EXECUTIVE SUMMARY
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Zions Bancorporation
developed Employee Stock Option
Appreciation Rights Securities (ESOARS)
as a market-based pricing
technique for expensing stock options
under FASB Statement no. 123(R).
ESOARS auctions may
be able to achieve a lower expense
for Statement no. 123(R) purposes
than other option-pricing models such as
Black-Scholes or the binomial method.
ESOARS are
SEC-registered traded securities
and can require substantial
upfront costs, including legal and
accounting fees to prepare an offering
prospectus, advertising to attract
investors, screening of investors to
ensure an appropriate level of expertise
and setting up a record-keeping system for
the ESOARS that is tied in with the
record-keeping system for existing
options.
The SEC’s analysis of
ESOARS says the method is an
acceptable market-based approach to
valuing employee share-based payments
under Statement no. 123(R), but also
outlines several conditions that should be
met for each auction to qualify as an
appropriate market-pricing mechanism.
Steven Balsam, CPA,
Ph.D., is professor of accounting and
Merves Research Fellow, Fox School of
Business, Temple University in
Philadelphia. His e-mail address is
drb@temple.edu.
|
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”).
Consider the following example of how the
security works:
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.
| ESOARS
Accounting Treatment Unsettled
The SEC’s Office of the Chief
Accountant and Zions are still hashing out
the proper accounting treatment for
ESOARS. Consequently, it may differ from
that discussed below, but the framework
should be similar. The accounting
treatment for the cash flows involved
should hinge on whether the security is
classified as a liability or equity. This
depends a great deal on whether the final
payment is in cash or shares of the
issuing company’s stock.
As a liability. If
the ESOARS are classified as a liability,
the company would credit the proceeds to a
liability account, and under Accounting
Principles Board Opinion no. 21,
capitalize and amortize the issuance costs
over the life of the security. Issuance
costs would include the costs of the
auction, registration of the security, and
legal fees. Payments to purchasers
at the time the underlying options are
exercised would be treated like
cash-settled Stock Appreciation Rights
(SARS). Thus, an expense would need to be
recognized at the end of each period so
the balance sheet liability equals the
difference between the exercise price of
the options and the current market price
of the stock for the number of ESOARS that
remain outstanding. When the underlying
options are exercised, the company would
make cash payments to ESOARS holders,
debiting the liability and crediting cash.
As equity. If
ESOARS are classified as equity, issuance
costs would be treated as a reduction of
proceeds, with the remaining proceeds
being credited to paid-in capital. When
the underlying options are exercised, the
company would issue additional shares to
ESOARS holders, debiting paid-in capital
and crediting common stock for the shares
issued. |
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. |