A Bid for Fair Value

he expensing of stock options has been a reality for public companies for two years now thanks to FASB Statement no. 123(R), Share-Based Payment . While the standard settled whether to record expenses for stock-based compensation on earnings statements, it did not solve the problem of how to accurately value those costs.

The consensus of academic research is that options are worth significantly less than the value generated by the Black-Scholes-Merton model. This perception prompted Zions Bancorporation to develop a market-based pricing technique, which it calls Employee Stock Option Appreciation Rights Securities (ESOARS).

ESOARS take advantage of the market-value alternative to option-pricing models allowed by paragraph 22 of Statement no. 123(R). They are derivative securities designed to provide a market basis for estimating the fair value of stock options granted to employees. Zions, which recently received SEC approval to use ESOARS, plans to use these securities itself and to market them for other companies.

Zions developed ESOARS with an eye toward solving some of the problems that delayed FASB’s imposition of fair value accounting in Statement no. 123(R). Experts had competing views on how to value options, with many arguing that options were not “valuable” and others arguing they could not be valued. In particular, many have argued that option-pricing models (such as Black-Scholes) overstate the value of employee stock options because they assume the abilities to trade and short sell, and ignore the effect of the continued employment requirement, all of which reduce the options’ value to a risk-averse, underdiversified employee.

WHAT ARE ESOARS?
ESOARS are derivative securities whose value depends not only on the price of the underlying share of stock, but also the vesting and exercise patterns of the underlying stock options to which they are tied. Page 7 of Zions’ Sept. 22, 2006, submission to the SEC states: “The net realized value is calculated as the difference between the trading price per share of Zions’ common stock at the time employees exercise their ESOs [employee stock options] and the exercise price of the reference options, multiplied by the number of shares of common stock obtained by ESO holders on exercise. Payments to ESOARS holders will be made quarterly.”

(The complete text of Zions’ submission is available at www.auctions.zionsdirect.com/static/doc/zions_submission.pdf.)

But it is not so simple. Unlike an option that has one exercise date, the issuer must pay out to the ESOARS holders quarterly and based upon the percentage of reference options exercised during that quarter. Although the payout to the initial ESOARS offerings will be in cash, Zions has indicated that payouts on future offerings could be in company stock. Whether the payout is in the form of cash or company stock will affect whether the security is treated as a liability or equity for accounting purposes (see sidebar “ESOARS Accounting Treatment Unsettled”).

n The number of ESOARS sold equals 100,000, which is 10% of the 1 million reference options.

 n The exercise price of those options is $20.

 n The average market price of the company’s stock during the fourth quarter of 2007 is $25.

 n Five percent of reference options are exercised during the fourth quarter.

Under these circumstances the payout to all ESOARS holders would equal 100,000 units X 5% exercised X ($25 market price – $20 exercise price) for a total of $25,000. The ESOARS would remain outstanding, with the holders continuing to receive payments in future quarters when and if the remaining 95% of reference options are exercised.

THE BENEFIT TO CORPORATIONS
The benefit to the corporation, ostensibly, is a more-accurate measure of the cost of the options. In practice, this may mean a lower measure of the cost. Based upon the results of the initial auction, conducted on June 28–29, 2006, Zions estimates the value of the options granted at $8.57 per option, whereas the Black-Scholes model yields a per option value of $12.65. Thus, the accounting expense is substantially reduced using the market-based approach. Zions expects auction prices to increase somewhat over time as more investors enter the market and become familiar with the securities. As some evidence of it, in Zions’ second auction, which was conducted from May 4–7, 2007, the price per option was $12.06 (Zions has not disclosed the equivalent cost under the Black-Scholes model, although in the most recent year available, 2006, they valued their average option at $15.02).

While research indicates the market value for ESOARS is likely to stay below a Black-Scholes price, that will not always be the case, says Evan Hill, a vice president of Zions who helped develop the security. “You could have a situation with an ESOARS issuer who has been extremely aggressive on Black-Scholes,” says Hill. He says the price disparity between the two is likely to vary by company.

COSTS TO THE CORPORATION
ESOARS are SEC-registered traded securities. Issuing a security involves substantial transaction costs. Zions has applied for a patent on the security and plans to provide auction services to other companies. Costs involved in issuing ESOARS include:

 n Engaging a law firm and CPAs to prepare an offering prospectus.

 n Advertising to attract investors (Zions spent “in excess of $100,000” on this in its first auction) and screen those investors to ensure a sufficient level of expertise.

 n Setting up an auction.

 n Setting up a record-keeping system for these securities that is tied to the record-keeping system for existing options (recall the value of the ESOARS is tied to the vesting and exercise behavior of the underlying options).

