United States: SEC Staff Extends Use Of Simplified Estimates Of "Expected Term" For Certain Stock-Option Grants

Last Updated: March 31 2008
Article by John Henry

Acting in response to growing evidence that adequate "empirical" data for estimating the expected term of stock options would not be timely available for valuation purposes, the Securities & Exchange Commission's Office of the Chief Accountant of Corporation Finance has extended beyond year-end the benefit of its previously announced simplified method for estimating the term of certain options.

Under Statement of Financial Accounting Standards No. 123R ("SFAS 123R"), registrants are required generally to expense employee stock options. In doing so, companies are permitted to use recognized algorithms, such as the Black-Scholes-Merton model, to develop an estimate of stock-option compensation expense. Such models require an estimate of an option grant's expected term. As noted in SFAS 123R paragraph 17, "[F]or equity share options and similar instruments the effect of nontransferability (and nonhedgeability, which has a similar effect) is taken into account by reflecting the effects of employees' expected exercise and post-vesting employment termination behavior in estimating fair value (referred to as an option's expected term)." The Commission anticipated that estimates of expected term would be based on evidence of actual employee exercise practice. Nevertheless, in March 2005, the Commission issued SAB 107, which permitted issuers that had not yet developed such empirical evidence to employ a simplified method of estimate involving, in essence, a simple average of the time to vesting and the full term of the option. The relief granted by SAB 107 was scheduled to expire at year's end, 2007.

On December 21, 2007, the Commission acknowledged the fact that, notwithstanding its previous expectations, many issuers were experiencing difficulty in developing data regarding exercise practice sufficient to make a reasonable, fact-based estimate of term for valuation purposes. Accordingly, the Commission issued SAB 110, which permits issuers to continue to use the simplified estimate of term for certain options.

SAB 110 amends and replaces Question 6 of Section D.2 of Topic 14, Share-Based Payment of the Staff Accounting Bulletin Series stating the Staff's view that it is appropriate to average the vesting term of the option and the original contract term for option-valuation purposes. The relief is limited however, in several respects. In order to use the method, the registrant must conclude and state that it is unable to rely on its historical data. Examples given by the staff where a lack of reliance is appropriate include:

  • The company does not have sufficient historical data to provide a reasonable basis upon which to estimate expected term due to the limited time its equity shares have been publicly traded;
  • The terms of the option grants have been significantly changed or the types of employees receiving grants have changed such that prior experience is not applicable; or
  • The company expects to have "significant structural changes to its business" such that prior data is no longer relevant.

Moreover, the simplified method is available only for so-called "plain vanilla" option grants, that is, grants that are made at the money, where exercisability is conditioned only on performing service through the vesting date, and where the options are forfeitable if an employee terminates service prior to vesting or there is a limited time after termination during which the options may be exercised. Furthermore, the options must be non-transferable and non-hedgeable.

Disclosure of the registrant's use of the simplified method of estimating expected term and its reasons for using it are required in the notes to the financial statements. Perhaps most significantly, the method may not be employed with respect to all options in a given grant if data is available for some of the options in the grant. For such options, the available data must be used to estimate expected term.

The valuation of equity grants under SFAS 123R is complicated. As envisioned by the Commission, estimates of expected employee behavior that affect such valuations will be experience-based. To the extent that experienced-based data is slow to develop, it may be expected that the Commission will be encouraged by registrants to extend further interpretive guidance and relief.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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