Valuing Employee Stock Options Part 4 pptx

CHAPTER 4Haircuts on Nonmarketability, Modified Black-Scholes with Expected Life, and Dilution NONMARKETABILITY ISSUES ESOs are neither directly transferable to someone else nor freely tr

CHAPTER 4

Haircuts on Nonmarketability, Modified Black-Scholes with Expected Life, and Dilution

NONMARKETABILITY ISSUES

ESOs are neither directly transferable to someone else nor freely tradable in the open market Under such circumstances, it can be argued based on sound financial and economic theory that a nonmarketability and non-transferability discount can be appropriately applied to the ESO However, this is not a simple task as will be discussed

A simple and direct application of a discount should not be based on

an arbitrarily chosen percentage haircut on the resulting binomial lattice result Instead, a more rigorous analysis can be performed using a put op-tion A call option is the contractual right, but not the obligation, to pur-chase the underlying stock at some predetermined contractual strike price

within a specified time, while a put option is a contractual right but not

the obligation, to sell the underlying stock at some predetermined

contrac-tual price within a specified time Therefore, if the holder of the ESO can-not sell or transfer the rights of the option to someone else, then the holder

of the option has given up his or her rights to a put option (i.e., the em-ployee has written or sold the firm a put option) Calculating the put op-tion and discounting this value from the call opop-tion provides a theoretically correct and justifiable nonmarketability and nontransferabil-ity discount to the existing option

However, care should be taken in analyzing this haircut or discounting feature The same inputs that go into the customized binomial lattice to cal-culate a call option should also be used to calcal-culate a customized binomial lattice for a put option That is, the put option must also be under the same

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risks (volatility that can change over time), economic environment (risk-free rate structure that can change over time), corporate financial policy (a static or changing dividend yield over the life of the option), contractual obligations (vesting, maturity, strike price, and blackout dates), investor ir-rationality and nonmarketability (suboptimal early exercise behavior), firm performance (stock price at grant date), and so forth

Albeit nonmarketability discounts or haircuts are not explicitly dis-cussed in detail in FAS 123, the valuation analysis is performed in Table 4.1 anyway, for the sake of completeness It is up to each firm’s manage-ment to decide if haircuts should and can be applied Table 4.1 shows the

shows the results from a nonmarketability analysis performed using a down-and-in upper barrier modified put option with the same exotic in-puts (vesting, blackouts, forfeitures, suboptimal early exercise behavior, and so forth) calculated using the customized binomial lattice model The discounts range from 22 to 53 percent These calculated discounts look

these discounts are not explicitly sanctioned by FASB, be careful using them in determining the fair-market value of the ESOs

The marketability discount can be captured and calculated in several ways The first is using the corresponding put option as described previ-ously The second approach is to calculate the relevant carrying cost of the option and adjusting an artificially inflated dividend yield to convert the

ESO into a soft option, thereby discounting the value of the ESO

appropri-ately This soft option method is more difficult to apply and is susceptible

to more subjectivity than using a put option The put option approach is more advantageous in that all of its inputs have already been predeter-mined in the ESO valuation Simply deducting the corresponding put op-tion value from the calculated ESO value would give you the nonmarketability- and nontransferability-adjusted ESO valuation The third approach is to take market comparables and calculate the corre-sponding percentage marketability discount that is appropriate for similar types of assets (contingent claims issued by firms with similar functions, markets, risks, and doing business in similar geographical locations) This third method is usually difficult to perform due to lack of pertinent infor-mation and data Therefore, the best alternative is still the use of the corre-sponding put option to offset the calculated ESO value

Still others would claim that the use of the suboptimal exercise behav-ior multiple in the customized binomial lattice is sufficient to account for the nonmarketability and nontransferability aspects of the ESO In reality, employees tend to exercise their options early and suboptimally anyway, regardless of the suboptimal exercise behavior multiple This occurs

be-42 IMPACTS OF THE NEW FAS 123 METHODOLOGY

TABLE 4.1

Customized Binomial Lattice

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TABLE 4.2

Haircut (Customized Binomial Lattice

Nonmarketability and Nontransfer

cause of a variety of personal reasons (need for liquidity, need to pay off a debt, down payment to buy a home, a child’s college tuition fees being due, and so forth), as well as the employee’s lack of knowledge on how to capi-talize on and maximize the value of an option (i.e., when is it optimal to execute or what is the optimal trigger price for execution) Also, suppose

an employee has decided to leave the firm (or is being terminated) He or she has a set period (usually 15 to 45 days) to execute the ESOs if they are in-the-money Further suppose that the ESO is currently exactly at-the-money (stock price is yielding $50 and the contractual strike price is also

$50) This means that the ESO has a value of zero In contrast, if this were

a tradable and marketable security, due to time value and volatility, the same option can be sold in the market for some value greater than zero Thus, the employee loses out on this marketability value, regardless of his

or her suboptimal exercise behavior multiple threshold So, a marketability discount should be allowed on top of the ESO valuation that has already been adjusted for the suboptimal exercise behavior multiple

EXPECTED LIFE ANALYSIS

The 2004 proposed FAS 123 revision expressly prohibits the use of a mod-ified BSM with a single expected life The requirements are rather explicit:

A better estimate of the fair value of an employee share option may be obtained by using a binomial lattice model that incorporates employ-ees’ expected exercise and expected post-vesting employment termina-tion behavior than by using a closed-form model (such as the Black-Scholes-Merton formula) with a single weighted-average ex-pected option term as an input.

