All you need to know about the hybrid option pricing model
The hybrid option pricing method is a hybrid between Scenario analysis and Option pricing method (OPM). In the hybrid method, total equity value is estimated across multiple scenarios where each scenario is assigned a probability, but the allocation of value in one or more of these scenarios is done using the OPM. Scenario analysis models each future outcome explicitly, but the hybrid method allows for explicit modeling of those scenarios which are near term and more likely to realize and using the OPM to capture those outcomes where there is greater uncertainty.
For example, consider a firm that anticipates a 70 percent probability of an IPO in six months; however, if the IPO falls through due to market or other factors, the chances for a liquidity event are much more uncertain, and the firm is expected to remain private for four years. Under these circumstances, it is more appropriate to use a hybrid method. The value of different classes of equity under the IPO scenario might be based on the expected valuation and timing of the anticipated IPO, explicitly modeling this scenario. Then, an OPM with a four-year time to liquidity might be used to estimate the value of the share classes, using the conditional equity value, assuming the IPO does not occur. In this instance, the resulting values for different share classes under each scenario would be weighted by their respective probabilities.
The following are the steps in the Hybrid method:
- Determination of future outcomes: The preliminary step in the hybrid method is the determination of future outcomes. This is usually done based on discussion with management considering their expectations. In this case, future outcomes represent possible exit scenarios such as an IPO, Merger or sale, dissolution, etc.
- Estimation of future Equity value under each scenario: The next step is to estimate future equity value under each future outcome. Equity value can be a point estimate or a range of values. It might be determined using OPM.
- Allocate the value under each outcome: The next critical step is to allocate total equity value to different share classes. Allocation is based on the assumption that each shareholder will seek to maximize its value. Different rights and preferences of share classes must be considered while allocating value. OPM might be used for allocation.
- Probability weighs each outcome: Each of the future scenarios is assigned a probability based on their likelihood of occurrence. This results in a probability-weighted expected value for each share class.
- Discounting: The expected value for each class of equity is discounted back to the present using an appropriate risk-adjusted discount rate. For Each class of equity, a different discount rate may be used if appropriate.
- Additional adjustments: Any additional adjustments, such as the applicability of discounts (for lack of marketability or control), should be considered in the analysis.
In a hybrid method, it is important to reconcile the preferred stock values to the most recent financing round. This process involves developing the future scenarios, as described above, and then calibrating the current equity values and probabilities for each scenario such that the value for the most recent financing equals the actual price.
Advantages and limitations of the Hybrid Method
An advantage of hybrid methods is that they take benefit of the conceptual framework of option pricing theory to model a continuous distribution of future outcomes and capture the option-like payoffs of the various share classes while also explicitly considering future scenarios and the discontinuities in outcomes that young companies experience.
A disadvantage could be that these models require a large number of assumptions and inputs and may be more complex. A tiny increase in precision may not justify such increased complexity.
The hybrid method has an excellent theoretical base and is a forward-looking methodology; however, applying the hybrid approach is more complex and time-consuming. So, do the incremental benefits of the hybrid method outweighs its complexity? Share your thoughts.