RADFORD REVIEW. When Expected Life Isn t As Expected. Transitioning from Topic 718 to IFRS2 and Multiple Tranche Expected Life
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1 RADFORD REVIEW The valuation of employee stock options with graded vesting will change significantly with IFRS2 When Expected Life Isn t As Expected Transitioning from Topic 718 to IFRS2 and Multiple Tranche Expected Life This Radford Review is the first in a series of white papers focusing on the valuation side of the conversion from Topic 718 (formerly FAS 123R) to IFRS2. Throughout the series we will examine an issue and provide analysis, examples, and practical solutions for addressing each challenge. This first white paper addresses the fair value measurement of stock options, in particular the development of an expected life assumption for the Black- Scholes model. The valuation of employee stock options with graded vesting will change significantly with IFRS2. Under Topic 718, companies had a choice between valuing the entire award using a single set of weighted-average assumptions or developing a fair value for each tranche of the award. The vast majority of companies chose the simpler single-valuation approach. This choice disappears with the conversion to IFRS2 forcing all awards with graded vesting to apply the multiple valuation approach. While the valuation of each tranche should not present a challenge to most administrative systems, the development of separate assumptions may prove more difficult. Companies currently using a binomial or lattice model should not encounter much difficulty developing tranche-level fair values. In fact, those using the Black-Scholes formula should be able to make simple adjustments to the measurement of the economic assumptions (volatility, risk-free rate, and dividend yield) to satisfy this requirement. However, the challenge lies in the development of the expected life for each tranche for use with Black- Scholes. Most companies develop a single expected life assumption from historical experience. This Radford Review examines three reasonable approaches companies can undertake to develop an expected life for each tranche: 1. Time After Vest Adjustment 2. Ratio Adjustment 3. First-In, First-Out (FIFO) Radford is an Aon Consulting Company
2 Page 2 In order to better illustrate each method, we will utilize a simple example based on a grant of 20,000 options on January 1, 2001 that vests annually over four years and has exercises and cancellations: The Time-After-Vest Adjustment approach is the most straightforward and simplest to apply Type Number Transaction Date Time Since Grant Exercise 5,000 April 1, years Exercise 2,500 September 1, years Exercise 7,500 May 1, years Cancelation 5,000 July 1, years Totals 20, years Approach 1: Time-After-Vest Adjustment The Time-After-Vest Adjustment approach is the most straight-forward and simplest to apply. It relies on adjusting the single weighted-average expected life assumption for the difference in the post-vesting exercisable period. The adjustment is determined by subtracting the weighted average vesting period from the single weighted-average expected life assumption. This adjustment or post-vesting holding period is then added to the vesting period to determine expected life of each tranche. Adjustment = Weighted-Average Expected Life Average Vesting Period Tranche-Level Expected Life = Vesting Period + Adjustment In the example above, the Adjustment is equal to 3.65 years minus the average vesting period of 2.5 years, or an average time after vest of 1.15 years. The expected life assumption for each tranche would be as follows: Vesting Expected Life Tranche Period Adjustment Assumption 1 1 year 1.15 years 2.15 years 2 2 years 1.15 years 3.15 years 3 3 years 1.15 years 4.15 years 4 4 years 1.15 years 5.15 years Average 2.5 years 3.65 years The Ratio Adjustment has the effect of stretching or squeezing the exercisable period While this approach is simple to administer, it is not without its downside. The major shortcoming with the Time-After-Vest adjustment arises when there is a change in the contractual term. The adjusted records may be lacking exercise behavior towards the end of the contractual term if the exercisable period lengthens. The opposite can be true if the exercisable period shrinks, which is common when the contractual term is shortened. Many of the records may need to be truncated to the contractual term. Both of these situations can create a bias in the resulting expected life.
3 Page 3 Another issue that can arise with the Time-After-Vest approach is when the expected life of a record is shorter than the average vesting time. This can occur due to an early exercise provision or due to an exercise from one of the earlier tranches in an award with a graded vesting scheme. Both of these scenarios would result in the adjusted expected life being less than the vesting period, which cannot occur in a cliff vesting scheme unless there is an early exercise provision in the new grants. The best way to deal with these potential issues is to apply a minimum and a maximum to force the records adjusted lives to fit within the allowable exercisable period, potentially creating a bias. Approach 2: Ratio Adjustment The Ratio Adjustment approach is slightly more complex than the Time-After-Vest Adjustment approach. The Ratio Adjustment has the effect of stretching or squeezing the exercisable period. The first step is to calculate the ratio of the assumed post-vesting holding period over the total post-vesting holding period using the single-weighted average approach: The FIFO approach is a data intensive analysis of historical experience on a tranche level basis, whereas the prior two methods rely on adjustments Ratio = Expected Life Average Vesting Period Contractual Term Average Vesting Period The second step is to apply this ratio to the post-vesting holding period of the individual vesting tranche: Post-Vesting Holding Period = Ratio x (Contractual Term Tranche Vesting Period) The final step is to add this new post-vesting holding period to the vesting period to obtain the expected life per tranche: Tranche Expected Life = Vesting Period + Post-Vesting Holding Period In the example above, the Ratio is the same average time after vest of 1.15 years shown above divided by post-vesting exercisable period of 7.50 years (10 minus 2.5) or 15.3%. The expected life assumption for each tranche would be as follows: Post-Vesting Holding Period Expected Life Assumption Vesting Exercisable Tranche Period Period 1 1 year 9 years 1.38 years 2.38 years 2 2 years 8 years 1.22 years 3.22 years 3 3 years 7 years 1.07 years 4.07 years 4 4 years 6 years 0.92 years 4.92 years Average 2.5 years 3.65 years
