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TRADITIONAL STOCK OPTIONS AWARD
Assumption Development
Both public and private organizations alike need supportable and auditable assumptions for use in an option pricing model. Our experienced actuaries and analysts can navigate through challenging data and valuation challenges to provide compliant solutions to FAS123(R) valuation. With any option pricing model, Black-Scholes, lattice model (binomial), hazard modeling, or Monte Carlo simulation, it is imperative to defensibly set accurate assumptions for exercise behavior or the expected life, expected volatility, and other critical assumptions. With our breadth of experience with Fortune 50 companies to smaller public and private organizations, Aon's consultants can help guide you to "best practices" in FAS123(R) valuation compliance.
Please see our Research Collection for further information on Best Practices in Assumption Development.
Model Selection
The Black-Scholes model continues to be the most prevalent valuation model disclosed in SEC Filings. As of December 17, 2007, however, more than 400 public companies have disclosed the use of a binomial model, including 82 members of the S&P 500.
Download a complete summary of companies that have publicly disclosed a binomial model.
There continues to be a trend of companies moving towards more sophisticated valuation techniques to capture the inefficiencies of the Black-Scholes model, to either a binomial model or alternatively the Aon Multiple Point Black-Scholes Model, which can effectively capture a distribution of exercise behavior around a single point. Aon believes in the transparency of all FAS123(R) valuations, and therefore we have published the mathematics of our models.
Please see our Research Collection for further information on The Mathematics of Aon's Models.
- The Mathematics of Aon's Models
- Aon Research Brief - Employee Stock Options:An Analysis of Valuation Methods
The Future of Option Valuation
One of the challenges in option valuation is that most companies do not have sufficient stock price paths to accurately develop exercise behavior under all possible scenarios. Further, companies change award provisions (vesting schedules, contractual terms), which modifies the underlying exercise behavior. Aon believes that through aggregation of data, the credibility and consistency of option valuation can be bolstered. Aon is very active with the Society of Actuaries who is currently studying how to aggregate employee exercise behavior into defensible tables of exercise behavior.
Read about the Society of Actuaries project on stock option valuation.
Back to topPERFORMANCE AWARDS WITH MARKET CONDITIONS
As the corporate world adapts to the regulatory requirement for the expensing of employee stock options, corporate boards and executives are searching for ways to control compensation expense, while still maintaining equity-based incentive plans that optimize and incent employees. Because FAS 123(R) no longer requires "variable" accounting for Performance Plans based upon stock returns have gained favor in the marketplace - described as "market conditions."
The most prevalent types of market-based conditions found in equity and cash plans can be described as Absolute performance plans and Relative performance plans. Absolute performance plans base vesting on the performance of the granting entity regardless of how the rest of the market performs. Relative performance plans compare returns of the granting entity to the returns of a selected group of peer companies. This type of plan is more complex but will protect employees in the case of a general market downturn because the company will only have to outperform its peers for the instrument to vest. Learn more about these awards at www.RelativeTSR.com
Read more about the mathematics behind these models.
MODIFICATIONS OF EQUITY AWARDS
Award modifications are becoming more commonplace in the FAS123(R) environment. Award modifications, however, create unique valuation and accounting challenges. Modified awards require that the fair value be determined immediately prior to the modification as well as immediately after the modification. However, since modified options generally are not "at-the-money", and do not generally have the full remaining contractual term, it can be challenging to pick reasonable assumptions for exercise behavior or an expected life. Some common approaches may be to use the simplified approach as defined by SEC Staff Accounting Bulletin #107 or Staff Accounting Bulletin #110, or the "Computed Expected Life" as defined by IRS Revenue Procedure 98-34 for use in the Black-Scholes model. However, both of those approaches were intended to be used for vanilla at-the-money options. A more sophisticated approach may be to thoroughly study exercise behavior through use of a lattice model, Monte Carlo simulation, or hazard model.
The most prevalent types of modifications that we see are:
- Extensions of the Exercisable Period post-termination (with knowledge of a terminating event) - Companies may extend the exercisable period for several reasons such as increasing post-termination compensation, or alternatively to allow for terminated executives to exercise when they may not have been able to due to a blackout period.
