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Brought to light in yesterdays WSJ, The Securities and Exchange Commission for the first time has blessed a method for valuing employee stock options derived from market prices rather than academic models.

Since the institution of FAS 123R, a big problem has traditionally centered around the fact that employee stock options do not resemble those that are publicly traded on common option exchanges. Most significantly, the term of the employee options may be as long as 10 years. A common flaw in the Black Scholes model is that it is best for "short-term" options, usually 1 month to less than 1 year,
like those that are publicly traded. The flaw resulted in overstated option values, which to any company's chagrin, resulted in lower reported earnings.

Last year, Zions Bancorp (ZION) addressed the problem by creating securities that mirror the stock options granted to its employees. The company then sold the securities to sophisticated investors in a public auction, deriving a market value for the options from the bidding. The buyers paid about one half the amount indicated by the Black Scholes model.

This is good news for all companies facing FAS 123R issues. How auditors interpret this news will be interesting. Many companies already create markets for their options, although they tend to be related party transactions. Now employee option grants just have to include a public auction to institutional investors. This may be a big task for the smaller cap companies, who by the way, tend to be the largest issuers of employee stock options.

Category(s): IRC 409A
Posted by Tom Miller at 08:07 PM | Permalink | Comments (0) | TrackBacks (0)