Don’t understate your profits! How early exercise behaviour can reduce employee option cost

Since the Australian Government relaxed the rules around the taxation of options (see break out box) in 2015, we have seen a number of clients adopt options as executive or employee remuneration.  Unfortunately, for accounting purposes, many adopt the standard Black-Scholes online financial models for valuing these options. 
 
Our view is that this model is often inappropriate for valuing employee options where there is likely to be “early exercise” behaviour and at worse, is likely to overstate their cost and understate company profits.
 
In all cases, you still need to know the underlying share price to calculate the option value – usually observable for listed companies, but for unlisted private companies, we need to undertake a valuation of the company first, adding a further layer of complexity.

What do the Accounting Standards say?


Firstly, entities that adopt AASB 2 Share-based payment are required to recognise the fair value of any options (equity-settled share-based payment transactions) issued to employees and executives at the date at which they are issued.
 
These options are usually unlisted and therefore there is no reliable market to determine the fair value of these options.  The Standard does not prescribe the exact method in which the options must be valued but states that the “valuation technique shall be consistent with generally accepted valuation methodologies for pricing financial instruments, and shall incorporate all factors and assumptions that knowledgeable, willing market participants would consider in setting the price” (AASB 2 para 17).
 
Summary of taxation changes to employee share schemes (ESS)

The taxing point in tax-deferred schemes has become the earlier of:
  • when there is no risk of forfeiting the ESS interests and any restrictions on their sale are lifted;
  • in the case of rights, when the employee has exercised them and there is no risk of forfeiting the resulting share and no restriction on disposing of that share;
  • when the employee ceases the relevant employment;
  • 15 years after the ESS interests were acquired.
Start-up concessions – if eligible, CGT tax only on disposal of right or share.  Safe harbour valuation methods are also available for tax purposes.  

For more information on these changes, please contact Philip McIsaac, Tax Director or your Moore Stephens Victoria representative.

Philip MacIsaac
Director - Taxation
P +61 3 9608 0157
pmacisaac@moorestephens.com.au
  
There is further guidance in Appendix B of AASB2 which highlights that the fair value of unlisted  share options “shall be estimated by applying an option pricing model” (AASB 2 Appendix B4), taking into account, as a minimum: 
  • the exercise price, 
  • the life of the option, 
  • the current price of the underlying shares, 
  • the expected volatility, 
  • any dividends expected, and 
  • the risk-free rate.  
Appendix B to the Standard also describes how employees often exercise options early and the effect of early exercise also should be taken into account in the option pricing model adopted.

Option pricing models


The most commonly used option pricing model is the Black-Scholes Merton model, commonly referred to as the Black-Scholes model.  The Black-Scholes model is a mathematical method of option pricing first published in 1973 (by Fischer Black and Myron Scholes through a formula developed with fellow economist Robert Merton) and uses various inputs including those listed above.  Whilst easy to calculate with the presence of a number of free calculators available online, the standard Black-Scholes model is only suitable for calculating the price of European-style options which can only be exercised at expiry of the option. 
 
Most employee share options are American-style options which can be exercised early prior to expiry.  The Black-Scholes option model was really designed for option traders where there is an active market for tradeable options.  
 
A more complex option pricing model is known as the binomial, an extension of the trinomial model. It calculates the option by generating a binomial lattice (tree), showing all the possible prices of the underlying stock at any given time and assigning probabilities of each event occurring.  This approach takes into account certain points in time where it may be more optimal for the option holder to exercise prior to expiry (i.e. early exercise). 

We take early exercise into account by using a leading third party-provided software model which itself is adapted from a trinomial lattice model developed by John Hull and Alan White in 1990, (referred to as the Hull-White model).  Our preferred model adjusts the valuation for any market-based vesting conditions as well as an input for the early exercise behaviour of the option holder, referred to as the “exercise multiple”.  
 
The exercise multiple is a measure of how much the share price exceeds the exercise price when it was exercised.  For example, if the exercise price is $1and share price is $1.63 on the day of exercise, then the multiple is 1.63x. 
 
Early exercise at a share price multiple occurs because employees cannot usually sell or trade their share options, so in order to convert them to cash they must exercise their option and sell the resulting shares.  This often leads to employees exercising their options early before expiry and thus not realising the full theoretical value of the option.  Adjusting for the employee multiple will nearly always result in a lower market value compared with the standard Black-Scholes model assuming the full option term.  The question therefore arises, what is an appropriate early exercise multiple?

Our study of employee multiples (early exercise behaviour)


In order to identify these practices, we conducted a study of mid-market Australian companies and their directors’ early exercising behaviour on options by researching public announcements.  Our sample[1] consisted of 67 companies listed on the ASX, based on the following criteria:
  • Market capitalisation between $20 million and $500 million;
  • Net income greater than $1 million;
  • Options outstanding at the end of 30 June 2015 (latest financial reports).
We ascertained that from this group, 12 had directors who exercised options within our sample timeframe.  Our research found that the average exercise multiple amongst directors was 2.20x and a median of 1.51x.  This compares to a US study conducted in 1996 by Huddart and Lang that looked at more than 50,000 employees between the middle of the 1980s and the middle of the 1990s, which yielded an executive multiple of 2.20[2].   
 
In our study we were unable to obtain data on regular (non-director) employee option exercise behaviour.  Anecdotally, the exercise multiple of regular employees is usually less than that of directors or executives as lower paid employees are usually more motivated to cash out early. 
 

Option valuation comparison 


Below is a scenario valuing an option using the standard Black-Scholes model compared to our preferred model by using our observed exercise multiple of 2.20 (note no other vesting conditions have been assumed).
 
  Black-Scholes Preferred model
Stock price $4.00 $4.00
Exercise price $4.50 $4.50
Time to expiry 5 years 5 years
Volatility 50% 50%
Risk-free rate 2.5% 2.5%
Exercise multiple N/A 2.20
Value $1.70 $1.52


The table shows Black-Scholes has overstated the value of the option by $0.18 or 12%.  The magnitude of the variance can be greater the higher the assumed volatility and timeframe inputs.  Keeping all other assumptions constant, changing the time period to 10 years results in a difference of $0.54 ($2.40 vs $1.86) and changing volatility to 70% results in a difference of $0.45 ($2.27 v $1.82).

Other vesting conditions


As a final note, both Black-Scholes and our preferred model do not take into account other non-market vesting conditions.  It is typical in executive plans to have conditions such as attainment of a sales target or other business operational metric.  The accounting standard requires that having determined the fair market value.

Conclusion


We often are approached by clients who are considering using employee options as a form of remuneration for executives - with recent tax treatment changes this can be an effective non-cash incentive.  However, when it comes to the accounting, using the standard Black-Scholes option pricing model, which may not take into account early exercise behaviour, can lead to understated profits.



[1] Source: S&PCapIQ and ASX, from January 2014 to January 2016.  We’d also like to acknowledge the assistance of James Dickson, our work experience vacationer who trawled through the Appendix 3Ys and other ASX announcements over summer – many thanks.  
 
[2] Accounting for employee stock options written by John Hull and Alan White (2003)