Mar 06

Employee stock options (ESOs): Investor Perspectives: Part 2

by David Harper, CFA, FRM, CIPM

CFA |

This post-series highlights concepts from our free movie tutorial (a.k.a., screencast): Employee Stock Options (ESOs) from the Investor Perspective. The CFA Institute pre-qualified this tutorial for 1.0 credit hours under their Professional Development (PD) program. In Part 1, we summarized the accounting treatment of employee stock options (ESO) under FAS 123R, just as we declared it appropriately useless to the analyst:

  • SCOPE: it's not universal, not all economic dilution falls under FAS 123. It applies to employees and nonemployee directors who are paid for services rendered with equity-like instruments (as opposed to cash liabilities)
  • SUMMARY: The standard (FAS 123R) in one sentence: From footnote disclosure to income statement recognition, company must deduct as a cost the fair value estimate on the grant date. Our favorite four-word summary: "grant date fair value."
  • ALLOCATION: In most cases, this total expense is amortized over the vesting period; e.g., 4 year vesting means $300,000 expense is allocated $75,000 over each of four years
  • REVERSAL: The expense is fixed in regard to cost per share. But forfeited shares are reversed if the service condition is either service- (time- or tenure-) based or performance-based. If the service condition is market-based (e.g., vest if total shareholder return exceeds some level), then both are fixed.

Companies can select their valuation model

Traditionally, companies used the Black-Scholes-Merton option pricing model (OPM) to value their ESOs. While the Financial Accounting Standards Board (FASB) was deliberating over the new rules, they flirted with favoring a binomial model. And, theoretically, a binomial is better suited to the valuation of ESOs where are technically "exotic options" because the binomial is much more flexible (in fact, you could view the Black-Scholes as a special case of the binomial). However, FASB punted on this and essentially delegated the model choice to companies. Companies can choose their valuation model as long as it meets three conditions (it's a fair value model, it is theoretically valid, it reflects the option's economic substance).

Although there are several choices, most will continue to use Black-Scholes or adopt the binomial:

Please note: some people mistakenly think that a switch from Black-Scholes to binomial will automatically reduce the option's value. This is untrue. If the goal is to reduce the option expense, both models provide plenty of wiggle room. But an objectively-based switch in models (i.e., from Black-Scholes to binomial) could produce a higher, lower, or roughly equivalent cost.

But don't confuse option value (or option cost) with dilution

We are now to a point where we generally understand the accounting: an option model is used to determine a present value expense, which is amortized typically over the vesting period. That's fair value at grant, and it's probably the best we can do "at grant." But it's not dilution. To illustrate, if the stock sinks, the options will expire worthlessly and no dilution will have happened.

In the screencast, we set up a ladder of investor perspectives on the cost of ESOs:

Starting at the bottom is the FAS 123R expense charge. Related to this, but not the same, we can also look at the Diluted EPS (an interesting but very imperfect measure of dilution). Above these, we enter into relevant measures of dilution: potential dilution (a.k.a., equity incentive overhang), economic dilution, and net cash flow. More in the next post...

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