Compensation through options and shares, as well as the issuance of similar warrants to external parties, represents a regular source of financing for an organization. Therefore, in valuation, it is necessary to account for them within the capital structure:

  1. Normally, in the formula for the Equity Cost of Capital or WACC, such securities are included under Equity, since their value is tied to the value of the firm’s stock. However, they can—and sometimes must—be separated out, especially when their weight is significant.
  2. When compensation is provided in the form of restricted shares (RSUs) or other share-equivalent obligations, it is necessary to distinguish their value from that of ordinary shares. In such cases, there may also be a tax saving.
  3. If guarantees tied to the share price have been issued (i.e., call options), and at the moment of valuation they are exercised (for example, in the case of a merger where negotiations require that all such options be closed), then the value of such options is defined as the difference between the stock price and the exercise price (formula 12.6).
  4. If options have been issued but are not exercised/closed at the valuation date, then the value of the granted compensation options and warrants (Employee Stock Options & Warrants) is calculated on the basis of the Black–Scholes–Merton model. Such options differ from standard investment options in that they cause dilution of the company’s own equity. For valuing these instruments, a more sophisticated formula exists (Daves & Ehrhardt, 2007 – formula 12.11).

P.S.
Employee stock options differ in substance from warrants and regular options in that they do not fully satisfy the standard assumptions of the general option-pricing model. For example:

  • Employees typically are not allowed to trade these options or hedge the risks associated with them.
  • Standard models assume that options will not be exercised before the “rational” optimal time. In practice, however, employees usually do not seek to maximize profit in this way, as they are more risk-averse. For this reason, expected exercise life is used in calculations instead of the contractual maturity.
  • Finally, the U.S. tax system allows companies to directly use the Black–Scholes model for tax purposes when valuing such options, without dealing with more complicated dilution-adjusted formulas.

Source:

Corporate Valuation Theory, Evidence and Practice
Mark E. Zmijewski; Robert W. Holthausen
Second Edition