TLDR:
The Black-Scholes model is a mathematical framework for pricing European-style options, using factors like current stock price, strike price, time to expiration, volatility, and risk-free interest rate.
Key Inputs and Mechanics
Black-Scholes takes five inputs: current stock price (S), strike price (K), time to expiration (T), volatility (σ), and risk-free interest rate (r). The model assumes constant volatility, no dividends, efficient markets, and continuous trading. The output is the theoretical fair value of a European call or put option. The framework earned Robert Merton and Myron Scholes the 1997 Nobel Prize in Economics (Fischer Black having died in 1995).
Relevance to Startups
Black-Scholes is the standard methodology for valuing employee stock options (ESOs) for financial reporting under ASC 718 and tax purposes. Startups granting options must perform regular 409A valuations to set fair market value strike prices, and the Black-Scholes model is used to expense those options on financial statements over their vesting period. Inputs are adjusted to reflect startup-specific factors like high volatility and expected employee behavior.
Limitations
Black-Scholes has known limitations including its assumption of log-normal price distributions (which understates extreme events), constant volatility (volatility is observed to vary), and European exercise (only at expiration). For American-style options, employee stock options, and exotic options, modifications or alternative models (binomial, Monte Carlo) are often used.