Weighing the options

By Prem M. Lobo
Illustration: Cathy Pentland

How should valuators respond to and treat the compensation expense related to employee stock options?

Stock options and stock-based incentives have, for some time, been widely accepted as a means of employee compensation at all levels of employment. The popularity of stock-based incentives is evidenced by the fact that in 2003 nearly 20 million US employees participated in more than 15,000 stock-based incentive plans, while in Canada, as early as the 1990s, 67% of the largest Canadian public companies granted their executives stock options.

Understanding the accounting treatment of stock options and stock-based incentives, and the economic impact of such compensation on annual cash flow is important for merger and acquisition personnel, valuators, CFOs and most legal counsel for a variety of purposes. These include the valuation of a business for M&A or corporate finance purposes, setting executive compensation, quantifying damages in wrongful dismissal and the determination of net family values, among others.

Until recently in Canada, no specific CICA Handbook rule existed with respect to the treatment of employee stock options for accounting purposes. Many companies did not report any impact on their financial statements from the issuance of employee stock options. Effective January 1, 2002, the CICA introduced Section 3870 — Stock-Based Compensation and Other Stock-Based Payments. Pursuant to this section and its later transitional provisions, by January 1, 2004 most companies were required to determine the fair value of equity instruments such as stock options that have been granted to employees and recognize this as a compensation expense.

The introduction of Section 3870 has resulted in a renaissance of sorts in terms of how to determine the fair value of stock options for accounting purposes. However, much less attention has been directed to the impact of Section 3870 on the financial data used in value determinations. Specifically, how should valuators respond to and treat the compensation expense related to employee stock options — what are the earnings, cash-flow and equity/dilutive issues in particular.

The impact of Section 3870 on the reported net income of companies can be significant. Cott Corp.’s net income before option compensation was $6.13 million in 2002. Including the impact of option compensation decreases Cott’s net income to a loss of $2.36 million, a decrease of nearly 140%. Similarly, Nortel Networks reported a net loss of $5.631 billion in 2002. Including the impact of option compensation increases this loss to $7.13 billion, an impact of nearly 27% or approximately $1.5 billion.

Prior to Section 3870, companies could choose to adopt the intrinsic approach to recognizing employee stock options whereby they would record as an expense the amount by which the market price of the underlying stock exceeded the exercise price of an option at its grant date. Where the market price of the stock did not exceed the option exercise price at the time of grant, companies were not required to record any accounting impact on their financial statements.

This changed with the introduction of Section 3870, which specifies that “equity instruments awarded to employees and the cost of the services received as consideration should be measured and recognized based on the fair value of the equity instruments” (3870.24). It does not state which method to use to determine the fair value of a stock option or equivalent but does mention the Black-Scholes or binomial method by way of example.

Section 3870 states: “The total amount of compensation cost recognized for an award of stock-based employee compensation should be based on the number of instruments that eventually vest” (3870.44) and “the compensation cost for a stock-based award to employees should be recognized over the period in which the related employee services are rendered, by a charge to compensation cost if the award is for future performance. … If an award is for past services, the related compensation cost should be recognized in the period in which it is granted” (3870.49).

Pursuant to the transitional provisions of Section 3870, the expensing of stock option compensation became mandatory for public companies for fiscal years beginning January 1, 2004. Private companies could defer the expense recognition treatment until fiscal years beginning January 1, 2005. Since 2002, many firms have chosen early adoption of Section 3870 and have begun recording compensation expense for employee stock options.

Dilution and the impact of the related cash infusion on issuance and exercise respectively are relatively simple issues. For instance, the issuance and exercise of the options would increase the number of shares outstanding, diluting the fair-market value per share. The extent of the net dilution depends on the facts of each situation. If stock options were exercised at $1 a share, the en bloc fair-market value of a company’s equity would increase by $1 a share due to an inflow of cash, which would then become a redundant asset.

However, with Section 3870 come more significant earnings or cash-flow related valuation effects.

Valuators employing a cash-flow or earnings approach would normally prepare projections of normalized future cash flows/earnings using past and present income statements as important reference points or starting points. In such cases, the following questions might arise:

• Since the compensation expense under Section 3870 is a noncash item, should the entire amount be added back in the determination of cash flow from operations?
• Should the entire compensation expense be left unadjusted under the view that it is akin to a normalization adjustment that reflects the cash compensation that would otherwise have been paid to keep and motivate employees?
• Should another amount be determined to reflect the fair-market value of the compensation that would have to be paid to employees?

On one hand, the argument to add back the entire compensation amount has its merits. The compensation determined is indeed a noncash amount, akin to depreciation and does not reflect a decrease in the cash resources of a company. In addition, Section 3870.49 calls for the amortization of the determined compensation over the estimated period of employment service or, if related to past services, the recognition of the entire compensation amount in the period the option is granted. Whether the compensation amount is amortized over time or recognized in one year is essentially a financial accounting matching issue and does not have any bearing on a firm’s cash position. In both cases, adding back compensation into net income would appear to make sense.

On the other hand, adding back the entire compensation amount might overstate net income and cash flows. The rationale is that stock options provide employees with compensation that would otherwise have to be paid by a company in cash. Although the issuance of stock options does not represent a direct drain on the cash resources of a company, the fact remains that if the same company chose not to issue stock options or could not issue options pursuant to shareholder or statutory restrictions, employees would have to be paid bonus or incentive amounts in cash or other benefits to encourage them to remain with the company and be adequately motivated.

Exactly how reflective the recorded option compensation may be relative to the cash amount that would otherwise be paid is another issue. In particular:

• The compensation amount recorded on the entity’s income statement is impacted by the amortization policy of that firm, which is, in turn, impacted by estimates of the likely employment tenure.
• The determination of the compensation amount is based on several assumptions. For instance, if using an option pricing model to calculate the fair-market value of employee stock options and, hence, compensation expense, assumptions that need to be made include assessing the expected volatility of the underlying stock, estimating dividend yield, determining the appropriate risk-free interest rate and expected lives of employee stock options, among others. Assessing each element requires considerable professional judgment and consideration of a variety of factors and assumptions.

Some companies may choose to rely on stock-option plans for remuneration and motivation to a greater degree than other companies. Therefore, although companies may report a particular amount for stock-option compensation, this may not necessarily reflect a “normalized” amount of benefit in all cases.

In short, although adding back the entire compensation expense may overstate cash flow or net income, the reported compensation may, nevertheless, not be reflective of the normalized cash that would otherwise have to be paid to employees.

Perhaps, therefore, some assessment of a normalized compensation should be made instead of the amount reported on the financial statements. However, this method also has its challenges:

• Normal compensation must be tailored to the specific industry in question, different ownership structures (private versus public) or different life cycles of firms.
• Assessing normal market equivalent compensation is made difficult by the fact that management talent is often a difficult quality to compare and quantify. How does one assess whether the management team of one company is more talented than another and hence deserves a higher level of cash-equivalent stock-option compensation?

Perhaps if one were to look at Disney’s Michael Eisner, who made more than US$680 million from the exercise of stock options between 1998 and 2000, one might conclude this represents an above-normal level of remuneration. However, determining what would be a more normal level of cash-equivalent option remuneration for Eisner versus another CEO or employee based on their differing skills and talents would be a much more difficult next step.

What then is the correct approach to stock-option compensation expense? Add it back, leave as is, or normalize? Each approach has relative merits and difficulties depending on the specific application. What is important is that valuators be aware of the alternative treatments available and be cognizant of the economic impact of each on cash flows, normalized future earnings and present and terminal values. Reconciliation between alternative methods will always be revealing.

One thing, however, is certain: there is no option but to consider the option.