Alternatives Emerge For Options Valuation

Improper backdating of stock options might be in the spotlight these days, but don’t forget—at the urging of the Securities and Exchange Commission, financiers are still slaving away to create better ways to value the pesky things, too.

Two new ideas of how to do so have emerged recently. Both come from financial institutions, eager to create new instruments companies can use to establish a fair market value for their stock options. New accounting rules now require companies to expense options against earnings, so determining that value quickly and accurately has become a much-prized accounting goal. Otherwise, companies are stuck using the simple Black-Scholes model or more complex lattice model, but both are widely criticized as inaccurate and easily manipulated.

Investment banking powerhouse Bear Stearns has begun talking up one idea: three new financial instruments that in tandem would establish a market-based value for employee stock options. The three-instrument system would consist of a restricted stock option issued to employees that would be tradeable upon vesting, a market-traded stock option that would be sold when restricted options are granted, and a restricted bond unit that would be based on a bond investment financed with the proceeds of the sale of the market-traded option.

Employees would be given a choice of whether they want the restricted stock option units that convert to stock options on the vesting date, or the restricted bond units that represent the cash value of stock options sold on the grant date and held in trust earning interest until the vesting date. The company retains ownership of options that don’t vest because of employee terminations, and the rest continue to trade until exercised.

Mott

“The options sold in the market have no employee characteristics attached to them, so we’re saying an option traded in the market has no employee impairments attached to it,” says Dane Mott, the Bear Stearns research analyst and accountant credited with conceiving the three-instrument system.

That lack of employee influence, Mott says, helps address one of the obstacles to a market value for employee-held stock options: that employees’ exercise behavior is not based on the same risks or considerations as investor behavior. The differences between investors and employees became a focal point last year when Cisco Systems presented its proposal for a market instrument to the SEC. Regulators patted Cisco on the back for its efforts, but declined to embrace the approach as an acceptable valuation strategy.

In addition to the Bear Stearns proposal, Zions Bancorp has established and sold in an online auction the first issue of a new security it calls Employee Stock Option Appreciation Right Securities. “ESOARS” are derivatives that track the cost Zions incurs in granting stock options to employees, then pay investors a pro rata share of the value employees realize when they exercise their options.

In its first issue, Zions sold 93,610 ESOARS units for $7.50 each to 21 buyers from a field of 57 bidders. At the time of the auction, held June 28 and 29, Zions shares were trading on Nasdaq for about $78. In its 2005 annual report, Zions reports a weighted average for options granted of $15.33, based on a valuation following the Black-Scholes formula.

Terry Adamson, vice president with Aon Consulting, says he has some concerns about how valid Zions’ option value is when based on such a small auction. “There were only 40 or so bids,” he says. “I wouldn’t call that a liquid market. I like the concept a lot, but I’m not comfortable with the price yet. I would hope it would get more active than that.”

Acknowledging the small scale of the issue, auction and number of bids, and the resulting low sale price, Zions nonetheless is satisfied that the value per share is real. “Generally speaking, a real market number is always better than a theoretical one,” spokesman Clark Hinkley says. “What you get out of Black-Scholes is highly theoretical.”

Adamson contends that investors assume a great deal of risk with an ESOARS investment as well, because investors lose everything if the underlying option fails to vest. He questions whether the investor’s risk in that case adequately correlates with the underlying transaction, because the consequences to the employee and the company are not nearly as severe if an employee is terminated before an option vests.

Paula Todd, a principal in executive compensation with Towers Perrin, questioned whether companies will embrace approaches like those from Zions or Bear Sterns as they settle into the use of existing models.

Todd

The Financial Accounting Standards Board and the SEC have assumed a market for option-based securities would appear, she says, “but will these securities be useful enough in valuing stock options to create these other securities? A lot of companies have said no, we’ll just value our options in a theoretical sense,” adds Todd. “Option traders have different risks than employees.”

Todd doesn’t dismiss the possibility, however, that an instrument-based approach will emerge and take hold in the market. “These are interesting proposals, and this is exactly what the SEC wanted to happen,” she says. “This is not mainstream whatsoever. A few companies are likely to experiment, but the bulk of companies will still use option pricing models.”

Zions hopes not only to issue new ESOARs in future auctions based on its own option grants, but also to offer up its auction infrastructure to help other companies auction their own comparable securities. Hinkley says a number of companies have expressed interest, but so far Zions hasn’t lined up any subsequent events.

Bear Stearns and Zions both say they have submitted their ideas to the SEC as well, but have received no feedback to date. An SEC spokesman said the agency has no comment on the submissions.

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