What is an option or right really worth?
05/04/2008
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Almost everyone engaged in reviewing executive remuneration is dissatisfied with how options and performance rights are valued. 

Currently an estimate of fair value is provided and used in the calculation of share based payments in executive pay tables.  While not the complete answer, it may be worthwhile speaking with your company’s favoured investment banker to replace a fair value calculation of options and rights with a market value.  In this article we discuss one way on how this might be achieved.

Regular readers of this Newsletter may recall the article in our July 2006 edition (HERE) on moves by Zions Bancorporation (“Zions”) in the US to develop “Employee Stock Option Appreciation Rights Securities” (ESOARS) as a market-based approach for valuing employee share-based payment awards under FASB Statement No. 123R, Share-Based Payment (this is the US equivalent to the Australian Accounting Standard AASB 2 Share-Based Payments, which requires expensing of options, rights and shares under employee equity plans).

In January 2007 the US Securities and Exchange Commission accepted that ESOARS could be used to provide a market price for FASB 123R purposes, as long as

1. the ESOARS were modified to eliminate the effect of possible forfeitures of the underlying employee options on investors in ESOARS (Zions had suggested two possible modifications to the auction process to achieve this); and

2. the ESOARS price is representative of the fair valuation of the underlying employee options.

The SEC recommended that each ESOARS auction be analysed to determine whether it results in the sale of ESOARS at what can truly be deemed market prices, having regard to factors such as:

• the size of the ESOARS offering relative to market demand
• the number of bidders (e.g. did a sufficient number of bidders participate in the auction?  Were they independent?)
• technology issues, including delays
• bidder perception concerning costs of holding, hedging or trading the instrument.

The SEC stated that the prices determined by the auction process for ESOARS need not replicate those produced by one or more models in order to be deemed suitable for use as estimates under FASB 123R, but noted that it may be useful when analysing auction results to compare the auction results with the estimated fair value derived through broadly accepted modelling techniques. The SEC letter to Zions outlining its decision can be found (HERE)

The SEC’s Office of Economic Analysis has indicated (refer to its memorandum of September 2005 HERE) that the use of an appropriate market instrument for obtaining an estimate of fair value has certain distinct advantages over a model-based approach, including:

• The market price can efficiently reflect a consensus view among informed market participants on the variables affecting the value

• The instrument’s price could establish the true opportunity cost of the award to the issuer by having it priced by the market

• Use of a market instrument may promote competition between different approaches to the estimation of the value of the market instrument and thereby lead to innovations in models and techniques used to price employee share options.

Not surprisingly, the US Council of Institutional Investors (which represents 140 public, corporate and union pension funds with combined assets of over US$3 trillion) has opposed the Zions approach, arguing that it is biased to producing lower valuations.

In Australia, little consideration seems to have been given to the possibility of developing a market-based approach to valuing employee equity grants (and there are obviously lots of practical hurdles to overcome) notwithstanding that AASB 2 requires the fair value of equity instruments granted to be based on market prices if these are available.  Only if market prices are not available is a valuation technique to be used to estimate what the price of those equity instruments would have been on the grant date in an arm’s length transaction between knowledgeable, willing parties (refer paras 16 and 17 of AASB 2).

Valuing equity for expensing purposes is one thing, and may not be such a big deal if it only affected corporate P&L accounts.  However, AASB 2 ‘fair values’ are used for remuneration disclosure and are increasingly being used for other remuneration purposes – to determine how many options will be granted for a given annual LTI value, in remuneration surveys and databases, to communicate the value of remuneration packages and in some cases as the basis for determining the rate of exchange between different forms of remuneration (e.g. salary or bonus for options or rights/shares). 

Companies and Directors need to work through the implications of using a particular valuation method before making decisions on which value to use for remuneration purposes.  Matters that need special consideration include:

• The fact that different expensing ‘fair values’ will be calculated for two otherwise identical options or performance rights if one is subject to a market performance condition such as relative total shareholder return (which is taken into account by reducing the fair value) and the other is subject to a non-market condition such as earnings per share growth (which is taken into account not by reducing the fair value but by estimating the number of options or rights that are likely to vest each year).  Dividing the annual LTI value by the expensing fair value to determine how many options or rights will be granted will produce different answers according to the nature of the performance condition used, irrespective of the relative degree of difficulty of the two tests

• While it makes good sense from the company’s perspective to reduce the value expensed because the existence of performance conditions lowers the probability the equity will vest, there is a good argument that the impact of performance conditions should be ignored when calculating LTI grant quanta: granting more options or rights because the performance condition reduces the fair value of each option or right effectively offsets/negates the point of setting the performance hurdle in the first place – and any share acquired by an executive when the performance condition is satisfied has the same value as any other share.

• Problems with consistency of grant quanta can be minimised if the valuation used to determine grants is consistent with the valuation used to collect the remuneration data referenced in salary reviews and the size of the LTI component of executive remuneration.

• At least where market performance conditions are used, companies should not change from determining grant quanta using share price (for rights) and Black Scholes value for options grants (each with no discount for performance conditions) to assess the AASB 2 fair value from one year to the next, because this may result in an arbitrary and unjustifiable increase in the number of rights/options granted.

© Guerdon Associates 2021
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