In addition, the Standard provides an alternative to estimating expected life of an option:

Expected term is an input to a closed-form model However, if an en-tity uses a lattice model that has been modified to take into account an option’s contractual term and employees’ expected exercise and post-vesting employment termination behavior, the expected term is esti-mated based on the resulting output of the lattice.

For example, an entity’s experience might indicate that option holders tend to exercise those options when the share price reaches

200 percent of the exercise price If so, that entity might use a lattice model that assumes exercise of the option at each node along each

Haircuts on Nonmarketability, Modified Black-Scholes with Expected Life, and Dilution 45

share price path in a lattice at which the early exercise expectation is met, provided that the option is vested and exercisable at that point Moreover, such a model would assume exercise at the end of the con-tractual term on price paths along which the exercise expectation is not met but the options are in-the-money at the end of the contractual term That method recognizes that employees’ exercise behavior is cor-related with the price of the underlying share Employees’ expected post-vesting employment termination behavior also would be factored

in Expected term then could be estimated based on the output of the resulting lattice.

This means that instead of using an expected life as the input into the BSM

to obtain the similar results as in a customized binomial lattice, the analy-sis should be done the other way around That is, using vesting require-ments, suboptimal exercise behavior multiples, forfeiture or employee turnover rates, and the other standard option inputs, calculate the valua-tion results using the customized binomial lattice This result can then be

compared with a modified BSM and the expected life can then be imputed.

Excel’s goal-seek function can be used to obtain the imputed expected life

of the option by setting the BSM result equal to the customized binomial lattice The resulting expected life can then be compared with historical data as a secondary verification of the results, that is, if the expected life falls within reasonable bounds based on historical performance This is the correct approach because measuring the expected life of an option is very difficult and inaccurate FAS 123 provides further guidance on this issue:

Option value is not a linear function of option term; value increases at

a decreasing rate as the term lengthens For example, a two-year op-tion is worth less than twice as much as a one-year opop-tion, other things being equal Accordingly, estimating the fair value of an option based

on a single expected term that effectively averages the widely differing exercise and post-vesting employment termination behaviors of identi-fiable groups of employees will potentially misstate the value of the en-tire award.

Table 4.3 illustrates the use of Excel’s goal-seek function to impute the ex-pected life into the BSM by setting the BSM results to the customized bino-mial lattice results

Table 4.4 illustrates another case where the expected life can be im-puted, but this time the forfeiture rates are not set at zero In this case, the BSM results will need to be modified For example, the customized binomial lattice result of $5.41 is obtained with a 15 percent forfeiture

46 IMPACTS OF THE NEW FAS 123 METHODOLOGY

TABLE 4.3

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TABLE 4.4

*Note: Uses the binomial lattice result to impute the expected life for a modified BSM † Note: Uses the binomial lattice but also accounts for the forfeiture rate to modify to BSM.

rate This means that the BSM result needs to be BSM(1 – 15%) = $5.41 using the modified expected life method The expected life that yields the BSM value of $6.36 [$5.41/85% is $6.36, and $6.36(1 – 15%) is $5.41]

is 2.22 years

DILUTION

In most cases, the effects of dilution can be safely ignored as the propor-tion of ESO grants is relatively small compared to the total equity issued

by the company In investment finance theory, the market has already an-ticipated the exercise of these ESOs and the effects have already been ac-counted for in the stock price Once a new grant is announced, the stock price will immediately and fully incorporate this news and account for any dilution that may occur This means that as long as the valuation is performed after the announcement is made, then the effects of dilution are nonexistent The proposed 2004 FAS 123 revisions do not explicitly pro-vide guidance in this area Given that the FASB has decided to ignore the issue of dilution, and the fact that forecasting stock prices (as part of esti-mating the effects of dilution) is fairly difficult and inaccurate at best, plus the fact that the dilution effects are small in proportion compared to all the equity issued by the firm, the effects of dilution are assumed to be min-imal, and can be safely ignored

SUMMARY AND KEY POINTS

value of assets that cannot be sold openly in the market but the pro-posed FAS 123 does not explicitly allow a marketability discount

53 percent, which is in line with market expectations

as an input into the GBM or BSM Instead, the expected life can be im-puted from the results of a customized binomial lattice and can be used

as a secondary verification of the results to be benchmarked against historical average lives of ESOs

ad-justed once the ESO grants are announced In addition, the proportion

of ESOs to the total equity in the company is relatively small to have any significant impact

Haircuts on Nonmarketability, Modified Black-Scholes with Expected Life, and Dilution 49