- Extensions of the Exercisable Period (absent knowledge of an impending terminating event) - Similar to the prior modification, an extension of the exercisable period may occur, however, in this case, it will be necessary to create a probability of termination. A company may want to look to its pre-vesting forfeiture rate (essentially a termination rate), for a possible alternative.
- Acceleration of Vesting upon Termination - Many companies may accelerate the vesting of non-vested awards for some employees. This would be considered a Type 3 modification (Improbable to Probable). Since immediately prior to the modification, the awards are non-vested and therefore have no value, and immediately after the modification, the awards are vested, an organization is required to take a charge for the full value of the awards post modification.
- Restructurings through acquisitions under FAS 141 purchase accounting and FAS123(R)- Upon an acquisition, many companies take on the outstanding equity awards of the acquired company with no change in provisions. The new awards are treated as a new grant and need to be valued on the conversion date, with consideration of each awards at-the-money level and the remaining contractual term.
- Assumptions for exercise behavior or an expected life-some common approaches may be to use the simplified approach as defined by SEC Staff Accounting Bulletin #107 or Staff Accounting Bulletin #110, or the "Computed Expected Life" as defined by IRS Revenue Procedure 98-34 for use in the Black-Scholes model.
ACCOUNTING AND RECONCILIATION OF FORFEITURE ESTIMATES
Companies are tasked to assume an estimated forfeiture rate on grant date. Ultimately, the actual awards that should be expensed will equal the number of awards that vest (absent any market conditions). There can be many challenges in the reconciliation of the assumed forfeiture rate with the actual experience.
Read about Aon's approach to FAS123R expense allocation in our Technical Roadmap to Expense Allocation. Our Consultants can help you with the challenges of FAS123R accounting.
ESPP VALUATION AND ACCOUNTING
Employee Stock Purchase Plans with lookback provisions have unique valuation considerations. Depending on the type of the award, the valuation may consider a share of stock, a Call option, a Put option, and interest foregone. FASB Technical Bulletin 97-1 provides further guidance for these instruments. Further, the accounting for modifications, resets, and reconciliation of assumed forfeiture rates can be challenging to administer. Our experts are equipped to handle these challenges for all types of plans.
INDIA FRINGE BENEFIT TAX
Many issuers who “pass through” the cost of the Fringe Benefit Tax liability to the option holders for future option grants will effectively be raising the exercise price of the underlying option. The variable or floating strike price will change based on different stock price appreciation scenarios. Since the strike price is not fixed, it generally requires a valuation technique that can handle a floating strike price. Generally, this is not available with the Black-Scholes model, and will likely require a Monte Carlo simulation to determine a fair value under FAS 123(R).
Read more about the valuation of options due to the Fringe Benefit Tax below.
SABBATICAL VALUATIONS UNDER EITF 06-02/FAS 43
Employers must accrue an expense for future sabbaticals or similar paid absences over the service period during which the benefits are earned, according to the Emerging Issues Task Force (EITF) Issue 06-2. EITF is part of the Financial Accounting Standards Board (FASB).
An employer should then determine the cost associated with its sabbatical or service award program. The proper valuation of the program under EITF 06-2 will require the use of actuarial methodologies and assumptions. These assumptions will include the incidence of retirement, termination of employment, death, and disability prior to eligibility for the sabbatical. Further, assumed rates of future salary increases will need to be reflected. Lastly, assumptions regarding the timing of taking sabbaticals will need to be reflected.
GOLDEN PARACHUTE ESTIMATES UNDER IRC 280G
Radford Consultants are prepared to support you with your reporting needs for Internal Revenue Code Section 280G, which requires the calculation of all payments contingent on a change in control - a golden parachute. Parachute payments can include severance benefits, health and welfare benefits, nonqualified pension benefits, and the accelerated value of any equity awards. Parachute payments in excess of the Base Amount (effectively a five-year pay averaging) are not tax-deductible, and Section 4999 imposes a 20 percent excise tax on the recipient of any excess parachute payment. Our team has the expertise to help you understand and manage the 280G reporting process, ensuring proper compliance.