How Employee Stock Options Are Valued (ESOP Valuation Explained)

Why your option strike price sits below your last round, the methods behind it, and a worked example from a seed round to a strike price

Employee stock options are valued twice. For tax, the company values its common shares to set a fair-market-value strike price, as in a US 409A or UK EMI valuation. For the accounts, it values the option under IFRS 2 or ASC 718, usually with Black-Scholes. Both normally land below the last round’s price.

Rules and sources checked 18 October 2026. Numbers in the worked example are illustrative.

Not the US retirement plan. In the US, “ESOP” also means an Employee Stock Ownership Plan, a retirement plan that invests primarily in the employer’s shares. For unlisted companies, US tax law requires those plans to have all valuations done by an independent appraiser. This page is about employee stock options in startups.

General information, not tax or accounting advice. Check your plan with an adviser in each country where you grant options.

Two valuations, two purposes: strike price vs accounting expense

An ESOP valuation is the process of putting a value on the shares behind employee options, or on the options themselves, for a specific legal purpose. Most founders hear “ESOP valuation” and think of one number. There are two, asked for by different people, and mixing them up leads to bad decisions.

The two are linked. Under IFRS 2, every option pricing model needs, at minimum, “the current price of the underlying shares”, along with the strike, the option’s life, expected volatility, expected dividends and the risk-free rate (IFRS 2, para. B6). The share price input usually comes from the tax valuation. The US standard setter says the same input “is typically the most difficult input for private companies to estimate”, and since 2021 lets private companies use a valuation done under the 409A regulations for it (FASB ASU 2021-07, BC2 and BC14).

Why options are priced below your last funding round

Two separate effects push the value of an employee share below the price investors paid.

Investors bought a different share. In a priced round, investors usually buy preferred shares with a liquidation preference: in a sale, they get their money back before common shareholders see anything. Employees get options over common shares, which carry no preference and usually fewer rights. The round price is the price of a preferred share, and a headline post-money valuation applies that price to every share, including the common shares that lack those rights. In a study of 135 US unicorns, Gornall and Strebulaev found that reported post-money valuations “average 48% above fair value” once the preferred terms are accounted for, with the gap largest for common shares (Journal of Financial Economics, 2020). Those are late-stage companies with complex terms, but the same effect applies, in direction if not in size, to a seed round with a simple 1x preference. We cover preference stacks in liquidation preferences explained.

A fundraising valuation assumes the money arrives. A pre-money valuation agreed with investors already prices in what the company will do with the new cash. It just doesn’t add the cash itself. A compensation valuation looks at the company as it stands today, with no new round assumed. In Equidam’s view, both numbers should rest on the same outlook for the business, so the gap between them has to be explainable, not arbitrary. This second effect matters most when you grant options before a round closes, or when your plan assumes further rounds. Once the money is in the bank, a status-quo valuation includes it. Our article on why fundraising and ESOP valuations are different walks through this in more detail. If you hold options and want to know what they might pay out at an exit, rather than how the strike was set, read what is my startup equity actually worth.

ESOP valuation methods explained

The US regulation does not prescribe a single method. Fair market value is “a value determined by the reasonable application of a reasonable valuation method”, and the factors listed include the present value of future cash flows, comparable companies, “recent arm’s length transactions” in the stock and “discounts for lack of marketability” (26 CFR 1.409A-1(b)(5)(iv)(B)). US practice is described in the AICPA’s “cheap stock” guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, whose stated aim is to “describe best practices for estimating the fair value of a minority interest” in private company securities (AICPA-CIMA). The AICPA released a revised working draft on 21 December 2025 (Deloitte DART), so check whether a final edition has replaced it.

Most valuations work in two steps: first value the whole company’s equity, then split that value between the share classes.

Backsolve from a recent round

The backsolve method works backwards from a recent arm’s-length round. It asks: what total equity value, run through the allocation model, makes one preferred share worth exactly the price the investor paid? The answer is the company’s implied equity value, and the same model then gives the value of a common share. A practitioner summary of the 2013 AICPA guide describes it as an approach that “derives from a timely transaction in a private company’s equity” (Accounting Today, 2013). It is the usual method in the months after a priced round, because the round is the best available evidence of value.

