Stock-Based Employee Compensation
The importance of value
Employee equity incentive plans, including stock option plans, are a good way for companies to attract top management and motivate and reword key employees. Such plans link employees’ interests with those of the company and other shareholders. Equity incentive plans can help smaller/developing companies preserve cash while giving employees a piece of future growth. Such plans most often involve issuance of options, but can also involve issuance of restricted stock, stock appreciation rights, and phantom stock.
As of 2014, the National Center for Employee Ownership (NCEO) estimated that 7.2 million employees held stock options, not including an estimated several hundred thousand employees with other forms of equity in the company they work for. Since the late 1980s, the number of people holding stock options has increased about nine-fold .
What is a stock option?
A stock option issued under an employee equity incentive plan gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. The price at which the option is provided is called the "grant" price (exercise price) and is usually the market price when the options are granted. Employees who have been granted stock options hope that the share price will go up and that they will be able benefit by exercising the option (purchasing the stock) at the lower grant price (exercise price) and then selling the stock at the current market price.
Valuation is Needed
Under IRS Section 409A, companies are required to show that their common stock options are issued with a strike price (exercise price) that is at or above fair market value of the underlying equity in order to satisfy certain safe harbor requirements. If your company fails to comply with 409A, then your employees will be personally liable for immediate taxation — plus a 20-percent penalty tax and potential interest. A formal valuation opinion of the underlying common stock should be obtained whenever new options are issued to employees in order to help establish an appropriate strike price (exercise price) and avoid potential penalties.
A valuation of the stock option itself is also used to support the Fair-Value method of accounting for stock-based compensation, as required by the Financial Accounting Standards Board (FASB) rules under ASC 718 and 505 .
How is value determined?
Option pricing models estimate what an option would sell for in the market today given the terms of the option and the underlying stock characteristics, including future expectations. For publicly traded companies, the marketplace sets the value of the underlying stock. However, in the case of a closely held company, the value of the company must be determined by performing detailed financial analysis of the company and considering the three primary approaches to value: income, market, and cost approaches. Determining the value of the underlying common stock of an option is critical since the underlying stock value is a key input to the option valuation model. Although there are various option pricing methodologies, in practice, the Black-Scholes model is the preferred method for determining the value of an option for financial reporting and taxation purposes. The main assumption underlying the Black-Scholes model is that the underlying stock behaves in such a way that future price changes can be modeled by a probability distribution. These modeled future values, along with other variables, are then used to determine the option's estimated fair market value. These variables used in the Black Scholes model include:
- underlying stock's value
- exercise price of the option
- underlying stock price volatility
- dividend expected
- risk-free interest rate for the option term remaining
- time until expiration (or the expected life) of the options
For companies with complex capital structures, such as those with multiple rounds of preferred stock, warrants, and preferred stock and common stock options, the determination of the common stock value is a complicated task. Gordon Brothers considers, and applies when appropriate, the Current Value Method, the Back Solve Method, the Option-Pricing Allocation Method, the Probability Weighted Expected Return Method, and the Monte Carlo analysis method.
Keys to successful stock option valuation reports
While every company and valuation context is unique, there are several guidelines to look for in a valuation report that will withstand scrutiny:
- Methodologies sanctioned by the AICPA Practice Aid and that conform with IRS regulations
- A thorough, well-documented and auditable report that can be used for both tax and financial reporting purpose
- A valuation needs to be performed by someone who is qualified (based on their knowledge, training, experience, certification)
- The valuation should be updated at least every 12 months, or more frequently if significant changes occur in the business between grant dates (such as new rounds of financing)
- Industry-standard valuation and allocation techniques, including the Current Value Method (CVM), Back Solve Method, Probability Weighted Expected Return Method (PWERM), Option Pricing Method (OPM), and Monte Carlo analysis.
- An option pricing model and waterfall analysis that accounts for the rights and preferences of preferred shareholders, along with consideration of probability-weighted scenario modeling, which might better reflect the distribution of potential outcomes for companies in certain industry sectors or stages of development.
- Support from valuation professionals continuing through the audit process
Gordon Brothers’ valuation analysis, with respect to equity-based compensation, is not purely the result of a mathematical process; it involves numerous qualitative considerations and professional judgments regarding the relative investment characteristics of the subject security. Stock option valuations (and valuations for other equity-based instruments for employee compensation plans) are complex problems that require critical, expert decisions. Gordon Brothers has the experience and credentials to make defensible assertions on the value of any type of stock option or equity-based compensation plan.