Companies are required to expense the theoretical values of

employee stock options at grant day against their earnings.

This is mandated beginning January, 2006

The question arises as to how these ESOs should be calculated

at grant day.

The SEC and FASB generally recommend calculating the Black

 Scholes theoretical values or the binomial model values of the

employee options on grant day (with modified assumptions

regarding time remaining to expiration). They then suggest

delaying the actual expenseing of the grant day value to some

period related to the vesting dates.

There are several problems associated with this method.

First, you must understand that even in the hands of expert

practitioners, Black Scholes and binomial models are nothing

more then very useful tools and can not be overly relied upon

to give “precise estimates". The nature of employee stock

options contracts being non-standardized and the value of

the options being subject to the expectations and actions of

employees add to the difficulty of getting accurate values.

Nevertheless, this writer believes that reasonably useful

theoretical values of employee options can be calculated

at grant day for expensing. This method, however, gives

the appraiser some discretion as to variables such as volatility

and expected time to expiration. This can open the door for

abuse of that discretion to appraise the options as low as

possible by the company on its financial statements.

There are other problems associated with that method.

If after the values of the options are calculated, the stock

drops; then the compensation expense calculated at grant

day is overstated. If after the value is calculated, the stock

increases substantially, then the compensation expense is

understated.

Now, some may say that over time there will be increases

and decreases in stock values, so the net effect is washed

out. However, this does not consider that stocks may go up

for years in a row and then down for years in a row and it

may take decades to get the net effect to wash out.

Another reason to be critical of the “valuing at grant and

expensing soon after method” is that the employee stock

options are granted essentially pursuant to a contract of

employment.

This contract requires the employee to perform for years

into the future to achieve the full value of his options.

He will receive money directly from the options only if and

when he exercises his options. Of course, he can receive

money indirectly by hedging the employee options in the

listed options markets, assuming he is not prohibited from

doing so.

The direct payout may be as long as ten years from the

date of grant. He may actually receive nothing from the

options as they may expire un-exercised (unless he hedged

earlier in the life of the options). Delaying the expensing over

the vesting period of the options does mitigate the possible

mismatching of costs with employee benefits. But, in my

opinion, all of these calculations become quite complex and

do not contribute to clarity.

It is also the case that assumptions about volatility, interest

rates and dividend payments change over long periods of time.

These changes create the need to recalculate the theoretical

values of those employee options if the objective is higher

accuracy. The method of valuing at grant day and sticking

with those values does not allow for recalculating.

Some argue against expensing in this manner, saying that the

Black Scholes model is not useful in calculating long term

employee stock options.

Some also argue that the Black Scholes values are not

discounted enough to consider non - transferability and

alleged prohibitions against hedging.

They also argue that the “expense” is taken care of in the

reporting of potential dilution of the stock and does not need

to be expensed twice.

What is the solution?

One simple solution would be to expense the options when they

are exercised. This takes care of the need to use Black/Scholes

and eliminates the argument about the stock moving up and

down and having incorrect expenses.

The problem with this method of expensing at exercise is that

the expenses are delayed to some time substantially distant from

the time the actual rise of the stock and the growth in the

options’ value takes place.

There is another simple better solution and it follows:

When new employee stock options are granted, no

theoretical calculations are made and no expense

recorded. No potential dilution of the stock is ever reported.

At the end of the quarter after the grant, the intrinsic values

of the newly issued options are calculated and summed. This

amount is expensed against earning for that quarter.

For example: Assume options to purchase 1 million shares of

the common stock of a company trading at 40 were granted

to employees on January 15, 2005.

Assume the stock was trading at 45 at the close of business

on the last day of the first quarter of 2005. The company

would report an expense against earnings of $5 million for

compensation related to options.

Now assume no other options were granted, and the stock

is trading at 43 at the close of business on the last day of

the second quarter.

The second quarter report would show a compensation expense

of negative $2 million for compensation related to options.

The total compensation expense related to options for the

first two quarters would be $3 million.

Any options that may have been forfeited are removed from

the calculations. Any options that are exercised are also

removed but the intrinsic value of those options when they

are exercised becomes a part of the expense.

This method is much more simple than the method of

calculating theoretical values, since companies would never

be required to calculate theoretical values at all. It also

assignsthe expenses to periods when the expenses are

incurred.

There is no double expensing since the options are expensed

against earnings and there is never any dilution of earnings.

This method somewhat accommodates the advocates of

non - expensing by showing only the intrinsic values as an

expense.

It can also be argued that under this method, whenever the

stock advances a substantial amount, the compensation

expenses go up more than it should and causes havoc with

earnings. I discount that claim as the expenses are matched

correctly.

Some may say that this method understates the value of the

options' expense because it does not include the value of the

"time premium" above the intrinsic value

This is true. But, over time, the intrinsic value tends toward

theoretical value and either at expiration day or when the

options are exercised the intrinsic value and theoretical

value become the same.

When all is considered this is the best method.

 

John Olagues olagues@hotmail.com

www.optionsforemployees.com

The author, JOHN OLAGUES, is a former member of the Chicago Board Options Exchange and the Pacific Stock Exchange for over ten years. He offers a unique view of employee stock options from a trader’s standpoint rather than from the standpoint of an accountant, compensation planner or academic. To contact JOHN OLAGUES email olagues@hotmail.com and  see www.optionsforemployees.com.