Share-based Payment

Share-Based Payment Valuation (Share Valuation/Share Option Valuation)

IFRS 2, FRS 20, IFRS 13, ASC 718, ASC 820: Fair Value of share-based payments

Calculating the fair value of share-based payments, such as employee share options, is required by IFRS 2, FRS 20 and ASC 718.  The valuation of share-based payments under IFRS 2, FRS 20 and ASC 718 may well be accompanied by a requirement from tax colleagues to value the same equity incentives for tax purposes in accordance with ITEPA or other national tax statutes.

The accounting standards require companies to recognise all share-based payment transactions as an expense in their financial statements.  This expense is apportioned over the vesting period unless there is no vesting period, in which case the expense is recognised in full. The expense is based on the number of financial instruments which are expected to vest and the fair value of those financial instruments at the date of grant.

Fair value is defined in IFRS 2 and FRS 20 as “the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted between knowledgeable, willing parties in an arm’s length transaction.”

Fair value is defined in ASC 820 and IFRS 13 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

The fair value of equity instruments granted should be based on market prices.  In the absence of market prices, fair value should be estimated using a suitable valuation technique and should take into account the terms and conditions upon which those equity instruments were granted.  Valuation techniques include:

• Black Scholes Option Pricing Model
• Lattice Model (Binomial or Trinomial)
• Monte Carlo Model
• Asset or nothing models
• Gap models

IFRS 2, FRS 20 and ASC 718 make a distinction between the treatment of market and non-market-based performance/vesting conditions:

• Market vesting conditions are those related to the market price of an entity’s equity, such as achieving a specified share price or a specified target based on a comparison of the entity’s share price with an index of share prices of other entities.  Market-based performance conditions must be taken into account when determining the fair value.
• Non-market vesting conditions cannot be taken into account when estimating the fair value of equity instruments.  Instead, non-market vesting conditions are reflected by adjusting the number of equity instruments which are expected to vest.

In all option valuation models, the most significant elements of the option value are volatility and time to expiry.  The greater the time to expiry, or the greater the volatility of the underlying asset over which the option is exercisable, the greater the value of the option.

Volatility Input & Leverage
Volatility is a particularly complex input, especially as it concerns share options in private companies.  Typically a valuer will look to read across from the equity volatility of comparable public companies.  However, these comparable public companies may be capitalised with significantly less debt than a private company. 
The effect of increased debt can be to significantly increase the equity volatility.  For example, if a company is capitalised with 100% equity, if the value of the company doubles, the value of the equity increases by a factor of two.  However, if that same company is capitalised with 75% debt and the value of the company doubles, the value of the equity increases by a factor of five.
To better match the market volatility, it may therefore be necessary to adjust the equity volatility evidence from the comparable companies using a series of equations designed to normalise equity volatility to account for different levels of leverage.

Black Scholes Option Pricing Model Valuation Approach

The Black Scholes Option Pricing Model is a “closed-end” valuation technique which is usually applied to relatively straightforward share-based payments.  The premise is that it is possible to create a perfectly hedged position by buying and selling the underlying asset in a way that eliminates risk, such that there is only one right price for the option.  It is either profitable or not profitable to exercise the option depending on the growth in the current share price. 

The Black Scholes Option Pricing Model determines the probabilistic values of the current share price increasing or decreasing and computes the value of an option in a risk-neutral framework based on the probability of the share price exceeding the exercise price.  The Black Scholes Option Pricing Model computes an option’s total value by determining its intrinsic value and time value. 

AICPA Guidance
The “Option Pricing Method” set out in “Valuation of Privately-Held-Company Equity Securities Issued as Compensation” (from AICPA, the American Institute of Certified Public Accountants) outlines how of a series of standard Black Scholes Option Pricing Models can be used to value more complex share-based payments.
This method distributes the proceeds of a transaction involving the sale of the company in question to various classes of share holders dependent on the sequential “waterfall” distribution set out in the company’s articles of association, partnership documents, or similar.
The distribution is then allocated by using two separate Black Scholes Option Pricing Model calculation’s at each payoff level to create a “floor call” and a “cap call”.  This enables an estimate of the probability adjusted value of the current total equity value, thus attaining a value to be able to satisfy the shares in question.

Lattice models (Binomial and Trinomial) Valuation Approach

“Closed end” option valuation techniques such as the Black Scholes Option Pricing Model cannot easily incorporate the possibility of early exercise.  “Finite difference” valuation techniques such as binomial or trinomial methods have the advantage of being able to take account of the fact that employees may wish to exercise their options prior to expiry, particularly if the share price reaches a certain level. Such early exercise behaviour leads to the option being a type of “barrier option”.  In a finite difference model, the early exercise behaviour of employees is modelled by assuming that exercise takes place whenever a set level (the barrier) is reached. 

It is computationally more efficient to use a trinomial rather than a binomial tree when valuing a barrier option, as it uses three, rather than two, probabilistic movements of the current share price from a starting point over a specific time period.

A lattice model is extremely imprecise if the share price movement over a period of time is modelled just once.  However, if a large number of movements are modelled, one after the other, the time periods involved become smaller and the model becomes much more accurate.

Monte Carlo Model Valuation Approach

A Monte Carlo model is a flexible tool, which can be used to model complex features of equity awards.  For example, equity awards containing path dependent features, such as a ratchet mechanism, made by companies with multiple classes of shares, as is common in private equity portfolio company management incentive schemes.

A Monte Carlo model performs many simulations of the evolution of the price of an equity instrument over a period of time.  The values obtained from one simulation to the next can vary greatly.  With increased simulations, the average value obtained from the simulation will converge upon a single estimate, in accordance with the statistical law of large numbers. 

Our Work

American Appraisal consultants, both in the UK and across our network of global offices, have the complex modeling skills required to value most types of financial instrument. Models that tend to be applied include:

• Discounted Cash Flow
• Real option pricing techniques
• Black Scholes
• Binomial
• Lattice
• Monte Carlo
• Asset or nothing models
• Gap models

Recent instruments that we have valued include:

• Options with a performance condition linked to the share price performance compared to the FTSE
• Options with a hurdle linked to the value of the underlying shares
• Convertible preference shares with a redemption premium
• Options with a strike price that altered a year after grant based on the share price movement
• Shares whose payout was dependent on the value of the company being over a certain level at exit
• First to default credit linked notes
• Loan notes with interest paid in shares based on the future share price performance

American Appraisal consultants are active in:

• the ICAEWs Valuation Special Interest Group
• HMRC’s Shares & Asset Valuation Fiscal Forum
• the International Valuation Standards Council
• the Appraisal Issues Task Force
• the FASB’s Valuation Resources Group
• the Appraisal Foundation
• the American Society of Appraisers
• the American Institute of CPAs

This involvement ensures our knowledge of current valuation standards, practices and procedures.