FASB Offers Relief to Private Companies Issuing Stock Options with Service and Performance Conditions

On December 17, 2014, the Financial Accounting Standards Board (FASB) said it would allow private companies to use the simplified method to estimate the expected term of stock option awards with service conditions as well as those with probable performance conditions.

FASB’s decision is an important advancement to the accounting guidance for share-based compensation instruments. As I explained to Bloomberg BNA, “The prior limitation of this method to awards with only service conditions left private companies caught between a rock and a hard place when issuing stock options with performance conditions. On the one hand, they still needed a shortcut approach for estimating expected term, but the only one available was off limits due to the presence of a performance condition in the award terms.”

To understand why this was so, let’s first take a look at how expected terms affect stock option valuations.

Employee stock options give an employee the right (but not the obligation) to buy the underlying security at a predetermined price. Unlike quoted options traded on public exchanges, though, employees rarely hold their stock options until they mature. There are good reasons for this. For one thing, employees can’t create liquidity by trading the option. (Unlike a market traded option, an employee stock option isn’t tradable).

Because employees exercise their options early, this informs how they should be valued. An option with a shorter expected “life” is less valuable than one with a longer expected life. For example, suppose I gave you an option in Google stock stating you could buy Google stock at $500 any time in the next 50 years. This would be quite valuable.

Suppose instead I told you that you could buy Google stock at $500 any time in the next 5 years. This would still be relatively valuable.

Now suppose I told you that you could buy Google stock at $500 anytime in the next 5 minutes. You probably would not be very excited.

So when valuing employee stock options for financial accounting purposes, you need to estimate how long you expect them to be outstanding. The contractual term is normally 10 years. But if in substance you don’t expect employees to hold the options that long, you need to estimate some shorter lifespan for valuation purposes. We call this estimate the “expected term,” and it’s an input to the Black-Scholes-Merton pricing model commonly used to value employee stock options.

Ordinarily historical data is used to calculate expected term. This requires an analysis of how long employees have held their options in the past. For instance, we might crunch 20 years of historical data and conclude that, on average, employees hold their options for only 4.5 years. That’s the estimate we’d use in the Black-Scholes-Merton model.

But private companies might not have very good historical data to support such an analysis. Acknowledging this, in 2005 the SEC offered a “simplified method” for calculating expected term, taking the midpoint between the vesting date and maturity date on the option. If an option vested in 4 years and expired in 10 years, the simplified method would yield an expected term of 7 years.

The catch? Companies could use the simplified method only on options containing service conditions. A service condition links vesting in the award to continued service. For example, an award may vest after an employee renders 4 years of continuous service.

But remember that employee options (or employee restricted stock) also can have performance or market conditions. A performance condition links vesting to an operational metric, such as EPS, sales, or even the company’s successful effort to go public. A market condition links vesting to a stock price hurdle.

Before FASB’s recent decision, private companies issuing stock options with performance conditions faced a dilemma. On the one hand, they might have lacked historical data on which to analyze the expected term. On the other hand, they were precluded from using the SEC simplified method shortcut.

The FASB update fixes this conundrum by enabling private companies to use a non data-driven expected term estimation approach when they might have very few credible alternatives.

FASB’s decision to restrict use of the simplified method to probable performance conditions is logical. To see why, suppose the performance condition is improbable of being achieved. In that event, it’s not even clear when the option will vest, which means it’s not clear how to mechanically perform the simplified method calculation (since the timing of vesting is an input to it). The FASB approach means there’s a clear line of sight to when the performance condition is likely to be achieved.

One last observation. It’s interesting that the recent guidance doesn’t apply to public companies. As I observed to Bloomberg BNA, “Public companies can face very similar situations, and the scope limitation to private companies suggests that public companies may still be expected to perform finer analyses in developing expected term estimates.”

My remarks appear in the January 16 issue of Bloomberg BNA’s Accounting Policy & Practice Report. You can download a copy of the report here. The story is called “Private Companies Face Conundrums About Applying PCC’s GAAP Alternatives,” and it begins on page 95.

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