Valuation Assistance with the Complexity of ASC 718

Transcription

1 Valuation Assistance with the Complexity of ASC 718 Stock-based compensation generally consists of either the transferring of stock or the issuance of stock options to an employee, officer of a company, board member or independent contractor. Nearly eight years after it was issued, the application of FASB Statement No. 123(R), Share-Based Payment, now referred to as Accounting Standards Codification Topic 718, Compensation - Stock Compensation (ASC 718), continues to be a complex undertaking from an accounting and/or valuation standpoint. FASB ASC 718 was effective in Aside from its name, ASC 718 is identical to FAS 123(R), which was effective in FAS 123 was effective in 1994 and superseded Accounting Principles Board Opinion No. 25 (APB 25), which was issued in October From a valuation standpoint, the primary change from APB 25 and FAS 123 to FAS 123(R) was that for most situations the option needed to be accounted for at fair value at the grant date. Previously, most options were accounted for using the intrinsic value, which is the difference between the fair value of the underlying share and the exercise price to acquire the share. This meant that in most cases, given that the exercise price was equal to or greater than the underlying fair value of the share, the options were granted without any expense recognition before FAS 123(R) was issued. The measurement objective for equity instruments awarded to employees is to estimate the fair value at the grant date of the equity instruments that the entity is obligated to issue when employees have rendered the requisite service and satisfied any other conditions necessary to earn the right to benefit from the instruments (for example, to exercise share options). To satisfy the measurement objective, the restrictions and conditions inherent in equity instruments awarded to employees are treated differently depending on whether they continue in effect after the requisite service period. a. A restriction that continues in effect after an entity has issued instruments to employees, such as the inability to transfer vested equity share options to third parties or the inability to sell vested shares for a period of time, is considered in estimating the fair value of the instruments at the grant date. For equity share options and similar instruments, the effect of nontransferability is taken into account by reflecting the effects of employees expected exercise and post-vesting employment termination behavior in estimating fair value (referred to as an option s expected term). b. In contrast, a restriction that stems from the forfeitability of instruments to which employees have not yet earned the right, such as the inability either to exercise a nonvested equity share option or to sell nonvested shares, is not reflected in estimating the fair value of the related instruments at the grant date. Instead, those restrictions are taken into account by recognizing compensation cost only for awards for which employees render the requisite service. Valuation Transaction Consulting Real Estate Advisory Fixed Asset Management 2013 American Appraisal

2 Awards of share-based employee compensation ordinarily specify a performance condition or a service condition (or both) that must be satisfied for an employee to earn the right to benefit from the award. No compensation cost is recognized for instruments that employees forfeit because a service condition or a performance condition is not satisfied (that is, instruments for which the requisite service is not rendered). Some awards contain a market condition. The effect of a market condition is reflected in the grant-date fair value of an award. Compensation cost thus is recognized for an award with a market condition provided that the requisite service is rendered, regardless of when, if ever, the market condition is satisfied. ASC 718 (SFAS 123R) relates to all share-based payment. It focuses primarily on accounting for transactions in which an entity obtains employee services in exchange for a share-based payment, such as stock, options, appreciation rights or any other form of equity-based instrument. ASC 718 applies to all transactions in which an entity acquires goods or services by issuing its shares, share options or other equity instruments, or by incurring liabilities based on the price of its shares. The controversy with expensing stock options is that the value of an option is, in some fundamental sense, speculative. Exchange-traded options have a value set by a (generally) liquid and transparent market. Participants in options markets have developed a set of tools for valuing options, which are more or less regarded as useful. However, employee stock options are not exchange-traded and have a number of features that make them different. Exchange-traded options are generally for a short term, and the option holder s ability to exercise is completely unrestricted. A typical employee stock option has a term of up to 10 years, and frequently includes a vesting provision. It will also, typically, have a provision requiring exercise within, say, 90 days of termination of employment. There will also be blackout periods and insider trading restrictions on exercise. These and other features of employee stock options make their valuation much more complicated than the valuation of exchange-traded options. To meet the fair value measurement objective, a model must be applied in a manner consistent with ASC 718, be based on established principles of financial economic theory and reflect all substantive characteristics of the instrument. The fair value of a stock option granted by an entity shall be estimated in accordance with ASC 718 by an option-pricing model that takes into consideration, as of the grant date, the following factors: Exercise price of the option Expected life or term of the option, taking into account both the contractual term of the option and the effects of employees expected exercise and post-vesting employment termination behavior Current price of the underlying stock Expected volatility of the underlying stock Expected dividends on the stock The risk-free interest rate for the expected term of the option Consideration of performance, service and market conditions ASC 718 and the SEC s Staff Accounting Bulletin (SAB 107) state that there is no preferred model or valuation technique. ASC 718 suggests use of a closed-form model/black-scholes or a lattice model/binomial, which may include Monte Carlo simulation (discussed later in this article) for valuation of options relating to employee share-based compensation.

