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Over the years, we have assisted numerous clients with the valuation of stock
options and restricted stock. We have found in the course of our engagements
that companies often don’t understand upfront the overall costs of issuing
share-based compensation. Different terms and conditions can affect both the
timing and magnitude of option expense. The frequency of grants can increase
both the valuation costs and the accounting effort to comply with SFAS 123(R).
Compensation committees can do a better job aligning the costs and benefits of
their share-based compensation plans by understanding how specific grants will
affect the P & L over time. Issues a compensation committee should address
include the following: 1. ACCOUNTING TREATMENT
Will the awards be classified as equity or liabilities? Equity awards are
valued at the grant date, while liability awards are valued at each reporting
date.
2. CONTRACTUAL TERM
Most option awards have a 10-year contractual term, but only a handful of
employees hold their options for much longer than the vesting life. One factor
to consider is whether grants should have various terms for different employee
levels. Shorter option terms can reduce option expense without being generally
perceived as having less value.
3. VESTING CONDITIONS
Service and performance conditions are the most common vesting conditions.
Options are expensed only when the conditions are met.
Performance conditions are usually based on annual targets (e.g., revenues,
EBITDA) to be met over a period of some years. If the targets are set at the
outset for the entire vesting period, then the options can be valued at the
grant date. But if the targets are to be set annually, the options must be
valued each time a target is set. Further, if the performance is tied to the
underlying value of the company, then the condition is actually a market
condition.
Market condition awards vest based on the achievement of a target share price
(or total equity value). They are expensed whether or not the price (or equity
value) condition is met.
Depending on the relationship between the company’s current value and the target
value, the expense may be very large and would need to be taken over a short
period of time (if the targets are set too close to the current value and/or the
company’s volatility is very high), or may be small and could be expensed over a
long period of time (if the targets are set far from the current value and/or
the company’s volatility is very low). In either case the valuation of a market
condition option is generally a costlier undertaking than the valuation of
options with performance or service conditions because it almost always requires
Monte Carlo simulation in a customized model.
We have a number of clients whose boards have issued a market condition award
to only one or two senior executives, for a small number of shares, only to be
surprised by the high ratio of valuation expense to compensation expense.
4. MODIFYING STOCK OPTIONS
We have been involved in engagements where the client re-issues existing
stock options with a lower strike price. What companies often do not realize is
that this modification requires that the stock options, and possibly the
underlying shares, would need to be revalued. It also increases stock option
expense in the income statement.
5. TIMING OF OPTION AWARDS
Another issue that can have ramifications, particularly for privately-held
companies, occurs when a company grants stock options randomly throughout the
year, i.e. not at a single annual grant date. Even for a closely-held firm which
has its shares valued annually, if there has been a significant company, market
or industry event which impacts the company’s value it may need to commission
one or more additional stock valuations. We recommend that closely-held
companies issue share-based compensation in connection with annual or other
periodic share valuations.
6. RESTRICTED STOCK
According to SFAS 123(R), nonvested shares granted to employees generally are
referred to as restricted shares. Under SFAS 123(R), restricted shares are
expensed when vested at their fair value on the grant date. Private companies
may need a share valuation as of the grant date. If the shares vest based on a
market condition, they will also need a valuation of the specific grant which
takes into account not only the share value on the grant date, but the
possibility of the future vesting and value of the shares in the future.
RELY ON THE EXPERTS
The total cost of share-based compensation can and should be understood by
compensation committees. We recommend consulting with a valuation expert prior
to making new types of share-based grants, or restructuring existing
compensation schemes. The valuation professionals at VRC have extensive
experience valuing various forms of share-based payment. For more information
contact your Valuation Research representative or Summer Parrish at
609-243-7009. VR
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