Early Stage Valuation

CHAPTER 10Valuation of Options and Warrants

Options and warrants are a common feature in the capital structure of early stage enterprises (ESEs). We typically start seeing options being issued as the company approaches the first round of venture capital financing. In many cases, they are used as a tool by companies with limited cash resources to attract an expert workforce by allowing participation in the equity's upside potential. In a capital raising transaction, warrants can provide a potential return booster for investors, as an add on to stock or debt securities. Over time, and as the firm continues to grow, options and warrants may have a significant effect on the allocation of value among employees, management, and investors in the firm.

In this chapter, we address the valuation of options and warrants in an ESE. The first section, General Principles of Option Valuation, recalls some basic principles in option valuation.¹ The second section, Valuation of Options in a Complex Capital Structure, illustrates the valuation of options using an enterprise value allocation model. This section expands the discussion of the Option Pricing Model (OPM) introduced in Chapter 5 by considering options as part of the company's capital structure. The third and fourth sections, Valuations of Options as Stand-Alone Instruments using the Black-Scholes-Merton (BSM) model and the binomial lattice model (BLM), respectively. The fifth section, Valuation of Warrants, highlights some special ...