Employee stock options can be either qualified, also known as incentive stock options (ISOs), or non-qualified (NQSOs or non-quals). Employee stock options are typically issued to employees of the issuer based on a stock-option plan. To be considered a qualified plan, the plan must comply with the Internal Revenue Code and other rules. ISO treatment requires, for example, that:

• The option plan receive shareholder approval
• Options be granted within 10 years of adoption of the plan
• Option terms not exceed 10 years
• The option exercise price equal or exceed the fair market value of the underlying stock
• Executives not own more than 10% of stock voting power
• Options not be transferable, except upon death

If the options fail to meet ISO requirements, they will be considered non-qualified stock options. Stock options that fail the above-listed requirements do not receive the favorable tax treatment given to ISOs. However, unlike ISOs, they are transferable at any time and can be used in tax-planning strategies.

FAS 123R
Valuation requirements for financial reporting of stock options can be complex. Rules under FAS 123R, which regulates stock-option valuations, consider the following factors:

• Vesting
• Time to exercise (including actual expected time and maximum time)
• Employee turnover
• Different inputs for different groups of employees
• Volatility of the underlying stock and mean reversal of the volatility

Valuation Models
Two valuation models are acceptable. The Black-Scholes-Merton method provides values based on six inputs:

• Stock price
• Exercise price
• Volatility
• Time to expiration
• Risk-free rate of return
• Dividend yield

The second option, the lattice model, is more flexible and may be more appropriate for valuing options using different inputs.

For more information on our valuations of employee stock options, contact Pluris today.