Option pricing method (OPM): splitting value between share classes

The option pricing method treats each share class as a call option on the company’s equity. Preferred holders own the first slice up to their liquidation preference. Common holders own the slice above that. Above the point where preferred holders would rather convert, everyone shares pro rata. Each slice is valued with Black-Scholes, using a time to exit, a volatility and a risk-free rate. The OPM is what turns “the company is worth X” into “a common share is worth Y”. In practice, a backsolve usually runs an OPM in reverse, as in the worked example below.

PWERM and scenario methods

The probability-weighted expected return method (PWERM) models a few concrete outcomes, such as a sale, an IPO, staying private or a wind-down. It works out what each share class receives in each outcome and weights them by probability. It suits companies close to an exit, where the scenarios can be described with some confidence. A hybrid method combines two or more of these allocation methods (Accounting Today, 2013).

Early-stage companies: DCF, market and qualitative methods

Before any priced round, or long after one, there is no recent transaction to backsolve from. The company value then has to be built from fundamentals. Equidam combines five methods: the Scorecard and Checklist methods, the VC method, and two DCF methods, one with long-term growth and one with exit multiples. The weights depend on the company’s stage (five valuation methods), and the DCF methods apply survival rates and an illiquidity discount. For a compensation valuation, Equidam values the company under the status quo, without the next round’s money.

Worked example: from a €4M seed round to a strike price

All numbers below are illustrative.

A company has 3,000,000 common shares held by the founders. It raises €1.0M of seed money by selling 1,000,000 preferred shares at €1.00 each, with a 1x non-participating liquidation preference. That is a €3.0M pre-money and a €4.0M post-money valuation. Three months later, it wants to grant 100,000 options.

Why is the implied equity value (€2.64M) below the €4.0M post-money? Because the €1.00 price is what a preferred share with downside protection costs. The founders’ 3,000,000 common shares don’t have that protection, so in the model each one is worth less than €1.00.

The inputs move the answer. In this example, with volatility between 40% and 80% and time to exit between two and five years, the common share comes out at 50.5% to 68.2% of the round price before the marketability discount. In this model, a longer time to exit raises the common share’s value, volatility moves it both ways, and a larger preference or a bigger discount lowers it. There is no standard percentage of the round price, and no primary dataset we could verify gives one, so treat any rule of thumb you hear with caution.

If the company had set the strike at the €1.00 round price instead, employees would pay €1.00 for a share this model values at about €0.44.

A company with no recent round skips the backsolve. It starts from a status-quo company value, for example an Equidam valuation with no new funding assumed, and converts it to a value per common share: by allocating between share classes as in step 3, or by dividing by the fully diluted share count where there is only one class. If part of that company value already reflects illiquidity (in Equidam, both DCF methods apply an illiquidity discount), take care not to discount for the same thing twice in step 4.

Not every country accepts step 4, either. German tax guidance says transfer restrictions do not reduce share value (BMF, 1 June 2024, Rn. 20), and for French BSPCE a round from the previous six months is the reference for the strike, with a discount allowed only where it is justified, for example because the employees’ shares carry weaker rights (BOFiP, §§140-175). Check the local rules before you discount.

Valuing the option itself: Black-Scholes and IFRS 2 / ASC 718

Under IFRS 2, a company that pays employees in options measures the expense “by reference to the fair value of the equity instruments granted”, and that fair value “shall be measured at grant date” (IFRS 2, para. 11). US GAAP does the same: equity-classified awards “are initially measured at fair value at the grant date”, and the FASB notes that Black-Scholes-Merton “is the most commonly used model by nonpublic entities” (ASU 2021-07, BC6 and BC7).

The six inputs from IFRS 2 B6 are where the judgement sits:

• Share price: the common-share value from the tax valuation, which is the hard part.
• Strike: set by the plan, usually equal to the share price at grant.
• Life of the option: how long until employees are expected to exercise. The example assumes exercise at the exit.
• Volatility: an unlisted company “will not have historical information”, so IFRS 2 suggests looking at “similar listed entities” (IFRS 2, B27 and B29).
• Dividends: usually zero for a startup.
• Risk-free rate: “the risk-free interest rate for the life of the option” (B6).

For a founder, the practical point is that this expense is a non-cash cost in the profit and loss account. It does not change the strike price or the employee’s tax. Brief your accountant early, because an auditor will ask how each input was chosen.