3 Black-Scholes Model The Black-Scholes model is probably the most widely used and best known theoretical optionvaluation model. A theoretical model is a forward-looking model that attempts to determine what the option should sell for in the market given the option terms and the underlying stock s salient points. The Black-Scholes model is appropriate for options with expiration dates that are relatively short term in nature; however, it is often used to value options that have a fairly long time until expiration. It is important to be aware of the underlying assumptions of the Black-Scholes model to avoid misapplication. Lattice Model A more integrated and complex model used to value options is called the lattice model. This model is a theoretical model like the Black-Scholes model; however, it uses either a binomial or a trinomial distribution process to derive value by separating the total maturity period of the option into discrete periods. When progressing from one time period, or node, to another, the underlying common stock price is assumed to have an equal probability of increasing and/or decreasing by upward and downward price movements. Visually, a binomial lattice model would appear as follows: Monte Carlo Simulation Monte Carlo simulation is often used to value complex derivative instruments including stock options by simulating various path-dependent conditions. The advantage of Monte Carlo simulation is that it can be used when the payoff depends on the path followed by the underlying common stock value as well as when it depends only on the final value of common stock. Payoffs can occur at several times during the life of the derivative rather than all at the end. Page 3

4 Pros and Cons of Valuation Models Black-Scholes Lattice Monte Carlo Ease of Use Easiest Moderate-Difficult Moderate-Difficult Cost to Implement Lowest Moderate-High Moderate-High Ability to Capture Unique Features of Employee Awards No Yes Yes Relative P&L Expense Generally highest Generally lower than BSM Generally lower than BSM Assumption Flexibility Not flexible Very flexible Very flexible Ability to Handle Performance Features No Yes, but may be limited Yes Investor Friendly Yes, can easily replicate No, black box to many No, black box to many Evaluate Reasonableness Yes, can replace and compare to other companies using BSM More difficult Difficult Case Studies Client Need Valuation of employee stock options and restricted stock Valuation of Performance Limited Partnership (LP) units Valuation of Performance Stock Units (PSUs) Client Size and Status Public company (logistics industry), with market cap approximately $10 billion Private firm (nonretail mutual fund and investment company) with more than $66 billion in assets under management Public company (packaging), with market cap $3.5 billion Accounting or Tax Requirement Client required compensation expense estimate for ASC 718 purposes ASC 718 and 480 (liability cash settlement) Client required compensation expense estimate for ASC 718 purposes Scope and Valuation Method Fair value of restricted stock units required a marketability discount study since restrictions exist after vesting period. Valuation of employee stock options Fair value of restricted LP units required a marketability discount study since restrictions exist after vesting period. (Probability-Weighted Expected Returns Method - PWERM Approach) American Appraisal determined the value of the PSUs by modeling expected total shareholder return through simulation. Monte Carlo Simulation Crystal Ball Black-Scholes Client conducts waterfall Why American Appraisal? Preference for third-party support Contingent Value Rights (CVRs) and LP units valued in preparation for IPO; required third-party consultants Client requires outside assistance for Monte Carlo modeling

5 Case Studies Client Need Employee stock incentive plan and warrants issued in acquisition Employee stock incentive plan Valuation of common stock and options Client Size and Status Private firm (power and energy management) Public company (communications company); market cap over $100 billion Private company (payment processor); private equity ownership; revenue over $100 million Accounting or Tax Requirement ASC 718 and 820 (warrants fair value under 820) Client required compensation expense estimate for ASC 718 purposes Client required compensation expense estimate for ASC 718 purposes Scope and Valuation Method PWERM for common stock (minority interest) Black-Scholes for warrants Stock valuation: Our analysis was based upon publicly available information and simulated a publicly traded stock. American Appraisal valued the business enterprise, common stock (minority interest) and employee stock options. Black-Scholes Why American Appraisal? Long-standing relationship and requires third-party consultants Auditor - Top 10 Conducted purchase price allocation (PPA) when the company was formed in 2000 This type of work almost always requires third-party consultants. Experience in the payment processing industry This type of work almost always requires third-party consultants. CONCLUSION Valuations are needed for stock options issued by both public and nonpublic companies. The issuance and valuation of stock options is complex. The type of valuation model utilized will depend upon the complexity of the underlying option and the level of model flexibility required. Selection of the appropriate option-valuation model to fully consider the features of the sharebased compensation is an important step. An added level of valuation is required when the option is issued by a nonpublic company, as the value of the underlying stock must first be determined before the option can be valued (especially for Section 409A compliance purposes). Consultations from legal, tax and qualified independent valuation advisors are prudent steps to establish a stock option plan, given the tax and financial accounting ramifications of the option to the individual and to the company. Page 5

6 About American Appraisal: American Appraisal, the world s only glocal valuation firm, is a leading valuation and related advisory services firm that provides expertise in all classifications of tangible and intangible assets. It comprises 900 employees operating from major financial cities throughout Asia-Pacific, Europe, the Middle East, and North and South America. Our portfolio of services focuses on four key competencies: Valuation, Transaction Consulting, Real Estate Advisory and Fixed Asset Management. American Appraisal focuses exclusively on valuation and related advisory services. That independence guarantees our greater objectivity. Carlo A. Carpino, CFA, ASA Director 1500 Broadway New York, NY tel: ccarpino@american-appraisal.com Kevin M. Hagemeier, ASA, CPIM Senior Manager 411 East Wisconsin Avenue Milwaukee, WI tel: khagemeier@american-appraisal.com To learn more about us, visit our website: Call us: