Recognizing the diversity of compensation plans implemented by firms, FAS-123R does not strictly dictate the valuation approach that companies must follow. Rather, it suggests using an approach that appropriately captures the material features of the plan. The Wharton team offers expertise with each of the three commonly used valuation approaches:

 

For stock option plans, the Black-Scholes approach is most commonly used. The foundation of the Black-Scholes method is an option valuation formula that incorporates the firm’s stock price, the dividend yield of the firm’s stock, the option’s exercise price, the expected term of the option, the interest rate on risk free securities and the expected volatility of the firm’s stock. One challenge for a company using the Black-Scholes approach is estimating input parameters such as the expected term of the option. Since employees tend to exercise their stock options prior to the contractual option maturity date (because they leave the company or simply choose to cash in early), the expected option term used in the Black-Scholes formula can sometimes depend on the observed or expected behavior of employees. The Wharton team will help you use either your company’s own data or external data sources to develop inputs that will appropriately comply with FAS 123R guidance.

 

Many companies have switched to lattice models because they have the flexibility to capture features specific to a company and plan, such as the exercise behavior and termination (exit) rate of vested employees. In some circumstances, a lattice based approach can result in a lower measured option value. We can help you understand whether Black-Scholes or a lattice model is the appropriate choice for your company.

For more complex equity compensation plans, for example when a stock appreciation rights plan (SAR) has specialized performance benchmarks that must be satisfied, the Monte Carlo simulation approach may be required. Monte Carlo simulation has the flexibility and capability to value a wide variety of plans with any number of complicating features. However, in some cases it is computationally intensive, so it is often considered a last resort to be used only when other methods are not feasible.

 

The Wharton team will partner with you to help you understand which valuation approach is appropriate for your compensation plan and how a plan’s features affect its measured value. We will work to achieve accurate results by applying a consistent and appropriate methodology over time. Further, we will provide documentation and support to prepare you for audits.