Intrinsic value is the excess amount of the fair value of a share over the exercise price of an underlying stock option, multiplied by the number of shares into which the instrument converts. The concept is used in the recognition of the value of an issued stock option.
Example of Intrinsic Value
Luminescence Corporation is a privately-held company. It issues a $5,000,000 convertible debt instrument that can be converted to the company’s common stock in two years at a conversion price of $12 (which is also the current fair value of the stock). There is an additional provision in the debt agreement that the conversion price drops to $8 in 18 months if Luminescence does not complete an initial public offering by that date.
The intrinsic value of the conversion option is calculated as follows:
(Funding obtained ÷ Final conversion price) × Difference in conversion prices)
= ($5,000,000 ÷ $8) × ($12 - $8) = $2,500,000
Luminescence should recognize the intrinsic value of the conversion option when it issues the convertible instrument.