How is the expected term of the options estimated?

Option valuation theory assumes that options usually will be held for their full contractual term, because early exercise sacrifices the remaining time value. A holder who wants to realize the value of an option is better off to sell the option and capture the remaining time value rather than to exercise it. Employee options, however, typically are nontransferable. In addition, in many cases option holders who terminate employment are required to exercise within 90 days of termination. Finally, employees typically have a significant portion of their net worth invested in or otherwise tied to their employer and, contrary to option valuation theory, diversifying that risk may not be possible and, if possible, may be costly. As a result of all of these factors, employees tend to exercise options before their full contractual term. Option valuation theorists refer to this as sub-optimal exercise behavior.

In both Statement 123 and Statement 123(R), the FASB concluded that traditional option valuation models should be modified to reflect the unique characteristics of employee options by substituting the expected term of the option for the full contractual term. The expected term of an option is the period of time during which the option is expected to be outstanding. Some factors to consider in estimating the expected term of options include:

• Employee exercise and termination behavior, which should divide and analyze employees based on homogenous groupings (e.g. for example, hourly employees versus salaried). In SAB 107, the SEC staff comments that two employee groups are adequate for most employers.
• Reliability of data maintained by company versus data available from comparable sources (e.g., industry averages); and.
• Impact of non-transferability of awards and effects of blackout periods

Analyzing exercise and termination behavior based upon homogenous groupings of employees provides a better estimate than simply averaging the exercise behavior across all employees. A company also should review the reliability of data it maintains and consider utilizing comparable data, such as applicable industry averages. Another point is that the expected term of an option should never be shorter than the vesting period of the award. The assumption is that companies that allow exercise prior to vesting do so to obtain specific tax treatment and that shares must be returned if vesting conditions are not satisfied. We discuss vesting considerations further in a subsequent section.

As noted previously, under a lattice model the expected term of the option is an output. A company using a lattice model would enter specific assumptions about sub-optimal exercise behavior based on the terms of options and past employee practices. For example, if option grants require exercise within 90 days of termination of employment, a company would estimate the portion of employees who would terminate at various intervals after vesting, based on past experience. Similarly, an employer would examine past employee exercise behavior to see whether there are patterns of early exercise based on stock price movements. Anecdotal evidence suggests that employee exercises surge when the stock price reaches 200% of the strike price. Discerning such patterns of exercise involves significant data gathering, as well as subjective interpretations of the data. One factor that lattice models do not capture is the impact of personal financial situations on employee exercise behavior. Anecdotal evidence suggests that the timing of exercises may be linked to purchases of cars or vacation homes, significant home improvements, or a child entering college. No model captures such behavior, and to the extent that past employee behavior reflects such personal factors, it may not be predictive of future behavior of a different group.

The SEC staff recognized that for various reasons historical exercise activity of a company or other comparable companies may not be readily obtainable. Therefore, SAB 107 permits a "simplified" method for estimating expected term of a "plain vanilla option," which is computed as the arithmetic mean of weighted vesting period and contractual life³.

The simplified method is only allowed for options that contain all of the following characteristics:

• The share options are granted at the money;
• Exercisability is conditional only on performing service through the vesting date;
• If an employee terminates service prior to vesting, the employee would forfeit the share options;
• If an employee terminates service after vesting, the employee would have a limited time to exercise the share options (30-90 days); and
• The share options are nontransferable and nonhedgeable.

This simplified method may only be elected for those plain vanilla options issued prior to December 31, 2007, because the SEC staff believes that by then more detailed comparative information regarding expected term would be more widely available. In addition, the simplified method, if chosen, should be applied consistently to all plain vanilla options and disclosed accordingly. SAB 107 states that this method is not intended to be applied as a benchmark in evaluating the appropriateness of more refined estimates of expected term.

The simplified method also is appropriate for private companies.

Nonemployee awards

Note: In SAB 107, the SEC staff indicates that if nonemployee options have limits on transferability or hedgeability like employee options do, it would be appropriate to use an estimated term rather than the full contractual term. Otherwise, the use of an expected term that is shorter than the contractual term would generally not be appropriate in estimating the fair value of the nonemployee options.

Continue Reading - How are restrictions on shares or options considered?

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