What is the Option Pricing Model?
The Option Pricing Model is a method of calculating the value of a particular security in a company, using option pricing frameworks. In the Option Pricing Model, the total value of the company is allocated with consideration towards volatility, risk, and preference order to the various classes of security, thereby establishing the total value of a stake at a likely exit valuation.
Because private companies often have more than one class of equity, the value of any class is dependent on the order in which an exit (a sale or a liquidation event) pays out to each class. Under the Option Pricing Model, each class is treated as a call option (i.e. the right to buy) common stock at a specific price. Stock at each price is only available once all calls for the classes of grant above the call in consideration have been satisfied. So, for example, if there exist 1,000,000 preferred shares at $1.50 and 1,000,000 common shares with a par value of $0.0001, the common shares are not worth anything unless the total enterprise value at exit is at least $1.50 * 1,000,000 shares, or $1,500,000.
Using this mental model in conjunction with a mathematical model, such as Black-Scholes, an analyst can determine the estimated likely value of any stake in the private company, so it’s useful when allocating enterprise value in an ASC 820 report.