MEMORANDUM

At your request, we have reviewed various market-based approaches for estimating the grant-date fair value of employee stock options under FASB Statement of Financial Accounting Standards No. 123, Share-Based Payment ("Statement 123R"), which requires that companies recognize compensation paid in the form of employee stock options as a cost in their financial statements.

A market-based approach involves an instrument that will be traded among willing buyers and sellers, and the use of the instrument's market price as a reasonable estimate of the grant-date fair value of employee stock options.

The main conclusion of our analysis to date is that instruments that track the future flows of net obligations facing the company or net receipts by its employees under the option grant can yield reasonable estimates of fair value as defined in Statement 123R. Further, our analysis indicates that instruments that replicate the terms and conditions of employee stock options or other share-based compensation do not produce reasonable estimates of fair value.

These conclusions are relevant only to the design of the instrument. The suitability of any market-based approach to the estimation of fair value depends not only on an appropriate instrument design, but also on the presence of an appropriate market pricing mechanism and related information plan to ensure appropriate levels of competition and liquidity in the market for the instrument.

1. Background: Market-Based Approach and the Measurement Objective

The measurement objective under Statement 123R is the grant-date fair value of the company's obligation to its employees under the option grant, which is the cost to the company of making the grant, evaluated at the date of the grant. From an economic perspective, this can be viewed as the opportunity cost of the option grant to the company's shareholders.¹ The measurement objective is unaffected by the decision to use a market-based approach to valuation, rather than a model-based approach.

Under the market-based approach, the company uses a market price as an alternative to the model-based estimate as its measure of fair value. The market price is the price at which a market instrument is traded between a willing buyer and seller. The price is obtained through a competitive market process.

A market-based approach must have three elements in order to generate a market price that is a reasonable estimate of the fair value of an employee stock option grant. In order to meet the objectives of Statement 123R, each element of the market-based approach must be consistent with the measurement of fair value:

• A market instrument that confers net payments on its holder that are equal in value to the fair value of all or part of the employee stock option grant.², ³
   
• A credible information plan that enables prospective buyers and sellers to price the instrument. For example, the plan should provide information about the exercise behavior of the employees in the grant. It should be easily accessible to all market participants to reduce the potential for adverse selection.
   
• A market pricing mechanism through which the instrument can be traded to generate a price. It should encourage participation in the market in order to promote competition among willing buyers and sellers.
   

Thus, the instrument design is just one of several elements of a market-based approach that must be consistent with the objective of fair value in order to produce a price equal to fair value.

We understand that no instruments were publicly available for estimating the fair value of employee stock options before the promulgation of Statement 123R. A variety of candidate instrument designs have come to our attention since the issuance of SAB 107 in March 2005, which provided guidance for companies to follow in using models to estimate fair value. This memo reflects our review of instrument designs to date.

Our conclusions about the potential for alternative instrument designs to generate reasonable estimates of fair value appear in the next section. In reaching these conclusions, we have assumed that other elements of the market-based approach are suitable to the estimation of fair value.

2. Alternative Approaches to instrument design

The candidate instruments for valuing employee stock option grants under Statement 123R have tended to fall into two categories, which we distinguish as the tracking approach and the terms and conditions approach. Of the two approaches, only the tracking approach appears likely to produce a reasonable estimate of the fair value of employee stock options, as we explain below.

A. Tracking Approaches

Under the tracking approaches, willing buyers and sellers trade rights to future payouts that are identical to the future flows of net receipts by employees or, equivalently, net obligations of the company under the grant. For the purpose of valuing an employee stock option grant, these two designs are consistent with measurement of fair value:

• An instrument that promises payments to its holder that are similar to the future intrinsic values realized by employees under the grant. This can be accomplished through the competitive sale by the company of an instrument with payments that track the intrinsic value realized by employees upon exercise of some or all of the applicable stock options.
   
• An instrument that assigns obligations to a third-party holder that are similar to the actual net obligations of the company to employees under the option grant. This can be accomplished by paying a qualified third-party to meet some or all of the company's obligations to employees under the option grant.
   

