FAS 123R, issued by the Financial Accounting Standards Board (FASB), and SAB 107, issued by the SEC, govern how employee stock options and employee restricted stock are valued for financial-reporting purposes.

Employee stock options are sometimes exercised early. This feature is considered when determining an appropriate discount. For long-term options, volatility also affects the level of discounting. To determine the level of volatility, the analyst reviews the history of the company's stock and other features relating to volatility, such as the size of the company and the industry.

Either the Black-Scholes-Merton formula or lattice models may be used. Although the current version of FAS 123R does not include a preference for any specific valuation method, an earlier release explicitly favored lattice models, which are more flexible and are better at modeling actual employee behavior. However, we expect the Black-Scholes-Merton model to continue to be in widespread use because of its simplicity.

Because different groups of employees can be expected to behave differently with respect to their stock options, FAS 123R recommends valuing the options of certain groups differently from other groups. Based on a company's history, such judgments can often be made based on termination behavior and early exercise behavior.

Volatility
For most public companies, historical trading-price volatility is the starting point for the volatility estimate. However, companies must carefully consider whether or not the future might be different from the past. Also, private companies and others with limited trading histories can look to industry indices or public companies with longer trading histories for volatility estimates.

Risk-Free Interest Rate(s)
When using lattice models, the term structure of interest rates should be modeled directly from the yield curve for zero-coupon bonds. When using the Black-Scholes-Merton model, zero-coupon bonds with a term equal to the expected remaining term of the option should be used.

Expected Term
Generally, because of the illiquidity of employee stock options, employees have an incentive to exercise them early. The question is how early and under what circumstances. The lattice models and the closed-form models (such as Black-Scholes-Merton) treat the expected time to exercise very differently. The closed-form models assume an average expected term. The mid-point between the vesting period and the maximum term may sometimes be used for companies with limited histories. The lattice models, on the other hand, predict employee behavior based on how the stock price changes during the term, with greater probability of early exercise the higher the stock price rises. Lattice models can also model employee behavior based on any other factor deemed meaningful.

For more information on our valuations for FAS 123R compliance, contact Pluris today.