How to Calculate the Option Strike Price at a Fair Market Value

The idea to keep in mind when valuing the strike price of options is the objective: being in a safe harbor zone. The only objective for the appraiser is to give you a fair market value, but a safe harbor value, to mitigate any tax risk. If you want to have a higher strike price, it’s acceptable, even if the fair market value is lower based on the valuation report.

So, how does one calculate the option strike price at a fair market value? We've broken down the three steps that are involved in the valuation itself to make these calculations crystal-clear:

1. Calculate enterprise value. The first and arguably most important step is estimating the company’s valuation (“enterprise value”). This is very straightforward if you’re doing your valuation immediately after a fundraise, but becomes fuzzier a year (or more) after the fact.
2. Determine the value of the common stock. The second step is to take that enterprise value and distribute it up among all the different share classes (e.g. preferred, warrant holders, common) to determine the current value of the common shares—what is also known as the “fair market value” (FMV). This step takes into account all of the economic rights of each share class, otherwise known as liquidation preference (i.e. the order in which stockholders are returned their investment in a liquidity event) and rights related to conversion, dividends, and participation.
3. Apply a discount for lack of marketability (DLOM). The third and final step is to take the calculated FMV for the common shares and apply a discount to adjust for the fact that the company is not publicly traded—in other words, none of your employees could actually go and sell their shares at that price because there is no liquid market for them.

Financial professionals, such as M&A specialists, equity research analysts, and venture capital firms, employ various methods to assess a company's enterprise value. They usually use two key approaches: market-based and income-based. Stay tuned for another article that will further explain these two key approaches!