Introduction ■ ■ ■

As shared-based compensation continues to be a majorcomponent of employment costs for public companies,the Securities and Exchange Commission (“SEC”) continues to focus on the measurement of such compensation. Statement of Financial AccountingStandards No. 123 (revised 2004) (“SFAS 123(R)”) wasissued in December 2004, outlining various requirementsfor the recognition, valuation and disclosure of share-based compensation awards. As a result, traditionalstock option valuation approaches such as the Black-Scholes-Merton Option Pricing Model (“Black-Scholes”) are being utilized to value such awards.However, closed-form models such as the Black-Scholesmay not satisfy the Financial Accounting StandardsBoard’s (“FASB”) or the SEC’s collective goal of more analytical methods in supporting actual employeeexercise assumptions. Since employee exercise behaviorcan be difficult to predict, incorporating additional variables that influence exercise behavior, such as priceappreciation, into a valuation model is more appropriatethan one simply based on elapsed time.

Current Rules and Trends ■ ■ ■

In an effort to observe how companies are valuing share-based compensation awards under SFAS 123(R),we examined each of the public companies in the S&P

500 Index. Specifically, we reviewed disclosed informationfrom their latest available 10-Q or 10-K SEC filing.1

Due to disclosure limitations, we were only able toobserve share-based award grants for 444 of the 500companies in the S&P 500 Index. Of these reportingcompanies, the most popular type of shared-based compensation award was employee stock options. Infact, 97% of the reporting companies granted stockoptions to employees. Other types of awards grantedinclude restricted stock, restricted stock units, stockappreciation rights and share purchase programs.

As part of the disclosure requirements of SFAS 123(R),public companies must detail their method of estimatingthe fair value of equity instruments granted (or offered togrant). Moreover, a description of the significantassumptions used to estimate the fair value must be disclosed, including: (a) expected term (including themethod used to incorporate the contractual term andexpected exercise and post-vesting employee terminationbehavior); (b) expected volatility (and the correspondingmethod used to estimate it); (c) expected dividends; (d) risk-free rate; and (e) discounts for post-vestingrestrictions, if applicable.

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Trends in SFAS 123(R): Is the Black-Scholes Model Still King?

Gregory A. O’Hara, CFA – gohara@srr.comJason M. Muraco, CFA – jmuraco@srr.com

1This review was performed in November 2006.

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Based on our research, the most popular valuation methodologyutilized to estimate compensation cost associated with employeestock options was the Black-Scholes. Approximately 85% of thecompanies that disclosed information on methodology noted theuse of the Black-Scholes. A binomial or latticed-based modelfollowed at 14% of reporting companies.

The Black-Scholes is an arbitrage-pricing model that calculatesthe price of a traditional call option by analyzing the volatilityand opportunity cost of investing in the underlying asset. Itscurrent popularity is based on the fact that it is almost universally accepted in the financial and accounting fields, andis easy to utilize (if not easily understood). However, the Black-Scholes is a “closed-form” model in that it requires staticassumptions (for items such as volatility and expected term)that may not accurately reflect the dynamic characteristics of acompany’s stock price or employee exercise behavior. So, whileit is straightforward to use, the Black-Scholes does not offer anyflexibility in assumptions over time. This lack of flexibility hasrecently come under fire by the SEC.

On March 29, 2005, the SEC issued Staff Accounting BulletinNo. 107 (“SAB 107”) in an effort to offer the SEC’s interpretationregarding the interaction between SFAS 123(R) and certainSEC rules and regulations regarding the valuation of share-based payment arrangements for public companies. In accordancewith SFAS 123(R), no specific valuation technique or model isexplicitly preferred over others, as long as the model is (a)applied in a manner consistent with the fair value objective andrequirements of SFAS 123(R); (b) based on established principlesof financial economic theory and generally applied in the field;and (c) reflects all substantive characteristics of the instrument.

The SEC staff noted that certain valuation models may not meetthe third criteria because some models are not designed toreflect certain characteristics contained in the instrument beingvalued. The following example was provided:

For a share option in which the exercisability is conditionalon a specified increase in the price of the underlyingshares, the Black-Scholes-Merton closed-form modelwould not generally be an appropriate valuation modelbecause, while it meets both the first and second criteria,it is not designed to take into account that type of market condition.

