Response:
You raise a number of excellent questions, but I must caution you against overanalyzing this issue. You risk doing your company and your shareholders a disservice. Two things have become very clear over the last couple of years:
- There is NO consensus, either theoretical or practical, on the right way to value stock options. What a surprise.
- The impact on public-company valuations resulting from stock-option expensing appears to have been minimal. Again, no surprise – virtually all of the information needed to estimate the profit-and-loss impact of stock options, at least at a high level, has been disclosed in footnotes for decades, except for the actual valuation algorithm used. And how does the choice of valuation algorithm relate to the fundamental operations, or value, of your company?
In this environment, I would argue that your priorities in valuing stock options should rank in roughly the following order:
- Consistency.
- Comprehensibility to investors. In other words, don’t try to break any new theoretical ground.
- Cost. Beyond the fundamental compliance requirements, is the amount spent improving the option expense calculation justified by the increased clarity in your published financials?
If you go too far on this issue, you are (a) distracting yourself and your staff from other issues that might be more directly related to your company’s operations, (b) spending a lot of money, and (c) inviting longer and more detailed discussions with investors on this deeply fascinating issue.
By the way, in response to your question about using an outside firm, absolutely use one, because they will have expertise that’s probably not available in-house, except in the largest companies. And it’s often important to show that a third party was involved in producing the numbers. However, work hard to make sure that you do the basic data collection and legwork in-house, which will save you money and give you some reasonable control over the end product.
I want to stress that expensing options is an appropriate accounting method – options are, after all, real compensation with real value to the recipients. But that doesn’t mean you should move heaven and earth to get the numbers “perfect”, especially when there is no agreement on what “perfect” is, and no clear evidence, to say the least, that you will be adding value for investors. Sometimes “better is the enemy of good.”
Randy Bolten (RBolten@aol.com)
Response:
I agree with the March 2 response to the FAS 123R question [editor’s note: See below for the prior response to this question] with regards to not overanalyzing this.
However, I respectfully disagree with the recommendations for implementation. We are doing the calculations ourselves, and I would like to offer some suggestions that have worked for our organization.
We use the Express Options software package from Transcentive (they have changed their name in the past year), although there is at least one other package that will do the same. This package accepts all the variables, does the calculation in seconds, and the output is acceptable to our auditors.
There are five fairly readily available variables you will need to determine:
Expected life. Using the simple method, a 10-year option with four-year vesting has a calculated expected life of 6.25 years. I am sure your accounting firm has a write-up of this calculation using the simple method.
Turnover. Ask HR to calculate your company's annual turnover for the past three years, and then take an average.
Risk-free rate. See www.federalreserve.gov; use the rate for the expected life.
Volatility. Look up public comparables (see below).
Dividend. It’s probably zero. Use whatever yours is.
Obviously, the grant price and market price are important variables, and you will need these for all grants. But once you figure out the variables, the software does all the work. We are doing it ourselves – it takes about an hour to research and calculate the values and 15 minutes to enter the data. (Also, you will want to know the risk-free interest-rate/zero-coupon U.S. Treasury rate; you can find it at
http://www.federalreserve.gov/releases/h15/data.htm
The software costs about $1,000 per year and does all the option tracking and communication reports in addition to FAS 123R. We would use the software even if it didn't do FAS 123R. I don't see why I would use an outside service.
In terms of peer-group analysis, we looked up the 10Ks for comparable public companies and used the volatility they used to calculate their FAS 123R in the most recent quarter. We then took an average of three or four comparable companies. Our auditors were okay with this. In fact, they required us to do this, as we had been using a volatility of zero. The result is that your volatility (and thus your compensation charge) is going to be much higher using a public-company comparable, but there is really no alternative.
Charlie Tillett (Charlie.tillett@revealimaging.com )