Which Came First? Common Stock or Employee Stock Option Valuation

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It’s another one of those chicken or the egg questions. Which came first: the grant date value of the employee stock options or the fair market value of the common stock? As we all know, the fair market value of the underlying common stock is an input in any stock option valuation formula, but how can you know the value of the common stock of the enterprise if you don’t know how much to allocate to the employee stock options.

It’s no secret that privately-held companies face challenges in complying with FAS 123R (valuation and expensing) and Sec. 409A (enterprise valuation) since there is no established value for their common stock. In a recent article, three professors from the University of North Alabama have suggested a new wrinkle in the interplay between the valuation of employee stock options and the dilutive effect on the underlying common stock. The article was summarized in the July-August 2008 issue of the Employee Ownership Report, published by the National Center for Employee Ownership. It was originally published in the March 2008 issue of the Journal of Accountancy, under the title: “Are Your ESO Values on Target? Valuing employee stock options for closely held companies.” (See: http://www.aicpa.org/pubs/jofa/mar2008/eso_values.htm).

The executive summary for the article offered these considerations:

  • To determine the value of ESOs for a closely held company, first determine the fair value of common equity then allocate that value between the common stock and the ESOs.

  • The value of the options and the value of the common stock cannot be determined independently, with the remainder simply being allocated to the other. Because the value of each instrument is a function of the other, their values must be determined simultaneously.
  • The value of each of a company’s potentially dilutive instruments, including outstanding ESOs, warrants or convertible debt, must be included in the valuation of any new ESOs being granted.

The authors raise the question: “how can you determine the fair value of your employee stock options if a) the method you use to calculate the value of the options is based on the portion of the enterprise value allocated to the common stock, and b) the portion allocated to the common stock is a function of the value allocated to the options?” In essence, each input is based on the other.

The examples in the article are very helpful to illustrate the phenomenon. For instance, if a company is valued at $10 million and there are 1 million shares outstanding, you can use $10 per share when you calculate the fair value of the employee stock options to be granted. However, if you grant 100,000 options with a fair value of $3 per share (based on a BS valuation formula using $10 per share for FMV and exercise price) and therefore allocate $300,000 of value to the options, the FMV of the common stock has been reduced to $9.70 per share. You could improve your valuation by re-valuing the 100,000 options based on an FMV and exercise price of $9.70 per share. Then, you need to repeat the process until you narrow in on the best stock option valuation taking into account the value of the options being valued. The authors suggest the use of a “bisection method.”

The NCEO article summary explains it:

“For a private company to accurately value employee stock options for accounting purposes, according to the (JoA) article, the company must use an option pricing model that takes into account the dilutive effect the option exercise will have on the value of the company’s common stock. For a private company, each time an option is exercised, the new shares that are issued dilute the overall value of other shares.”

At the same time, the Journal of Accountancy article points out the precarious balancing act:

“To correctly account for these interrelationships, all new and existing ESOs and the common stock must be valued simultaneously. Since most option valuation models require stock value as an input (as opposed to an output), these models should be modified to let both stock value and ESO value be determined simultaneously, with fair value of equity being provided as an input.”

This commentary does not change the model that a company will use to value its new stock options under FAS 123R. However, it offers a new challenge when trying to determine the fair market value of the common stock underlying the options. Whichever valuation model a company uses, the dilutive effects of outstanding convertible securities, whether options, warrants or something else, should be kept in mind in the balance of valuation issues related to FAS 123R and Sec. 409A.

Despite this new challenge and others that will certainly be raised in upcoming articles yet to be written, as noted in past blog posts, the conclusion remains the same: It takes professional judgment or a great deal of expertise to get it right.

Gary D. Levine, President and CEO
Two Step Software, Inc.
www.CapitalizationMatters.com

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