By DAVID REILLY and SERENA NG
January 30, 2007; Page C5
The Securities and Exchange Commission for the first time has blessed a method for valuing employee stock options that relies on market forces rather than academic models.
The change potentially paves the way for companies to use techniques that lessen the hit to profit they take from this type of compensation.
In a Jan. 25 letter, SEC Chief Accountant Conrad Hewitt said an auction system designed by Zions Bancorp of Salt Lake City could be used to derive "market" values for employee stock options. The SEC had rejected earlier attempts at market-based methods, including a plan pitched by computer-networking company Cisco Systems Inc. in 2005.
Ever since accounting rule makers decreed that starting in 2006 companies would have to book an expense for issuing stock options, a number of companies and financial institutions have tried to develop new ways to value the instruments.
The 'Real' World
Both the SEC and accounting rule makers have said they believe market-based approaches are best for valuing options. Mr. Hewitt said yesterday that the problem is that the models currently in use produce "hypothetical numbers." Market-based approaches produce what "may be a real number," he added.
So far, though, no one had devised a market-based method that passed regulatory muster.
The problem: Regular stock options traded on financial exchanges and employee stock options differ in some main attributes. Both give holders the right, but not the obligation, to purchase stock at a preset price at a future date. But stock options traded on financial exchanges typically come due in at most two years, and there isn't any vesting requirement.
Employee options, on the other hand, typically vest over a number of years, and they can be exercised in some cases over a 10-year period. In addition, employees who leave a company usually have to exercise already-vested options or forfeit them.
The differences have left many companies, particularly heavy options issuers such as tech companies, grousing that existing option-valuation methods such as the widely used Black-Scholes model produce too high a value for employee stock options. That, in turn, results in a too-high charge against profit. At the same time, investors are often befuddled because companies can use different models to calculate options values, which are further influenced by assumptions regarding factors such as the expected future volatility of a company's stock price.
Zions last year tried to tackle the problem by creating securities that mimic the stock options granted to its employees. It then sold the securities to sophisticated investors in a public auction last June, deriving a market value for the options from the bidding. That value turned out to be roughly half the value of its options as calculated by academic models.
Accounting Tweaks
The bank then submitted its results to a months-long review by the SEC. Despite the green light, the agency signed off "on the process subject to several tweaks," said Evan Hill, a Zions vice president. Because of some technical issues, Zions can't use last year's auction to derive its stock-option expense for 2006.
Mr. Hill said the bank will conduct another auction when it grants its next batch of options, in May, and expects to use that to compute its option expense this year.
The main question related to Zions's and other market-based approaches is whether the values created are really "market" values. Mr. Hewitt's letter touched on that concern, cautioning that each auction based on the Zions approach would have to be individually analyzed to determine whether it actually generated a market value.
Among other issues, companies must consider the quantity of securities offered relative to market demand and the number and type of bidders.
Write to David Reilly at david.reilly@wsj.com and Serena Ng at serena.ng@wsj.com