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SEC Evaluates Approaches for Estimating Stock Option Fair Value

The SEC's Office of Economic Analysis has reviewed a number of market-based approaches for estimating the fair value of employee stock options and concluded that, of the two approaches that have developed, one appears likely to produce a reasonable estimate of the fair value of employee stock options and the other does not. Under the tracking approach, willing buyers and sellers trade rights to future payouts that are identical to the future flows of net receipts by employees or the net obligations of the company. These market instruments provide a reasonable estimate of fair value, according to the Office of Economic Analysis.

The other approach, referred to as a terms and conditions approach, replicates the terms and conditions of the employees who receive the options. The Office of Economic Analysis concluded that the design of this market instrument does not yield a transaction price that is a reasonable measure of the cost of the option grant to the issuer and does not meet the fair value measurement objective of Financial Accounting Standards Board Statement 123R.

The Office of Economic Analysis submitted its evaluation of the alternative market instrument designs at the request of Chief Accountant Donald Nicolaisen. Mr. Nicolaisen noted that the staff was aware of several different strategies that issuers were considering for valuing employee stock options. He encouraged an open discussion about valuation strategies for obtaining estimates of fair value of employee stock options. The staff will continue to monitor the implementation of Statement 123R and will consider whether additional guidance is needed, he advised.

The chief accountant expressed doubts about the effectiveness of measurement through market instruments. "Replicating all of the terms and conditions of employee stock options with a market instrument is difficult," he stated. Mr. Nicolaisen concluded that "we have significant doubts based on OEA's views, as to whether it would be possible to design an instrument that would achieve the measurement objective of Statement 123R by relying on similar contractual terms and conditions." Chairman Christopher Cox stated, however, that "it will be rare when there is only one acceptable choice in estimating the fair value of employee stock options," and he noted that "as the OEA memorandum makes clear, the use of an appropriate market instrument for estimating the fair value of employee stock options has some distinct advantages over a model-based approach."

The measurement objective under Statement 123R is the grant date fair value of a company's obligations to its employees under an option grant. The measure should reflect the cost to the company of making the grant as evaluated on the date of the grant. Using a market-based approach, a company uses a market price as an alternative to the model-based estimate to measure fair value. The market price is the price at which a market instrument is traded between a willing buyer and seller, obtained through a competitive market process. The Office of Economic Analysis noted that no instruments were publicly available for estimating fair value before the adoption of Statement 123R, but a number of designs have since been developed.

The tracking approach, one of the two categories of instruments that have been developed, promises payments to the holder that are similar to the future values to be realized by employees under the option grant. Companies would sell the instrument whose payments track the value realized by employees upon the exercise of some or all of their stock options. Alternatively, the instrument may assign obligations to a third party holder that are similar to the net obligations of the company to its employees under the option grant by paying the third party to meet some of all of the company's obligations to employees under the grant. In each instance, the conditions are binding. The Office of Economic Analysis noted that with this approach, there are no restrictions imposed on the holder's ability to trade or hedge the instrument. The company's cost of the option grant is captured through the promise of future payments or the assignment of future obligations.

The Office of Economic Analysis explained that imposing on the market instrument or its holder the restrictions that employees face against trading or hedging would likely cause a departure from fair value because the restrictions would affect the opportunity cost of the grant. Market instruments that assign the future flows of net obligations or net receipts under the grant to the holder are suitable for generating a transaction price that is a reasonable estimate of fair value, according to the Office of Economic Analysis.

Under the terms and conditions approach, the holder of the market instrument faces the same prohibitions against trading and hedging as employees would face. The Office of Economic Analysis said there are inherent difficulties with these instruments that would likely prevent the market price from reflecting a reasonable estimate of fair value. Factors that are relevant to the cost of the grant to the company are omitted from the instrument design under this approach, according to the Office of Economic Analysis. Investors cannot be expected to behave like employees and may have different risk profiles. Employees pay with service over time, rather than cash up-front, and may directly contribute to the company's success. In addition, employees' livelihoods are more directly related to the performance of the company than the investor's. The Office of Economic Analysis concluded that replicating the terms and conditions that the employee faces under the option contract is not sufficient to lead an investor to exhibit behavior similar to the employee's.

The Office of Economic Analysis also determined that the tracking approach offers an ease of implementation that is not available in applying the terms and conditions approach. Chairman Cox said the SEC is committed to the promotion of competition among the different approaches for valuing employee stock options. The SEC believes that competition will lead to further innovations and, over time, particular approaches will emerge as best practices.