NVCA: FASB’s New’ Method To Value Options Is Flawed –

NVCAThe employee stock option debate continues to rage both here and abroad. Legislation has been introduced in both the House and the Senate, and in Europe the EC has become increasingly concerned about the stock option expensing issue. The Financial Accounting Standards Board (FASB), however, continues to ignore the voices of virtually all constituents – all in the name of supposed “accounting purity.”

Current accounting rules permit a company to choose whether to apply either Accounting Principles Opinion No. 25 (APB 25) or Financial Accounting Statement No. 123 (FAS 123) to value their stock options. Under APB 25, used by venture-backed companies today, the compensation cost of an employee stock option is computed under the “intrinsic value method.” That is, it is equal to the excess, if any, of the quoted market price of the stock at the date the option is granted over the amount an employee must ultimately pay to acquire the stock when the option is exercised.

Today, most stock option plans are structured so that the amount the employee must pay to exercise the option exactly equals the quoted market price of the stock on the day the option is granted. As a result, the option has no “intrinsic value” on the date it is granted, the compensation cost is equal to zero, and the granting of the option has no impact on corporate earnings. However, companies that elect to use this method must make extensive footnote disclosures of what the stock option expense would have been if they had chosen to apply FAS 123.

Over the past few years, several companies have elected instead to apply FAS 123. Most have done so because they had either re-priced their options (which results in the required use of variable accounting) or because the company felt that in the post-Enron world, they would look like better corporate citizens by expensing their stock options. Under the “fair value method” of FAS 123, companies must determine the value of their employee stock options using a stock option pricing model that takes into account the option exercise price, the price of the underlying stock, the risk free interest rate, the life of the option, and expected volatility over the life of the option.

Historically, the option valuation model used by virtually all companies (either in their footnotes or, for those companies that have elected to apply FAS 123, to compute the actual expense) is called the Black-Scholes model. Use of this model, while simple and mechanical, is problematic because it was designed to value freely tradable, short-term options.

Simply put, it cannot account for the unique aspects of employee stock options, such as the fact that they generally have a long life, vest over time, are not freely tradable, cannot be hedged, are subject to forfeiture, and may be subject to external and internal company policies with respect to the ability to exercise (such as black out periods).

FAS 123 allows no discounts or other adjustments to be made to the value determined under an option-pricing model.

Flawed New Model

FASB is now backing away from the Black-Scholes model because of its obvious flaws. Instead, FASB now appears to be moving toward the use of so-called “binomial models.” Black-Scholes requires the input of data that remains static over the life of the option.

A binomial model permits the modeling of certain behavior over time, thereby allowing the inputs to change during the life of the option, as opposed to using a specific and constant number. For example, under Black-Scholes, one assumption is made about expected volatility, and that assumed number remains constant over the term of the option. Under a binomial model, multiple assumptions could be made about volatility, so that the volatility estimate could constantly change over the term of the option.

Binomial models require the use of various “binomial trees.” These binomial trees are analogous to a series of decision trees that are used to predict future events. Although binomial models give the appearance of more precision, they will not produce an “expense” number that is any less flawed than that of Black-Scholes.

According to binomial theory, the more decision trees that are used, the more precise the answer should be. The problem is that the more trees that are used, the closer the binomial estimate becomes to the Black-Scholes estimate. If Black-Scholes produces an unreliable number, the use of binomial models will as well. Both models require the use of inputs that are difficult for all companies, but particularly private companies, to reliably estimate. Following multiple decision paths in the options calculation, when the basic inputs are erroneous, will not produce an answer that provides any greater clarity for the users of financial statements. In addition, although the answer derived from a binomial model at any given point in time will likely differ from the answer derived under Black-Scholes, it will not be a “better” number.

New Threat To VCs

In FAS 123, FASB recognized that it was virtually impossible for a company whose stock does not trade to determine volatility. This private company exception allows the estimated volatility used when computing the stock option expense under an option-pricing model, to be set at zero. This is referred to as the “minimum value” method. Under the minimum value method, a company must still determine the risk free rate, the option’s strike price, the underlying stock price, and the expected life of the option.

Under the minimum value method, although the volatility input is set at zero, the resulting expense will not be zero. It will simply be less than if the volatility input had been set at a number greater than zero. As an example, using the Black-Scholes model, if the option price and stock price were set at 20, the expected life at seven years, the risk free rate at 3%, and the volatility at 60%, the total expense would be $12.35 per option. If the volatility input were changed to reflect the minimum value method (0 volatility, all else remains the same), the total expense would be $3.79 per option.

FASB has recently announced that it plans to eliminate the minimum value method. Instead, it has proposed that private companies who cannot estimate their volatility will have to use what they refer to as the “intrinsic method.” Beware. FASB’s use of this term is disingenuous at best and intentionally misleading at worst. Unlike the intrinsic value method permitted under APB No. 25, this new intrinsic value method will result in highly volatile financial statements and will greatly increase administrative costs because of the constant stock valuations that would be required.

Intrinsic Method

A little history is necessary to understand what FASB now means when it says “intrinsic method.” Under APB No. 25, an alternative method of accounting is required for stock option plans that are considered variable, as opposed to fixed. A variable stock option plan is one where either the number of options granted or the exercise price of the options is not fixed at the time the options are granted to the employee. An example of this type of stock option plan is one where an employee will receive a certain number of stock options only if the firm’s earnings increase by more than the average earnings growth of the S&P 500 or some other index. If a variable stock option is granted, the company must recognize an expense each reporting period based on the price of the underlying stock. As a result, the company’s stock option expense will change every reporting period as the firm’s stock price rises or falls.1 Because of the financial statement uncertainty that results from this accounting method, stock options that would be subject to this method of accounting are rarely issued.

This is precisely what FASB has now renamed the “intrinsic value” method. FASB is well aware that this supposed alternative is no alternative at all. In fact, at the FASB Board meeting where this alternative was proposed, one participant laughed and said that it was a great “alternative” because no one would ever use it.

Variable accounting has been criticized by virtually everyone. Even staunch expensing advocates have criticized this accounting method by saying that it makes no sense and brings the stock price right into the income statement.

FASB’s new “intrinsic value method” should be seen for what it is and rejected. This new “alternative” for private companies is nothing more than “variable accounting” under a different name. If FASB is successful in mandating option expensing, the likely result is that no private company will use this “alternative” and, instead, will be forced to estimate the volatility of their untraded stock and use the fair value method.

Be Concerned

This should give all VCs concern. Because net income is a key metric to evaluate financial performance, expensing stock options will result in unreliable financial statements, likely distort perceptions concerning a company’s viability, delay access to public equity markets and increase the cost of capital. A mandatory expensing standard also is likely to deter some people from starting or joining new companies. FASB’s refusal to consider the economic consequences of its actions has been the primary reason why Congress has become keenly interested in this issue.

Given all of the problems with valuation and the significant economic considerations that would flow from a mandatory expensing scheme, what is the right answer? Perhaps FASB should take a step back and look at the fundamental question of whether employee stock options are in fact a corporate expense or, rather, a cost to the other shareholders in the form of potential dilution. FASB has taken its eye off the ball. Failure to focus on the real issues will be bad for the venture capital industry and the American economy as a whole.

Kim Marie Boylan is a certified public accountant and partner in the Washington, DC., office of Latham & Watkins. Her experience includes tax controversy, litigation and legislative matters. Boylan is also serves as counsel to the National Venture Capital Association and has represented NVCA in connection with its presentations to FASB and at various Congressional hearings. She can be reached at