What a defensible ESOP valuation file contains

Where the law does not name a valuer, the tax authority looks at the file you kept. A file that is easier to defend has six parts:

1. Purpose and date. State that the valuation is for option grants, the valuation date and the grant dates it covers.
2. The method and why you chose it. For example, a backsolve from the March round, or a five-method valuation because there has been no recent round.
3. The inputs, with sources. Projections, comparables, the round terms, and for an OPM the volatility, term and risk-free rate.
4. The cap table and share rights. Show which class sits under the options and what rights it lacks compared with the preferred shares.
5. The result per share. Show the company value, the allocation to common and any discount, step by step, as in the table above.
6. The sign-off and refresh triggers. Record the board decision adopting the value, and list what would make you redo it: a new round, a large secondary sale, a big change in the business.

How often should you update an ESOP valuation?

In the US, a value is no longer reasonable once it is more than 12 months old or fails to reflect material new information, such as a new financing (26 CFR 1.409A-1(b)(5)(iv)(B)). In the UK, an EMI value agreed with HMRC is “valid for 90 days from the date of the agreement”, and HMRC considers both the actual market value, which reflects the restrictions on the shares, and the unrestricted market value (HMRC SVM110050). Our EMI guide covers the UK in full. For the accounts, every grant date needs its own fair value.

A sensible default is to refresh at least once a year and after any priced round, large secondary sale or major change in the business. A founder secondary at a high price can count as evidence of value too.

Common ESOP valuation mistakes

1. Defaulting to the round price. It is usually the cautious choice for tax, and for French BSPCE a recent round is the reference price unless a discount can be justified. But it often overprices common shares, and employees may get less upside than a documented lower value would allow.
2. Letting the valuation go stale. A 14-month-old US valuation, or a value from before your last round, loses its protection.
3. Telling two different stories. Projections for investors that bear no relation to the projections in the ESOP file are a red flag for any tax inspector or auditor. The status-quo case can be more cautious, but it should start from the same business.
4. Keeping no file. A number with no method, inputs or board sign-off is hard to defend years later, when employees exercise and the tax authority asks.

ESOP valuation rules by country

• United States: a 409A valuation of common stock, with a presumption of reasonableness for an independent appraisal under 12 months old (26 CFR 1.409A-1). See our 409A page.
• United Kingdom: EMI options are usually granted at market value, which you can ask HMRC to agree, valid for 90 days (SVM110050).
• Rest of Europe: each country has its own rules on strike prices, valuers and the timing of tax.

How Equidam helps

Equidam produces a documented five-method valuation of the company, with the method, inputs and weights set out in the report, which you can use as the basis of your ESOP valuation file. For US 409A and UK EMI valuations we work with specialist partners. Plans and prices are on our pricing page. To set up and run the plan itself, including the cap table and employee communication, our sister platform Share Council handles ESOPs.

FAQ

General information, not tax or accounting advice.

What is the fair market value of a stock option in a private company?

For tax, “fair market value” usually refers to the underlying common share, and the strike is set at or above it. In the US that means “the reasonable application of a reasonable valuation method” (26 CFR 1.409A-1). The option itself also has a fair value, measured for the accounts with a model such as Black-Scholes.

Why is my strike price lower than the last round price?

Investors paid the round price for preferred shares with a liquidation preference. Your options are over common shares, valued as the company stands today. A valuation that allocates value between the share classes, such as an OPM backsolve, usually puts a common share well below the round price.

What is the difference between a 409A valuation and a Black-Scholes value?

A 409A valuation sets the value of one common share, which becomes the strike price. A Black-Scholes value prices the option itself, adding time value from volatility and term, and it feeds the share-based payment expense under ASC 718 or IFRS 2. The 409A share value is one of the Black-Scholes inputs.

Which ESOP valuation method is used for early-stage startups?

If the company raised a priced round recently, a backsolve from that round with an option pricing method is common. Before any priced round, the company value is built from fundamentals, for example with Equidam’s five methods, and then converted to a per-share value. Close to an exit, scenario methods such as PWERM are used.

Does every option grant need a new valuation?

For the accounts, yes: each grant is measured at its own grant date (IFRS 2, para. 11). For tax, one share valuation can cover several grants while it stays current: up to 12 months in the US unless something material changes (26 CFR 1.409A-1), and 90 days for an HMRC-agreed EMI value (SVM110050).

Is an ESOP valuation the same as an Employee Stock Ownership Plan appraisal?

No. A US Employee Stock Ownership Plan is a retirement plan that holds company shares, and for unlisted companies its valuations must be done by an independent appraiser (26 USC 401(a)(28)(C)). Startup option valuations set a strike price and an accounting expense. They are different exercises under different rules.