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Expert Witnesses

INTRODUCTION

The Securities and Exchange Commission, on March 29, 2005, released its Staff Accounting Bulletin No. 107 (SAB 107). This bulletin provides guidance as to what the SEC Office of the Chief Accountant and Division of Corporation Finance deem to be the proper methodology, for financial reporting purposes, for valuing stock options issued by corporations to employees. This article will set forth a summary of the key points of guidance pertaining to option valuation to be found in the Bulletin.

BACKGROUND

The question of whether or not to expense employee stock options for accounting purposes gave rise to a long-running debate in the business and financial community. This debate, for practical purposes, came to an end with the issuance, by the Financial Accounting Standards Board, of its Statement of Financial Accounting Standards 123R (FAS 123R) in December, 2004. In a nutshell, FAS 123R requires, for financial reporting purposes, that companies expense stock options issued to employees. The options are expensed by determining their “fair value” at the time of issuance, and then recognizing this amount over the period during which the options are vested by the employee. The expensing of employee stock options will become mandatory for public companies for interim or annual reporting periods beginning after June 15, 2005.

“A necessary part of the process of expensing employee stock options is determining their value at the date of issuance.”

A necessary part of the process of expensing employee stock options is determining their value at the date of issuance. The most common way in which stock options are valued is by use of a mathematical formula known as the Black-Scholes Model (sometimes also called the Black-Scholes-Merton Model). The primary inputs to this formula are the following; the exercise price of the option, the market price of the underlying stock, the term of the option, and the volatility of the market price of the underlying stock. The formula also takes into account the risk-free interest rate and, if the underlying stock pays a dividend, the dividend rate.

The interplay of these inputs can be shown with a simple illustration. Assume that Acme Systems Company has an option outstanding on its common stock which allows the holder, upon exercise, to buy the stock for $50 per share at any time over the next ten years, whereupon the option expires. Assume further that Acme Systems stock currently trades for $45 per share, and that its market price volatility is 30%. If we plug the above information into the Black-Scholes formula, assuming a risk free rate of 5% and no dividend on the Acme common, the current value of the option works out to be $22.16 per share.

The sensitive variables in the above calculation are the market price of the stock, the term of the option, and the volatility of the market price of the stock. The value of the option varies with each of these as follows. The higher the market price of the stock, the higher is the value of the option. This is true because as the price of the stock rises, the option becomes a claim on a more valuable asset. Similarly, the longer the term of the option, the more valuable it becomes. This is true because, with a longer term, there is more of an opportunity for the market price to exceed the exercise price of the option. Finally, the greater the volatility of the market price of the underlying stock, the greater is the value of the option. This is true because a more volatile stock is likely to experience wider price swings, and (upward) price swings are what make options valuable. The table below shows the effect on the value of our Acme Systems option of changes in each of the three sensitive variables.

Stock price	Term	Volatility	Option value
$45	10 yrs	30%	$22.16
50	10	30	26.30
45	15	30	27.75
45	10	45	27.63

The Black-Scholes Model was originally developed to value stock options of the type which are traded in the public markets. It has been widely adopted in this context. By extension, it has been put into service in valuing the non-traded options normally used in employee compensation plans. There are two key differences, however, between the typical employee stock option and a publicly traded option. First, employee options are not normally exercisable by the employee until they are earned, usually by the employee remaining employed through a vesting period. Second, once the option is vested, it may not be sold by the employee, it may only be exercised. If the employment of an employee holding vested options is terminated, he is usually obliged to exercise the options immediately (within 30 to 90 days), regardless of their remaining term. Because of these differences, the determination of the term of an employee stock option for valuation purposes is not quite as straightforward as it is for a publicly-traded option. It requires a certain amount of management judgment. The application of this management judgment is one of the subjects dealt with in the SEC’s SAB 107. Another part of the employee option valuation process requiring management judgment is the selection of the volatility factor. This has also been addressed by the SEC. We will now turn to SAB 107 and look at its key provisions.

KEY VALUATION GUIDANCE POINTS OF SAB 107

General Principles

In addressing the overall approach to option valuation, the SEC staff states its recognition that there is a range of reasonable conduct that an issuer might use in valuing employee stock options. It goes on to say that differing methodologies or conclusions by different issuers in a given situation do not in and of themselves indicate that any of the issuers are acting unreasonably. (p.5)(page references are to SAB 107)

The staff sets forth the proposition “that there is a range of conduct that a reasonable issuer might use to make estimates and valuations” in implementing FAS 123R. It goes on to say that “(w)hile the zone of reasonable conduct is not unlimited, the staff expects that it will be rare when there is only one acceptable choice in estimating the fair value of share-based payment arrangements … in any given situation.” (p.5)

The Bulletin makes it clear that the valuation point is the date of grant of the option, and that “the estimate of fair value should reflect the assumptions marketplace participants would use in determining how much to pay for an instrument on the date of the measurement…” It goes on to eschew Monday morning quarterbacking of valuations by saying “As long as the share options were originally so measured, changes in an employee share option’s value, no matter how significant, subsequent to its grant date do not call into question the reasonableness of the grant date fair value estimate.” (p.13)

Choice of Valuation Techniques

SAB 107 does not specify any particular valuation technique or model. What it does require is that the technique “(a) is applied in a manner consistent with the fair value measurement objective… of FAS 123R, (b) is based on established principles of financial economic theory and generally applied in that field and (c) reflects all substantive characteristics of the instrument.” (p. 13) The relevance of requirement (c) above is illustrated with the case of an option in which exercisability is conditioned on a specific price increase in the price of the underlying shares. Since the standard Black-Scholes Model does not take into account such a condition, it would not be an appropriate model to use. (p.14)

The staff does not object to a company changing its valuation technique or model, however it would not expect a company to frequently switch between techniques, particularly when there is no change in the terms of the option. (p.15)

“It does require, however, that the valuation ‘be performed by a person with the requisite expertise.’”

