Valuing Employee Stock Options with Zions

[qi:044] Long before the options backdating scandals brought the arcana of stock option accounting to light, companies have struggled with how to appropriately value and price the handy derivatives they give to their employees as inducements for peak performance and loyalty.

Pricing stock options is difficult because estimating an option’s future value depends on the assumptions you make about when the bearer of the security is likely to sell it. This is hard to predict. Markets are fickle because people are fickle. This is why, for decades, companies have had to value their employee stock option grants (ESOs) using complex theoretical models like Black-Scholes or the (even weirder-sounding) Lattice Binomial method — algorithms so fraught with variables that the concluding valuations are little more than arbitrary.

(Backdating, where the option grant date is altered to give the derivative instant value — without triggering an accounting charge — was just one way of getting around the uncertainty of ESO “valuation.” It was then end-run around the accounting rules that caused the resulting SEC and DOJ investigations.)

But it could be that tech companies no longer need to anguish over how to value their employee stock options.

Last week, the Securities and Exchange Commission gave final approval to an auction method for valuing ESOs proposed by Zions Bancorp (ZION) of Salt Lake City.

Zions will create a new security to mirror the ESOs, then sell these derivatives (they’re calling them “employee stock-option appreciation rights securities”) to public investors in an open-market auction. The price investors are willing to pay for the Zions ESO-derivatives will be used to determine the fair value of the ESOs themselves. This value is what a company will then use to properly account for the ESO grants on its income statement.

“For the first time, companies have a market-based alternative to employee stock-option valuation models,” the company said in a statement last Monday.

The financial services firm is expected to market its new service heavily to technology companies, where equity compensation remains important. They may have some takers. Tech companies have tried to win SEC approval for alternative ESO-pricing methods in the past. Cisco (CSCO) spent years on such an effort, only to have its proposal — which was similar to the Zions’ system — turned down. This explains why some folks, familiar with both the Cisco and Zions methods, have been expressing surprise.

The Financial Accounting Standards Board’s revised rule FAS 123R allows the creation of a derivative security to determine to price of an option, provided that:

The fair value of an equity share option or similar instrument shall be measured based on the observable market price of an option with the same or similar terms and conditions. (emphasis ours)

The problem with the Zions method, according to one critic, is that it will create a derivative “instrument” that is dissimilar to the underlying ESO, in three important ways:

1) Zions’ derivatives will be transferable, meaning they can be traded between parties (stock options are non-transferable).

2) Zions’ derivative can be hedged, meaning they can be sold short to mitigate risk (a stock option cannot be hedged).

3) The bearer of a Zions derivative will not get to decide when, or even if, the contract is exercised — that will be determined by the owner of the underlying option. When the employee exercises, the derivative investor will have to exercise, too.

This last characteristic is really strange. It is highly unusual for the “exercise decision” of any derivative to be out of the hands of the owner of said derivative. It also recreates the very problem that alternative ESO-pricing proposals purport to solve in the first place: If you don’t know if you can ever sell a security, how do you value it — much less account for it?

“With the Zions proposal, the employee and the [derivative] investor aren’t getting the same thing, so it’s not easy to tell if what the [investor] is getting is worth more, or less, than what the employee is getting. I don’t know that the value of the derivative is particularly relevant for pricing the option. Frankly, I don’t know what the SEC sees in this proposal,” one derivatives expert told me. (The expert asked not be identified because he’s not authorized to speak on the topic on behalf of his employer, a large investment bank.)

Since its own proposal failed, we wondered if Cisco would consider employing Zions’ new pricing mechanism. It doesn’t sound like it (but maybe it is just sour grapes):

“We are pleased that the SEC is open to market-based approaches,” spokesperson Heather Dickinson told Financial Week last Thursday, without addressing whether Cisco would try Zions’ newly-approved approach. (Cisco has been using the Lattice Binomial method since its own proposal failed.)

Intel (INTC) spokesman Tom Beermann said: “We’re monitoring developments in this area but haven’t made any decisions at this point.”

“The scuttlebutt that I’m hearing,” added our derivatives expert (he also consults to companies on their ESO policies), “is that Zions thinks this is the greatest thing since sliced bread. Everyone else thinks it’s just too obscure to use. I’d be surprised if it takes off.”