Clears Market-Based Way To Value Staff Stock Options
By David Reilly and Serena Ng
The Wall Street Journal
Tuesday, January 30, 2007
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 Sstems 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
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,"
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
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
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.
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.
David Reilly at
firstname.lastname@example.org and Serena Ng at