How does Pluris value stock options for financial reporting purposes?
We follow the guidance of ASC 718 (FAS 123R) for valuing employee stock options for financial reporting purposes. We use either closed-form methods, such as the Black-Scholes model, or theoretical models, such as the binomial models. Employee stock options are not valued at a discount from the model values. Rather, the valuation analysis attempts to allow for shorter effective times to expiration in the models.
Why are these stock options valued in such a different way from how non-qual options are valued for tax purposes?
ASC 718 (FAS 123R)’s “fair value” standard is different from the “fair market value” standard determined under the tax rules. In arriving at the valuation guidelines in ASC 718 (FAS 123R), the FASB determined after a lengthy debate that the effect of the illiquidity of these options was best determined by modeling the “early exercise” behavior of employees who are granted options.
The FASB’s goal with ASC 718 (FAS 123R) was not to value amounts transferring in taxable transactions, but rather to estimate the compensation expenses associated with employee stock-option grant programs. This is the main reason for the difference.
What is ASC 718 (FAS 123R)?
Statement of ASC 718 (Financial Accounting Standard No. 123R “Share-Based Payment” is the revised version of FAS 123). It sets forth in great detail the FASB’s views on how to determine the compensation expenses companies should take on their income statements when issuing stock options to their employees.
How does the ASC 718 view binomial model valuations?
The earlier version of ASC 718 (FAS 123) required public companies to use the binomial models over the closed-form models unless there were compelling reasons not to. The revised standard, in its implementation guidance, retains an implicit preference for the binomial models, due to their greater ability to provide more sophisticated modeling of actual real-world employee behavior with respect to early exercise. In the binomial models, early exercise is assumed to be a function of stock price trends, while in the closed-form models, a set expected time to expiration is assumed.
What are the main reasons for choosing the binomial model over “closed-form” models?
The binomial models are far more sophisticated and provide a much more accurate gauge of the magnitude of the stock-option compensation expenses. Thus, the financial reporting of the company provides better information to investors. The main drawbacks of the binomial models are complexity and the added cost of the valuation. Pluris performs option valuations using both kinds of models, and other models, such as Monte-Carlo simulation, as necessary.
How is the time to expiration estimated?
Generally speaking, in the closed-form models, the expected time remaining on the options should be based on actual early-exercise behavior of the company’s employees. However, many companies do not have enough information to estimate this with any certainty, especially if their stock-option grant programs are recently implemented. In those cases, the mid-point between the vesting date of the options and the last possible date of exercise is sometimes used.
How is the volatility estimated?
The volatility of the stock should be based on the actual stock price history of the company, or on guideline companies for private or recently public companies. Certain supplementary analyses may also be performed, such as an analysis of possible “reversion to the mean” and an analysis of past extraordinary events that may have influenced historical volatility statistics.