Pay vs. Performance Disclosure Requirements: Expected term of option grants, simple or not?
Estimated reading time: 1.5 minutes
Over a decade after the Dodd-Frank Act obligated them with the task, the SEC adopted pay-versus-performance amendments to the Securities Exchange Act of 1934. In this update to our recent article overviewing disclosure requirements, we address the challenge of developing and supporting the expected term used in the Black-Scholes Option Pricing Model to determine the fair value of grants to Principal and Named Executive Officers.
Plain Vanilla Grants and the Simplified Method
The Simplified Method, as provided by the SEC in SAB No. 109 in 2009, is familiar to most as the most practical method to develop the expected term for basic options that are issued with a strike price equal to the fair value of the underlying security at the time of issuance (”plain vanilla” options).
This allows for the term to be calculated as the average period of time between the vesting date of the grant and its expiration (e.g., 4-year cliff vest, 10-year life resulting in a 7-year term) is dependent on the grant being at-the-money at issuance.
Pay-Versus-Performance Fair Value Disclosures
With Pay-Versus-Performance disclosure requirements applicable to reporting dates subsequent to the at-the-money grant date, the Simplified Method cannot be relied upon as the in-the-moneyness or out-of-the-moneyness of the grant disqualifies its treatment as a plain vanilla option (at-the-money).
Why is the Simplified Method no longer available? Expected exercise behavior for at-the-money options is different than for deeply in or out-of-the-money options. That is, the expected term of a deeply in-the-money option with a strike price of $10.00 per share and a current stock price of $100.00 per share will be different from a deeply out-of-the-money option with a strike of $10.00 per share with a current stock price of $2.00.
The best practice is to determine the expected term using a Lattice Model structured to consider the remaining vesting conditions of each grant, the contractual term of the option, and the “moneyness.”
Proxy season is upon us, and VRC’s Complex Securities Practice Group together with its valuation teams supporting the fair value needs of more than half of the Fortune 500, are coordinating to address Pay versus Performance Disclosure Requirements. Our team offers deep experience valuing complex securities, including credit/debt instruments, derivatives, equity, and structured products. We welcome you to contact article authors Frank Mainville, Kevin Gawron, or any VRC professional for further expert views and assistance with share-based compensation considerations and other questions you may have.