In each instance, the conditions of the instrument are designed to be binding.

From an economic perspective, the opportunity to trade a tracking instrument creates an incentive for buyers and sellers to devote resources to estimating the value of the instrument, and to reveal this information through the market price. The tracking instrument creates an incentive to estimate a price equal to fair value by exposing its holder to future payment or obligation flows that are by design equal to what the company faces under the grant. In pricing the instrument, the prospective buyers and sellers are thus pricing the grant-date fair value of the company's obligation under the grant. The market price of the tracking instrument is accordingly a reasonable estimate of fair value in a competitive market.

Under the tracking approach, no restrictions are imposed on the holder's ability to trade or hedge the instrument. All of the cost of the option grant to the company, and thus fair value, is captured through the promise of future payments or assignment of future obligations. These future flows track the company's net payments to its employees under the option grant and, thus, fair value.⁴

Indeed, imposing the restrictions that employees face against trading or hedging on the market instrument or its holder would likely cause the market price of the instrument to depart from fair value. The reason is that these restrictions affect the opportunity cost of the grant to the company only through their effect on the exercise behavior of employees.⁵ This behavior is fully captured in the flow of payments or obligations under the tracking approach.

We conclude that market instruments that assign the future flows of net obligations or net receipts under the grant to the holder are suitable for generating a transaction price that is a reasonable estimate of fair value, as defined in Statement 123R.

B. terms and conditions Approaches

It has been suggested that, if a market instrument could be designed to impose on its holder the terms and conditions that employees face under an option contract, the market price of the instrument could be used as a reasonable estimate of fair value. This is the terms and conditions approach:

• The placement of terms and conditions on the holder of the instrument that replicate the substantive terms and conditions facing the employees who are the recipients of the options under the grant for which an estimate of fair value is sought. For example, the holder of the market instrument would face the same prohibitions against trading and hedging of the instrument as employees face under the terms of the granted options. Ideally, this would lead the holder to make the same exercise decisions as employees.
   

There are inherent difficulties with such an instrument that will likely prevent its market price from being a reasonable estimate of fair value.

The greatest difficulty is that the cost of the option grant to the company depends on considerations that are not captured by the terms and conditions that employees face under the option contract. For example, employees are typically restricted from transferring their options or hedging their option positions, so the terms-and-conditions approach prescribes the imposition of such restrictions on the holder of the instrument in order to affect its market price. Yet these restrictions are not relevant to the cost of the grant to the company. The company may transfer its obligations under the option grant to a third party, and is free to hedge its position. The company's cost of risk-bearing under the grant and, thus, the opportunity cost of the grant, reflects this ability to trade and hedge, even though the instrument designed by the terms-and-conditions approach does not. It is thus clear that factors relevant to the cost of the grant to the company are omitted from the instrument design under the terms-and-conditions approach.

It has been suggested that an investor who faces the terms and conditions that employees face will exhibit the same exercise behavior as the employees under the grant. The idea is that causing investors to anticipate exercise behavior similar to that of the employees will cause them to impound such information into the market price of the instrument. While exercise behavior is relevant to the estimation of fair value, the view that investors will behave like employees does not survive close inspection from an economic perspective. There is no reason to expect investors to exhibit the same exercise behavior as employees, even if they hold instruments that have similar terms and conditions. Differences between the preferences of employees and investors will generally prevent their exercise behaviors from being similar. For example: employees and investors may have different risk profiles; employees pay with service over time, not up front with cash; employees may contribute directly to the growth and success of the company; and employees' livelihoods are more directly related to the performance of the company than is the livelihood of the investor. Furthermore, post-vesting voluntary and involuntary termination of employment from the company can significantly affect exercise behavior and the cost of the company's obligations under the grant.

Replicating the terms and conditions that the employee faces under the option contract is thus not sufficient to lead an investor in the instrument to exhibit exercise behavior similar to the exercise behaviors of employees under the grant.

We conclude that the terms-and-conditions approach to the design of a market instrument does not yield a transaction price that is a reasonable measure of the cost of the option grant to the issuer and, thus, will not meet the fair value measurement objective of the standard.

