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Market-Based Option Valuation Gets OK

The new method is finally approved, but some doubt that many companies will be eager to use it.
Alan Rappeport, | US
October 24, 2007

Now that the Securities and Exchange Commission has decided that employee stock options can be valued with a market-based system, will there be a market for such a method? Despite the approval, some skeptics remain.

Earlier this week the SEC gave final clearance for Zions Bancorp, a banking group, to implement its auction system, known as Employee Stock Option Appreciation Rights Securities, or ESOARS. The system was developed in response to complaints from executives about Financial Accounting Standards Board's rule FAS 123R, which requires them to expense options. Existing models, such as Black-Scholes and lattice, they said, produced a too-high value for options and a too-big a hit to earnings.

ESOARS uses an auction process to assign a value to options. The high bidder owns the option and receives a payment from the company for the ESOARS when the employee exercises the option. Early tests of the ESOARS formula produced option valuations just half those generated by comparable statistical models, spurring calls that the method was flawed. During a test run in May, the results were 14 percent below the Black-Scholes model. The results are said to fall closer to the "binomial" lattice model.

According to Zions, ESOARS are "tracking instruments that measure the cost of the underlying option grant by making payments to holders when employees exercise their options." In this system, online auctions allow institutions or individuals to make unsealed bids near the time of the option's grant date. The auction's outcome theoretically determines fair value.

Zions has had its share of critics, and in January the SEC told the company it needed to correct some flaws before receiving clearance. The Council of Institutional Investors, a shareowner-rights organization, released a report in March arguing that "the design serves primarily to produce a predictably downward biased result." CII rebuked ESOARS' tracking security system and said the auctions present too many barriers and incentive problems for participants. The council was not pleased with the SEC's decision.

"Unfortunately, it appears that Zions did not make any of the major modifications suggested," says Jeff Mahoney of CII, who worked on the report with noted valuation expert Stephen Ross. "We are hopeful that those future evaluations will include some consideration of Mr. Ross’s analysis and the needs and demands of investors for high quality, credible information about employee stock option compensation."

In its approval letter last week, the SEC concluded that the ESOARS instrument is sufficiently designed to meet the measurement objective of FAS 123R. However, it noted that the market was still small for ESOARS-type instruments. Since the Zions approach focuses only on the bid-side, the SEC said there remained the potential for a "downward bias result" if other "ask-side" instruments are not developed. The SEC cautioned Zion to ensure that auctions have "sufficient sophisticated bidders" and that bidders have enough information to make sound decisions.

Zions soon posted the approval on its website. "For the first time, companies have a market-based alternative to employee stock option valuation models," said James Livingston, an ESOARS project manager and a vice president at Zions. "When sophisticated and informed investors compete for a properly designed instrument in a fair and open auction, the market-clearing price represents a fair market value."

Livingston told that Zions did, in fact, change ESOARS to comply with the SEC. The key change was to remove the risk of pre-vesting forfeitures. For example, if an employee forfeits options when leaving the company, it negatively effects the price of the ESOARS. Also, Zions agreed to create a "two-minute" rule so that bidding ends naturally, not with people making last second bids before a fixed time.

Deriving new methods for valuing options has been fraught with difficulty. In May 2005, Cisco Systems proposed selling a new derivative that would rely on market forces to price its options. That September, SEC chief accountant Donald Nicolaisen said in a statement that he had "significant doubts" about the possibility of designing an instrument that would achieve the goals of 123R. The commission ultimately withheld its approval.

Not everyone is convinced that ESOARS will take off. Cindy Ma, a valuation expert and managing director at Houlihan Lokey, an investment bank, says companies that have already switched from using the Black-Scholes model to a binomial model might not have the incentive to move to Zions' market approach. Moreover, firms could be reluctant to provide the sufficient information that would be required for credible auction. "It looks very good on the surface, but there are a lot of issues people need to consider," Ma says. "Not everyone is jumping on the bandwagon."