrary assumptions.
What Auditors Will Expect
The auditor’s objective is to determine whether the valuation is reasonable, supportable and consistently applied.
Companies should expect to provide:
Scheme Documentation
- Option agreements.
- Scheme rules.
- Board minutes.
- Grant letters.
Evidence Supporting Share Value
- Independent valuation reports.
- HMRC EMI valuations.
- Investment round documentation.
- Recent share transactions.
- Business plans and forecasts.
Valuation Workings
- Detailed calculations.
- Spreadsheets and models.
- Assumptions used.
- Sensitivity analyses.
Support for Judgements
Management should document how it determined:
- Volatility assumptions.
- Option life.
- Discount rates.
- Liquidity discounts.
- Performance expectations.
Remuneration Analysis
Where a compensation-based approach is used as supporting evidence, auditors may find it helpful to see:
- Benchmark salary data.
- Employment contracts.
- Evidence of below-market remuneration.
- Board papers explaining the rationale for the option grant.
However, auditors will usually require evidence supporting the value of the underlying shares in addition to any remuneration analysis.
Practical Tips for a Smooth Audit
Management can significantly reduce audit challenge by:
- Obtaining a share valuation before granting options.
- Seeking agreement with HMRC for EMI share values where relevant.
- Using recognised valuation methodologies.
- Documenting assumptions contemporaneously.
- Retaining all supporting evidence.
- Considering specialist advice for material or complex schemes.
Conclusion
There is no single valuation method suitable for every private company. Black-Scholes remains the most common model for straightforward schemes, while Monte Carlo and lattice models may be appropriate for more complex arrangements. Enterprise value-based methodologies are often used to establish the value of the underlying shares, particularly in privately owned businesses.
A compensation-based approach, based on the value of remuneration sacrificed by employees, may provide useful supporting evidence and a commercial sense check, particularly for start-ups and growth companies. However, it is unlikely to satisfy auditors as a standalone valuation methodology. Companies should ensure that any option valuation is supported by a robust assessment of the underlying share value, appropriate option-pricing techniques and comprehensive documentation capable of withstanding audit scrutiny.
This paper provides general guidance only and does not constitute accounting, taxation or valuation advice. Specific professional advice should be obtained for individual circumstances.
For more information please go to www.milletaudit.com
a useful link https://www.icaew.com/technical/tas-helpsheets/financial-reporting/share-options-under-frs-102