3. Ease of Implementation

In comparing alternative methods of instrument design, we have also considered the ease of implementation. Our initial analysis indicates that instruments that transfer future flows of net obligations or payments to a willing buyer or seller pose no significant implementation obstacles. The implementation difficulties encountered in applying a terms-and-conditions approach to obtain an estimate of fair value appear to be insurmountable.

4. Benefits from the Use of Market Instruments to Estimate Fair Value

The use of an appropriate market instrument for obtaining an estimate of fair value has certain distinct advantages over the use of a model-based approach to valuation, provided that the instrument design is sufficient for the measurement objective of fair value and is accompanied by an appropriate market distribution mechanism and information disclosure plan. In that instance, some of the advantages of the market-based approach are as follows:

• The market price obtained through a market-based approach value can efficiently reflect a consensus view among informed marketplace participants about an expense, asset or liability's utility, future cash flows, the uncertainties surrounding those cash flows, and the compensation that marketplace participants demand for bearing those uncertainties.
   
• The instrument's price could establish the true opportunity cost of the award to the issuer by having it priced by the market.
   
• Use of a market instrument may promote competition between different approaches to the estimation of the value of the market instrument, and thereby lead to innovations in models and techniques used to price employee stock options.
   
• There could be a positive externality for other firms that could use market prices to help improve their calibration of model-based estimates.
   

5. Conclusion

To summarize, our conclusions to date from considering alternative market-based approaches to valuation under Statement 123R, focusing on the design of a market instrument, are as follows:

• Market exchanges between willing buyers and sellers of instruments that are designed to track the future flow of net obligations of the company or net receipts by employees under the grant can produce reasonable market-based estimates of fair value consistent with the measurement objective of Statement 123R.
   
• Market exchanges of instruments that have been proposed to replicate the terms and conditions of employee options do not produce reasonable estimates of fair value.
   
• The tracking approach to the design of market instruments appears easier to implement than does the terms-and-conditions approach.
   

Restrictions against the trading or hedging of a market instrument are not consistent with the fair value objective under any of the approaches to instrument design that we have reviewed. All of this assumes that the market exchange occurs in a competitive market, reflecting the use of an appropriate market pricing mechanism and information plan.

       

See Press Release 2005-129

See Chief Accountant's Statement

Endnotes

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¹ Chester S. Spatt, Cindy R. Alexander, David A. Dubofsky, M. Nimalendran and George Oldfield, "Economic Perspective on Employee Option Expensing: Valuation and Implementation of FAS 123(R)," Office of Economic Analysis Memo to Donald Nicolaisen, Chief Accountant, March 18, 2005. http://www.sec.gov/interps/account/secoeamemo032905.pdf

² Under the proposals that we have seen, the amount of market instruments that would be issued is a fraction of the total option grant (generally 5-15 percent of the grant). Alternatively, a company could transfer part or all of its grant obligations to a third party that would meet the grant's stock delivery obligation. We have not evaluated the adequacy of any grant size or volume to the achievement of the valuation objective.

³ The net payment may be in the form of securities or cash.

⁴ The tracking instrument is designed to reflect the company's anticipated pre-vesting forfeiture rate, so that investors receive payouts consistent with this rate and price the instrument on this basis. Tracking based on pre-vesting forfeiture is accomplished by adjusting the payout associated with employee exercises by a factor to reflect the disparity between the anticipated and the realized rates of pre-vesting forfeitures. Companies can then update the reported cost over time to reflect new information about the actual rate of forfeiture, as required by Statement 123R.

⁵ Restrictions on the trading of the instrument and/or hedging of the exposure to the instrument (including replicating the instrument with the underlying asset using a dynamic strategy) can have a significant effect on price. For example, Brenner, Eldor, and Hauser, in their paper titled "The Price of Options Illiquidity," compare the prices of exchange-traded foreign exchange options with similar options that were auctioned off by the Central Bank of Israel that were not tradable. The non-tradable options in their data were on average priced at 21 percent less than the exchange-traded options.

http://www.sec.gov/news/extra/memo090905.htm