The SAB does not require that a company hire an outside third party to value its options. It does require, however, that the valuation “be performed by a person with the requisite expertise.” (p. 16)

Expected Volatility

Volatility is a measure of the amount by which a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility). Option pricing models require an estimate of expected volatility as an input. As stated earlier, all things being equal, an option on a share with high volatility is worth more than an option on a share with lower volatility.

The sources of information that can be used to develop an estimate of expected volatility include the following:

• Historical volatility of the company’s underlying stock.
• Implied volatility (derived from market price of other derivative securities of the company).
• Historical, expected or implied volatilities of other similar entities whose share prices are publicly available.

FAS 123R indicates that in using historical volatility data, companies should use a historical period of a length generally commensurate with the term of the option. The SEC staff believes that a company may use a period of historical volatility data which is longer than the expected or contractual term of the option, if it reasonably believes that the additional data will improve the estimate. (p. 20)

Regarding the frequency of price observations, the staff believes that daily, weekly or monthly observations are sufficient if the history is long enough to provide enough data points on which to base the estimate of volatility. In the case of a thinly traded stock, the staff believes that weekly or monthly price observations would be more appropriate. Daily observations could lead to an artificially inflated volatility due to a larger bid-ask spread and lack of consistent trading. (p.21)

If there are future events in view that a marketplace participant would reasonably consider in determining the value of an option (such as a merger), the staff believes that such events should be considered in estimating expected volatility. (p.21)

The staff believes that, in rare instances, a period of historical volatility data may be excluded as not being relevant. (p.22)

The staff sets forward a number of considerations to be kept in mind when using implied volatilities derived from the trading prices of other derivative securities issued by the company. First, there should be sufficient trading volume in these, and the underlying securities. Second, the price data should be close in time to the option grant date. Third, the exercise price of the traded option should be close to the exercise price of the employee option. If a close match is not available, two options whose exercise prices bracket the employee option’s exercise price can be used and averaged. Finally, if a traded option is used, it should ideally have a similar term to the employee option. If no such options are available, the staff believes that the traded options should have a term of six months or greater. Furthermore, in using traded options with a term of less than one year, the staff would expect the company to consider other relevant information in estimating expected volatility. (p.24)

A company which is private or newly-public and which therefore has no historic volatility data for its stock price may base its estimate of expected volatility on volatility data of similar entities whose shares are publicly traded. The staff cautions, however, against using the volatility of an industry index because of the effects of diversification that are present in such an index. (p.29)

Expected Term

The value of a traded stock option is based on its contractual term. This is true because it is rarely advantageous for a holder to exercise such an option prior to its expiration. Employee stock options differ from traded options in that employees cannot sell (or hedge) their share options, they can only exercise them. Therefore, employees normally exercise their options prior to their expiration. This reduces the option’s value, since early termination eliminates its remaining life and remaining time value. Accordingly, FAS 123R requires that a valuation of an employee option using the Black-Scholes model be based on its expected term rather than its contractual term.

The SEC staff believes that the estimate of expected term should be based on the facts and circumstances available in each particular case. (p.31) The company may use its historical stock option exercise experience. (p.34) If, however, the company concludes that its historical experience does not provide a reasonable basis upon which to estimate expected term, other sources of information may be used such as industry averages or published research. (p.35)

“The staff also sets forth a ‘simplified’ formula for calculating expected term.”

The staff also sets forth a “simplified” formula for calculating expected term. This is set forth for the benefit of companies issuing “vanilla” stock options, using the Black-Scholes valuation model, and having difficulty finding other exercise data. The formula is that the expected term equals the average of the original contract term and the average vesting term. If, for example, the original contract term is 10 years, and the average vesting term is 3 years, the expected term under the formula would be 6 ½ years. (p.36)

The staff makes it clear that it is not appropriate to apply an additional valuation discount to the value of an employee stock option to reflect the effects of nontransferability and nonhedgability. It is their view that these factors are already incorporated in the expected term assumption. (p. 31)

Similarly, the staff states that forfeitability should not be factored into the determination of expected term. These pre-vesting restrictions are taken into account by ultimately recognizing compensation cost only for awards for which employees render the requisite service. (p. 32)

CONCLUSION

The SEC, in SAB 107, seems to be following a flexible approach to the valuation of employee stock options, with the emphasis on “getting it right” rather than tying registrants to rigid cookbook procedures. They show deference to the methods that would be used by reasonable buyers and sellers to determine value in the financial marketplace. They also convey the sense that the methodology of valuing employee stock options is a work in progress, and that we will see changes and refinements in these guidelines as time passes and experience is gained.

Hempstead & Co. is a financial consulting firm providing services in the following areas:

• Valuations of Businesses and Corporate Securities
• Valuations of Stock Options
• Valuations of Intangible Assets
• Loss of Business Damage Analysis
• Mergers & Acquisitions

The members of our professional staff have backgrounds in valuation, finance, accounting, economics, engineering, and investment banking. Professional designations include Accredited Senior Appraiser, American Society of Appraisers (ASA), and Chartered Financial Analyst (CFA). We welcome the opportunity to serve you. Please call Mark Penny at (800)541-3323 or contact him via e-mail at jmpenny@hempsteadco.com.