4 The biggest potential issue with the Ratio adjustment is data integrity. A common practice used by administration systems is to adjust the expiration date after a termination event to reflect a shortened exercisable period. If this adjusted expiration date is used in lieu of the original, it can cause the ratio adjusted expected life to go askew. And similar to the Time- After-Vest Adjustment approach, if the expected life is less than the average vesting period it can lead to an unrealistic assumption. Approach 3: First-In First-Out (FIFO) The FIFO approach is a data intensive analysis of historical experience on a tranche level basis, whereas the prior two methods rely on adjustments. The data is broken down to the finest tranche level granularity before being analyzed. When an exercise occurs, it is assigned to the first tranche up to the number that would have vested and then allocated to the next level until exhausted. Page 4 The FIFO method arguably leads to the most precise alignment of historical experience with the tranche level assumption setting requirement In the example above, the exercises and cancellation are broken into the following tranches: Type Number Transaction Date Period Tranche Exercise 5,000 April 1, years 1 Exercise 2,500 September 1, years 2 Exercise 7,500 May 1, years 2 and 3 Cancelation 5,000 July 1, years 4 The expected life for each tranche would be calculated as follows (note the blended weighting required for Tranche 2): Expected Tranche Historical Experience Weighting Life Assumption years 100% 1.25 years years 50% 4.33 years 50% 3.50 years years 100% 4.33 years years 100% 5.50 years Average 3.65 years This method arguably leads to the most precise alignment of historical experience with the tranche level assumption setting requirement; however, one significant issue that may arise with this approach is how well historical vesting schedules match up with the vesting schedule of the new awards. If the historical granting practices were three-year annual and the current awards are four-year annual, then there is a new tranche not covered by historical data and therefore must be estimated using other means. If this situation arises, the approach shown above could be altered slightly to allow for an adjustment of the allocation and weighting of the historical experience in order to properly align with the newly issued options.
5 Page 5 Conclusion In this Radford Review we outlined the challenge of moving from developing a single weighted-average expected life assumption to multiple expected lives for each tranche of an award. We reviewed three reasonable approaches companies may consider using. As the table below shows, each method leads to slightly different assumptions for each tranche, but the same average: Approaches (in Years) Tranche Time-After-Vest Ratio FIFO Average However, this will not always be the case. In our simple example, we did not consider the impact forfeitures will have on the analysis of historical experience. Stay tuned for future Radford Reviews where we will examine this issue in depth in addition to a discussion of lattice-based assumptions and other IFRS2 valuation challenges. Jon W. Burg, FSA Vice President About the Authors Jon is vice president and West Coast Practice Leader of Radford Valuation Services, the equity valuation group of Aon Consulting. He has eleven years of pension consulting experience, including an emphasis on equity compensation in the last five years. Jon has a track record of working with companies on the plan design, valuation, and financial management of their retirement and equity compensation programs. He leverages an extensive actuarial background in analyzing historical plan experience and performing complex valuations to apply an added rigor and discipline to the world of equity compensation. He collaborates directly with audit and compensation committees to develop sound equity compensation design, practices and procedures. Prior to joining Radford, Jon served as a pension actuary for JPMorgan Compensation and Benefit Strategies and as National Practice Leader of their FAS 123(R) consulting practice. Jon earned a bachelor of science in mathematics and economics from the University of Washington. He is a Fellow of the Society of Actuaries and an Enrolled Actuary. Jon speaks on a variety of equity compensation topics at industry events in addition to local and national NASPP meetings. He is based in San Francisco.
6 About the Authors (continued) Colin J Donnelly Assistant Vice President Colin is an assistant vice president with Radford Valuation Services, the equity valuation group of Aon Consulting. He has more than 11 years of benefits and consulting experience. Colin works directly with employee stock option (ESO) and Employee Stock Purchase Plan valuation clients in analyzing stock option data, performing statistical analysis, developing assumptions, and producing financial reporting information under FAS 123 and FAS 123(R). He has been integral in the development of the Aon Actuarial Binomial Model. Colin also works with clients in measuring the impact of plan design changes. Clients on which he has consulted include 3M, US Bancorp, UnitedHealth Group, and Wells Fargo. Colin has extensive experience as a defined benefit retirement plan analyst, performing benefit calculations for AmerisourceBergen and IKON Office Solutions. He has participated in numerous plan design studies and government testing of 401(k) and 403(b) plans. Colin majored in mathematics at Drexel University and holds the Certified Equity Professional (CEP) designation. He is based in Philadelphia. About Radford Contact Us For more information on Radford, please contact us at: Toll-free in No. America: consulting@radford.com Locations For more than 35 years, Radford has provided compensation market intelligence to the technology and life sciences industries. Global survey databases, which include 3.6 million incumbents, offer current, reliable data to nearly 2,000 clients. Leveraging Radford survey data, our thought-leading global Radford Consulting team creates tailored solutions for the toughest global business and compensation challenges facing companies at all stages of development. In addition to our consulting team, we also offer equity valuation assistance via Radford Valuation Services, and leading-edge market analyses and survey services with Radford Analytic Services. Radford's suite of surveys includes the Global Technology, Sales, and Life Sciences Surveys, as well as the US Benefits Survey. For more information on Radford, please visit About Aon Consulting Aon Consulting is among the top global human capital consulting firms, with more than 6,300 professionals in 229 offices worldwide. The firm works with organizations to improve business performance and shape the workplace of the future through employee benefits, talent management and rewards strategies and solutions. Aon Consulting was named the best employee benefit consulting firm by the readers of Business Insurance magazine in 2006, 2007, 2008 and For more information on Aon Consulting, please visit Atlanta, Austin, Boston, Chicago, Denver, Hong Kong, London, New York, Philadelphia, San Diego, San Francisco, San Jose, Washington, D.C.
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