In the above example, the SEC staff criticizes the lack of flexibility within the Black-Scholes. Since the Black-Scholesrequires static assumptions (specifically term) in the valuationof employee stock options, factors other than time (such asstock price appreciation) may not effectively be modeled into anoption valuation if the Black-Scholes is utilized. In fact, the onlyway to attempt to model employee early exercise behavior intothe Black-Scholes is solely through the expected term assumption.

According to the SEC staff, when utilizing the Black-Scholes acompany must use an approach to estimate expected term thatuses assumptions and measurement techniques consistent withthose that a “marketplace participant” would likely use in determining an exchange price for the share options. A companycould consider historical share option exercise experience.However, there are alternative methods if historical experiencedoes not provide a reasonable basis upon which to estimateexpected term due to various reasons (e.g., life of company,stage of development, structural business changes, term differences in past option grants, lack of a variety of price pathsfor company, etc.). The SEC staff provided the following alternative methods: (1) use a lattice model (which incorporatesmany price paths) to determine the expected term; or (2) usedata about the exercise behavior of employees in similar industries and/or situations as the company.

Additionally, the SEC staff will also accept a simplified methodto calculate expected term, assuming the subject share optionhas “plain-vanilla” characteristics, such as: (a) granted at themoney; (b) exercisability is conditional only on performingservice though vesting date; (c) forfeiture of share option if employee terminates service prior to vesting; (d) limited timeto exercise share option if employee terminates service aftervesting; and (e) non-transferable and non-hedgeable. The formulafor the SEC staff’s simplified method is:

Expected Term = [(Vesting Term + Original Contractual Term) / 2]

Example: the expected term for a 10-year option that has a 3-year cliff vesting term would be 6.5 years (i.e., [(3 + 10) / 2] = 6.5).

Given that this simplified approach circumvents the analyticsneeded to support expected early exercise behavior, the primaryshortcoming of the Black-Scholes is mitigated and use of theBlack-Scholes model is appropriate. However, it is important tonote that the SEC staff does not expect this simplified method

85%

14%

1%

Black-Scholes Binomial / Lattice Other

% of Reporting

Companies

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would be used for share option grants after December 31, 2007,as more detailed information should be widely available by then.This implies that employee stock option valuations should beincorporating historical employee exercise behavior when suchinformation is available. Once the SAB 107 short-cut formula isno longer acceptable, companies will need to rely on othermethodologies to incorporate accurate expected terms that capture employee behavior, such as the binomial / lattice model.A binomial / lattice model provides more flexibility in the valuation of stock options due to the ability to model in factorsthat affect exercise behavior (e.g., price appreciation). Due tothe lack of such flexibility, the SAB 107 formula, while simpleand convenient to use, may provide a result that departs fromeconomic reality.

Future Expectations ■ ■ ■

Move Away from the Black-Scholes

As the SEC continues to emphasize the importance of factoringemployee exercise behavior into the valuation of employee stockoptions, we expect a trend in valuation methodologies to movefrom more traditional, closed-form models such as the Black-Scholes toward more flexible models such as the binomial / lattice or Monte Carlo model. These models allow various factors (such as price appreciation) that can influence employeeexercising behavior to be modeled into valuations. The only waythe Black-Scholes can factor employee behavior into an optionvaluation is to solve for an effective term that incorporates suchbehavior, which may require a binomial / lattice model to calculate anyway. Further, binomial / lattice models offer flexibility in assumptions over time (e.g., increasing volatility),while the Black-Scholes requires static assumptions throughoutthe life of the option.

