Model selection errors are more obvious to call-out and, for my money, constitute the biggest mistake we see companies making and unqualified professionals advising companies to use. People are quick to use the Black-Scholes Model (BSM) because it’s free and fundamentally easy to populate. A number of conditions exist, especially for small start-ups, where the BSM output is not a reliable indication of value. The BSM only works for “plain vanilla” options.
Smaller, privately-held companies pay folks with share-based compensation all the time. Growing companies also raise money in the form of equity or convertible securities to pay for growth or maintenance capital expenditures. Out of fairness to its employees, companies often include provisions in the compensation agreements that limit or negate the impact of raising more equity capital on the total compensation amount. These provisions are almost standard at this point.
Some of the terms that seriously challenge or negate the effectiveness and appropriateness of using a BSM to value share-based compensation are as follows:
In each of the above cases, the company or practitioner advising the company should consider using open-form, option pricing models like the Binary Option Pricing Model (BOPM) or a Monte Carlo simulation. While costlier in initial set-up, efficiencies may be applied quarterly going forward. More importantly, these open-form models can account for all the challenges in a supportable and proven manner avoiding more costly penalties or issues down the road. For more detailed information on misapplying Black-Scholes please view the attached PDF containing specific challenges for each consideration.
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.