Although all costs were not broken down, Zions’ prospectus supplement, filed with the SEC on July 3, 2006, said 21 winning bidders paid a total of $702,075, with proceeds of $340,075. This indicates expenses of the offering absorbed more than half of the gross proceeds. As the underlying options are exercised, the issuer then will have to make payments to the holders of the ESOARS, which will involve additional transaction costs.

An assessment of these costs needs to take into account that the ESOARS in this auction represented 10% of the total number of employee stock options. After adjusting for a “technical malfunction” that Zions says could have raised the ESOARS price, the auction yielded an expense 72% per share of that derived from a Black-Scholes model.

Zions’ Hill also notes that the first auction included “excessive legal costs.” He estimates legal costs for an ESOARS auction could be as low as $20,000 for smaller companies ($350 million to $750 million in market capitalization) and as much as $100,000 to $200,000 for larger companies ($2 billion to $20 billion market cap).

Another consideration is whether the issuer can, or even wants to, get fair value for the securities. For example, will the sales price be less than the present value of the expected future cash flows, and if so, by how much? Cindy Ma, who was a member of the FASB group set up to create option valuation guidelines, was quoted by Dow Jones Newswires as questioning Zions’ strategy, saying that, “the intimidating complexity of the Zions derivative will deter investors from offering full value.” The same article quoted Joel D. Hornstein, CEO of Structural Wealth Management LLC, a potential bidder who points out “the normal incentives in a stock offering are turned upside-down in the Zions case. … Companies, after all, have reason to seek a higher price for their securities, while Zions’ purpose is to establish a value for stock options that is below the value produced by current accounting methods.” (“Zions Seeks Bidders in Bid to Change Options Accounting,” Dow Jones Newswires, June 27, 2006.)

Hill counters these concerns by pointing out that an ESOARS auction “sells securities in an open auction that the company has to accept.”

The SEC’s response to Zions’ submission noted that “the use of an appropriate market instrument for obtaining an estimated fair value has certain distinct advantages over a model-based approach” and that use of market prices could “improve … calibration of model-based estimates.”

Will sophisticated investors be interested? There are costs involved to determine how much the securities are worth, and the size of the auctions may not provide sufficient opportunity for these investors to recover those costs, forcing the securities to trade at a large discount. Zions’ SEC submission notes it set a maximum bid amount of $350,000 per bidder, with a lower level of $10,000 for non-insider Zions employees. As noted earlier, 21 winning bidders paid a total of $702,075. Consequently, the amount involved averaged less than $35,000 per successful bidder.

OTHER ISSUES
The SEC in its letter to Zions concluded that “the ESOARS instrument is sufficiently designed to be used as a market-based approach to valuing employee share-based awards under Statement 123(R).” The SEC also recommended that “each ESOARS auction be analyzed to determine whether it results in an appropriate market-pricing mechanism. Specifically, the analysis should determine if the auction clearing price is representative of the fair valuation of the underlying employee share-based payments.”

The SEC said the factors to consider in determining whether an auction is an appropriate market-pricing mechanism include:

 n The size of the ESOARS offering relative to market demand.

 n The number of bidders (that is, did a sufficient number of bidders participate in the auction, and were they independent?).

 n Technology issues, including delays.

 n Bidder perception concerning costs of holding, hedging or trading the instrument.

(The letter from the SEC Office of the Chief Accountant is available at www.sec.gov/info/accountants/staffletters/zions012507.pdf.)

The letter implies that not all ESOARS will qualify. Who will make this determination? The independent auditor? Some anecdotal evidence suggests that auditors have discouraged the use of the binomial model for option valuation because of concern with their ability to audit the output (See “ Frontline Reaction to FASB 123(R),” JofA, April 07, page 54). Will auditors take a similar position with ESOARS?

Similarly, how will the use of ESOARS affect comparability? Will analysts and investors shy away from companies using financial derivatives they do not understand?

CONCLUSION
Zions Bancorporation has broken innovative ground with ESOARS. The SEC letter makes it likely, but not certain, that these securities can be used to determine the cost of employee stock options, and it is likely the cost established by these auctions will be lower than that established by option-pricing models. Some risk and substantial cost are also involved. The risk of course, is that future auctions may not meet the conditions set forth in the SEC’s letter, while the costs include those associated with the issuance of securities and the possibility that the corporation sells the securities at a substantial discount to fair value. Decision makers should tread carefully in determining whether the benefits involved exceed the costs.