Upfront: A New Take on Options Valuation

Companies that are under pressure to accurately value employee stock options are seeking new models that transcend the FASB-modified Black-Scholes and binomial methods. They are in luck.

Trying to quantify a cost that may or may not be incurred in the future creates a considerable amount of financial risk. Employee stock options often cannot be exercised during an initial vesting period of one to five years, and they generally expire after 10 years. During the vesting period, companies can only guess what the future will hold for their share price, who will leave the company before the options vest and which options will expire underwater. Yet accounting principles require that businesses deduct expenses during the period in which they are incurred.

Black-Scholes and other traditional approaches that were designed to value options traded on open stock exchanges fail to adequately account for employee stock options' lack of transferability, the possibility of early exercise and black-out periods that restrict their exercise. For that reason, National Economic Research Associates Inc. (NERA), a White Plains, N.Y., consulting firm owned by Marsh & McLennan, has developed a new model for stock option valuation that promises greater accuracy than those currently in use. The firm says its method enables organizations to meet accounting standards, make proper compensation decisions and improve management of financial risks.

What differentiates the NERA model from its predecessors is that it quantifies the cost to the company of hedging employee stock options, rather than determining the options' value to employees. NERA says the model is no more difficult to implement than the modified Black-Scholes. But its creators say it correctly captures salient features of employee stock options, such as vesting, employees' inability to transfer their options and the unpredictability of the options' exercise date.