Top of Mind: Sizing Up Stock Option Models

Public companies are still feeling the effects of the fallout from employee stock options backdating scandals as they seek the best means of valuing options, which now must be expensed.

While most businesses continue to rely on Black-Scholes and similar models to price options, the SEC has opened the door to an auction approach, which could result in lower values and commensurately a more benign effect on earnings.

"The reason that the SEC opened the door is because FAS 123R says that the best way to pass valuation on an option you're granting to an employee is some sort of market-based measure," says Stephen Zwicker, senior actuarial consultant at Watson Wyatt Worldwide. "The standard discusses the fact that there isn't anything in the market that replicates what a standard employee stock option looks like."

Enter Zions Bancorp, an S&P 500 index financial institution, which received final clearance from the SEC in mid-October to use an auction process to value employee stock options. Zions conducted an auction this spring, which valued options at 14 percent below the value that a Black-Scholes model would have produced. For their part, employees pay their company an agreed-upon price for what Zions calls Employee Stock Option Appreciation Rights Securities, or ESOARS; the company then has the use of money to invest or to hold in reserve for a possible payout in the future. The SEC issued a letter stating that it had no objection to the bank using auction results to reach its options expense and that they are a reasonable estimate of the fair value of the underlying employee stock options.

James Livingston, an ESOARS project manager and vice president of Zions, states on the bank's Web site, "For the first time, companies have a market-based alternative to employee stock option valuation models. When sophisticated and informed investors compete for a properly designed instrument in a fair and open auction, the market-clearing price represents a fair market value."

But some institutional investors have protested the auction approach to valuation, saying that the process is fundamentally flawed because the company running the auction and the buyers who participate in it both want to see as low a price as possible. "It is a bid processes for determining value, but there's not somebody on the other side of the table who's asking for a particular price," says Zwicker. "The best estimate of a fair value is somewhere between the bid and the ask price, and right now you're looking at a process that's coming up with just the bid price."

"There's also no established secondary market for these instruments, so investors in these types of derivatives just have to sit there and hold them because there doesn't seem to be any market for them to go out and trade them in," he adds.

While the SEC opened the door for other companies to use the auction method for valuation, and Zions intends to advise public companies and facilitate their use of ESOARS, is it likely that auction fever will take hold? "I don't think that in the short term we'll see many companies doing it because the amount of the discount on the auction process relative to what a valuation model would give isn't that great," says Zwicker. "That 14 percent discount is a decent savings, but it's not as high as some of the initial estimates that Zions had."

"And I'm not sure," Zwicker adds, "that many companies will go through all the bother associated with the accounting complexities that this auction process would bring about. The letter that the SEC sent to Zions indicated that future auctions are subject to independent audit review, and a lot of the burden is going to fall on the accounting firm to approve whether or not future auctions meet the requirement. I think that there will be a lot of hoops to jump through with a company's auditor to get this approved, which obviously means more fees as well. So there are a lot of hidden costs with this. And, a company that wanted to do this would have to go out and hire somebody to conduct the auction as well."