The importance of having the flexibility to model in factors suchas stock appreciation is exemplified in the fact that most companiesdo experience significant early exercising among their employees.As such, in order to accurately value employee stock options,valuations must incorporate some type of early exercise factor.In our review of public companies in the S&P 500 Index, weestimated the early exercise factor (also referred to as the “suboptimal factor”) of the companies by analyzing the implieddiscount between the expected (or effective) term and the contractual term of companies’ stock options. As presented inthe graph, the discount between effective term and contractualterm ranged from 20% to 100%, with an overall average ofapproximately 55% for the reporting companies. That is, theeffective term, on average, was approximately 55% of the contractual term. Therefore, for a 10-year contractual option,the estimated holding period is approximately five and a halfyears. The implied discount generally ranged between 40% and60% for the reporting companies, as more than 60% of thereporting companies exhibited an implied discount within this

range. It is important to note that these results may be a reflectionof companies utilizing the SAB 107 formula as opposed to statistical employee behavior analyses, which would suggestthat the range may alter going forward when the SAB 107 formula is no longer acceptable. (Note that these statistics alsoconsider that there is usually a minimum vesting period thatprecludes exercising.)

Our review of the S&P 500 companies also suggested that thetrend towards more flexible models such as the binomial / latticemodel may have already begun. Over thirty companies discloseda change in valuation model away from the Black-Scholes,including Aon Corp., Bank of America Corp., Cisco Systems,Inc., Nordstrom Inc. and Sabre Holdings Corp. According tothe footnote disclosures, the primary reason for the valuationmodel change was due to the inability of the Black-Scholesbeing able to factor in all characteristics of the stock options.

Efforts to Lower Compensation Expense

As companies continue to adjust to the requirements of SFAS123(R), we anticipate that companies will begin to make structural changes in their stock option terms in order to lowercompensation expense. SFAS 123(R) requires a public entity tomeasure the cost of employee services received in exchange foran award of equity instruments based on the grant-date fairvalue of the award (with limited exceptions). That cost will berecognized over the period during which an employee isrequired to provide service in exchange for the award – the requisite service period (usually the vesting period). Prior toSFAS 123(R), public companies had the option to recognizethese costs at fair value (under SFAS 123), or alternatively, use APB Opinion No. 25’s intrinsic value method of accounting (with only disclosure of the fair value in the foot-notes). Under APB Opinion No. 25, issuing stock options toemployees generally resulted in recognition of no compensationcost. Following SFAS 123(R), all public companies are nowrequired to record share-based compensation expense on theirincome statement.

Effective Term Discount Range

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Two specific ways companies can lower their share-based compensation expense include (a) lowering the contractualterm of their stock options and (b) shifting from time-basedvesting to performance-based vesting. The contractual term of astock option is positively correlated with stock option value.Accordingly, one way to lower annual share-based compensationexpense is to lower the contractual term of employee stockoptions. In our review of companies in the S&P 500 Index, mostemployee stock options had a contractual term of ten years.However, there were nearly twenty public companies that foot-noted a recent change in contractual term from ten years tosomething lower (i.e., six to eight years), including E*TradeFinancial Corp., HJ Heinz Corp., Juniper Networks, Inc., andManor Care Inc. We expect this trend to continue going forward.

Shifting from time-based vesting to performance-based vestingis another trend we would expect to see going forward.Performance-based vesting (e.g., often via issuance of restrictedstock) may lower annual compensation expense since theexpense must be adjusted for the probability of the performancemetrics being met. Time-based vesting does not require anyprobability adjustments and, therefore, typically results ingreater compensation expense, all else held constant.

Accordingly, performance-based awards offer the ability to“smooth-out” share-based compensation expense and bettermatch-up the expense with actual company performance. As aresult, for companies that experience an unexpected decline,performance-based awards may ultimately lower share-basedcompensation expense. This compares to time-based grants thatare “locked-in” on the grant date and the expense does notchange regardless of the company’s future results.

Our review of companies in the S&P 500 Index suggests that alarge portion of public companies are already beginning to movemore towards issuing performance-based awards. There were anumber of companies that recently issued new types of performance-based awards that were not historically granted.Additionally, most public companies we reviewed currentlygrant a variety of awards rather than only stock options.

Conclusion ■ ■ ■

In summary, it appears that the Black-Scholes is still reigningking, but may not be the “staple” valuation methodology forstock options in the future due to recent reporting regulations.Further, as all public companies are now required to fully recognize share-based compensation, we would expect variousstructural changes in stock options and different types ofawards to be issued in an effort to lower compensation expense.

% of Reporting Companies