Fortune 1000 IT Company with a Complex Market Award
This large IT company granted a restricted stock unit containing a market condition. Ordinarily, market award valuations are handled via the multiple tranche approach assuming the following:
- The units in each vesting tranche are known in advance (as of the service inception date)
- Fair values can be assigned to each tranche
- A requisite service period is assigned to each tranche
But the company’s award couldn’t meet the first condition because it contained catch-up opportunities. That is, people could earn shares based on share price performance as measured early in the award’s performance period. However, even if they didn’t earn shares then, they could still earn them at the end of the performance period based on the cumulative share price performance over a longer performance period.
So it was impossible to know how many shares were subject to the fulfillment of a market condition at a certain future time, like at the end of the performance period. It depended on how many shares had already been awarded based on a market condition earlier in the period.
Because of the cumulative catch-up provision, using the multiple tranche approach would have caused confusion from a recognition perspective, not to mention downstream complexities in earnings per share calculations.
Unable to break the award into separate vesting tranches, Equity Methods decided to value the award as a whole and produce a weighted average requisite service period. This was consistent with ASC 718 10.55.72:
An award with a combination of market, performance, or service conditions may contain multiple explicit, implicit, or derived service periods. For such an award, the estimate of the requisite service period shall be based on an analysis of (a) all vesting and exercisability conditions, (b) all explicit, implicit, and derived service periods, and (c) the probability that performance or service conditions will be satisfied.
Our interpretation was that in complex cases in which multiple explicit, implicit, or derived service periods were present, a single requisite service period should be estimated. This “unified tranche” approach would result in a single value per base share of the award being granted, as well as a single requisite service period which could also be calculated from within the Monte Carlo simulation.
After considering alternatives, Equity Methods recommended the unified tranche approach. Our argument for its theoretical voracity and technical compliance persuaded the company’s external auditors, who initially had favored the multiple tranche approach, and the company adopted the new valuation method for its complex market award.