letter reveals two misconceptions common among valuation professionals
concerning the valuation of ESOs that we sought to correct
in our article. First, the letter suggests that there has
to be symmetry in valuation: The value of an ESO to a company
must equal the value to an employee. Second, if these values
are somehow different, the writer claims that the value to
the employee is the relevant value for accounting purposes.
Neither claim is accurate.
value of an ESO as measured by an employee will generally
be less than the value as seen by the company. The difference
arises because restrictions prevent employees from selling
or hedging their ESOs, forcing them to bear the risk of
ownership. As a result, an employee’s valuation reflects
risk aversion and other necessarily subjective preferences.
Furthermore, the value of an ESO will be different for each
employee; indeed, it can even be worthless to some. For
this reason, some valuation professionals, who seek to justify
low values to attract clients, readily adopt this perspective.
But it is fundamentally inconsistent with accounting guidance
and fair value principles.
financial accounting purposes, the value of the ESO is the
value from the company’s perspective and not from
that of the employee. Readers of financial statements want
to understand how the company is performing, not how others
perceive its performance. This concept was repeatedly discussed
at FASB’s Option Valuation Group meetings, and met
with broad consensus agreement.
a discussion memo dated December 15, 2003, FASB stated that
the value of an ESO as measured by a company is the “fair
value” that the company would be required to pay a
hypothetical market participant to assume the company’s
ESO obligations. That is the company’s perspective.
In particular, “[t]he market participant is hypothetical
and does not represent the biases of a particular participant,
such as an employee whose personal wealth is concentrated
in the employer’s equity instruments, but rather reflects
the notional consensus of the market.” Indeed, if
a company used employees’ valuations, the resulting
estimates would not represent fair value, because they would
be the values to individual employees rather than to the
argues that ESO valuation asymmetry cannot exist because
a company would never issue an ESO if it costs more than
it is worth to an employee. This line of reasoning ignores
why ESOs are issued in the first place. ESOs are structured
to incentivize employees to raise their efforts to increase
the profitability and performance of the company. A company
expects that the difference between the employees’
and employers’ valuation of an option would be exceeded
by the increase in the employees’ productivity resulting
from the option grant.
misinterpretation of accounting guidance is similarly matched
by his mischaracterization of the evolution of SFAS 123.
The fact that current accounting standards do not require
companies to expense ESOs on their income statements does
not imply the ESOs are worthless. In 1995, political pressures
caused FASB not to require employee stock option expensing.
Under SFAS 123, companies can voluntarily value the ESOs
according to a Black-Scholes formula or a binomial model.
fundamental misconceptions as Crow’s are all too common
among valuation professionals. The issues involved in valuing
ESOs are surprisingly subtle. It is important that a valuation
professional possess not only valuation experience, but
a truly correct understanding of accounting and the “spirit”
of SFAS 123.
W. Ma, PhD, CFA, CPA
NERA Economic Consulting
note: NERA is a Mercer Inc. company, part of the
Marsh & McLennan Companies. NERA, Mercer Inc., and Marsh
& McLennan are unaffiliated with Mercer Capital. Ma
and coauthor Algis T. Remeza participated in discussions
with FASB on employee stock option valuation issues; Ma
is a member of FASB’s Option Valuation Group.