With Takis Makridis, Vice President of Professional Services

Q: “How can I create an accurate and auditable valuation methodology, whether it means selecting the right valuation model or effectively deriving the many and complex input assumptions?”

A: Valuation is about connecting the dots, but here there are really only two dots, and they are large ones: theory as it relates to valuation, which is a well-established branch of financial economics; and, secondly, firm-specific data related to the types of awards issued and historical exercise and cancellation behavior. The most sound valuation methodology, ranging from the model selected to the input assumptions derived, merges the facts and circumstances of a company’s stock plan and data to well-accepted fair value practices and techniques.

Q: “Our compensation committee has decided to grant complex performance or market-based instruments. How can I determine a compliant and defensible fair value, especially when the Black-Scholes formula cannot be used?”

A: The mandate in regulations such as FAS 123R, IFRS 2 and SAB 107 for handling market conditions is to formally incorporate their effect in the valuation methodology. This is possible using lattice or Monte Carlo simulation techniques, but requires the technique to be custom-built to handle the specific terms and conditions of the award in question. Performance conditions create a very different challenge: their effect cannot be directly incorporated in the estimate of fair value. Instead, they give rise to a moving target expense allocation process, whereby expense must be recognized against the expected outcome. This is best handled using a system that can track the many potential changes in outcomes expected over time.

Q: “How can I determine/estimate the impacts of changing conditions/variables (ie: volatility, dividends, earnings performance, stock price, etc.) on our overall stock option expense or earnings per share?”

A: There truly are a large number of moving parts that combine to impact compensation cost and dilutive shares. This realization could not be occurring at a more fortuitous time, either. Companies are increasingly keen on dissecting compensation expense to understand its change from last period or absolute magnitude. Two tools are generally useful in creating the transparency desired. First, efforts to understand and evaluate how various levers impact expense are best performed using an established system or algorithm. The interdependence of variables can make back-of-the-envelope predictions unreliable. Second, understanding themes and principles is important: even after developing a robust forecast, it is highly beneficial to learn the fundamental determinants of compensation cost and how they interact.

Q: “In a period of rapid compensation redesign, how can we determine what is the compensation plan design that optimizes the value for employees but minimizes our associated costs?

A: Compensation design is both an art and a science, and there are clearly multiple philosophies or best practices in the area. Regardless of one's preferred flavor, it is certainly true that compensation redesign choices should not be made in a vacuum: everyone would be better off if human resources, finance, accounting, and legal were all stakeholders in the process. As such, during this evolutionary period for compensation design, it is imperative that the financial statement implications of alternatives under consideration be well understood. This will improve and refine the decisions made, while also minimizing surprises after the decisions are implemented.