Valuing equity in privately held companies with complex capital structures can be challenging, especially when there are no active markets for these securities. The Option Pricing Method (OPM) is a popular approach that treats each class of security as a call option on the company’s total equity value, making it easier to allocate equity value among different securities like preferred shares, common shares, options, and warrants.

What is the Option Pricing Method?

OPM uses the Black-Scholes model, a well-known method for pricing call options, to value each class of security. In this context, the company’s total equity value acts as the stock price, and the exercise price corresponds to the liquidation preference of each security class. This approach is particularly effective for companies with long-term liquidity timelines and multiple exit strategies, and for valuing securities with option-like characteristics.

Steps to Apply OPM

1. Analyze the Capital Structure: Review the company’s equity components, including all shares, options, and warrants, and understand their rights.
2. Calculate Breakpoints: Identify the points where each class of equity starts to have value based on different liquidity event outcomes.
3. Determine Black-Scholes Parameters: Estimate inputs for the Black-Scholes model, including total equity value, exercise prices, time to liquidity, volatility, and risk-free rate.
4. Calculate Breakpoint Values: Use the Black-Scholes model to calculate the value of call options at each breakpoint.
5. Allocate Values: Distribute the incremental option values to each class of security according to their ownership interests at each breakpoint.

Why Use OPM?

Option Pricing Method provides a systematic way to value equity in private companies with complex capital structures, ensuring a fair and transparent value allocation among different securities. It’s beneficial when companies have multiple exit scenarios or long-term plans for liquidity events, offering clarity and structure in the valuation process.

Conclusion

The Option Pricing Method simplifies the allocation of equity value among various securities in private companies, accommodating their complex capital structures. By treating each security as a call option, OPM provides a fair and transparent approach to valuation, making it an essential tool for companies and investors navigating private equity markets.

Pitchers Global uses the OPM or Option Pricing Method to maintain a transparent and fair equity valuation for Private Companies that includes complex capital structures.