Academic journal article Journal of Applied Finance

ESOs for CFOs: Pricing Employee Stock Option Grants

Academic journal article Journal of Applied Finance

ESOs for CFOs: Pricing Employee Stock Option Grants

Article excerpt

Employee stock options (ESOs) are used by many corporations as a major part of their compensation programs. Expensing issued ESOs on the grant date is now mandated in FAS 123 (R). The SEC's specific measurement objective for disclosure is to estimate an ESO grant's expense to the granting corporation on the grant date. A model to value an ESO grant can be based on simple adjustments to the Black-Scholes-Merton pricing equation or can entail pool-based methods with path-dependent ESO survival and risk-neutral pricing. As an alternative to models, a corporation can issue a special financial instrument to get a market-based estimate of an ESO grant's expense. This requires careful instrument design, an efficient distribution mechanism, and an information disclosure scheme that allows potential buyers to make informed bids for the instrument. This paper explains how to estimate an ESO grant's expense with both model-based and market-based techniques.

Expensing employee stock options (ESOs) has been a contentious issue in the practice of financial accounting and corporate finance. It is not entirely clear what an at-the-money ESO represents to a granting corporation: a long-term liability, a short-term claim, an expense item, or a grant best reported in a note to the financial statements. What is clear, though, is that unvested ESOs have positive values when a grant is made. With some probability, an ESO grant will generate favorable exchanges by ESO owners of cash for shares at an unknown time in the future.

Based on this observation, the Financial Accounting Standards Board (FASB), in Financial Accounting Statement No. 123 (Revised 2004)-or simply FAS 123(R)-has chosen to treat granted ESOs as long-term claims that must be expensed at their grant date values. Given this accounting standard, corporate financial managers need to identify and use appropriate methods to estimate the value of granted ESOs. Only ESOs with exercise prices equal to a company's grant date stock price are considered in this discussion.1 No discussion of backdating or other such practices is given here.

The purpose of this paper is to explain the US security and Exchange Commission's guidelines for implementing FAS 123(R). Both good and bad ways to value ESOs are widely available. The simplest way to price ESOs is with a modified Black-Scholes-Merton option pricing model. Two other ways to estimate ESO grant values are outlined in this paper: 1) "model-based" and 2) "market-based."2 Either way, attention to pricing details is essential to get a useful ESO value figure. This is important for the granting company because its board of directors, management, and shareholders need to weigh an ESO grant's immediate cost against the likely future benefits it will create for the company. Moreover, the sec has published guidelines for using a model-based approach and also for a market-based approach.3 These publications give guidance to a corporation's directors, management, and auditors for applying FAS 123(R) in a fashion that can be certified by the responsible corporate officers. Note that it is the valuation procedure that is audited, not the exact expense figure reported. As long as a company uses a procedure that is well informed, appropriately documented, and based on a sound pricing technique, the reported ESO expense is certifiable and defensible.

Accounting for an ESO grant by a corporation poses three related challenges: 1 ) defining the type of corporate obligation an ESO grant represents, 2) specifying how the grant should be recorded and disclosed by the grantor, and 3) calculating a value for the grant. A variety of reasoned arguments have been advanced on these issues. For example, Bulow and Shoven (2005) have argued persuasively that an ESO grant should be considered to be a short-term obligation-one that is renewed and expensed quarter-by-quarter, based on the company's share price that quarter. This would give an updated value each quarter for the grant. …

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