Valuation of Full-Value Long-Term Incentive Awards

(originally published on www.CompensationStandards.com)

The recent interest in alternatives to stock options – fueled by corporate governance concerns, imminent changes in accounting rules, and changes in equity markets – has led to the discussion of the appropriate "conversion rate": how many units of the new form of award should be given in lieu of a stock option.

Because options have been the "currency" of long-term incentives for decades now, most survey data, grant guidelines, and measures of usage (overhang and run rate) assume that all grants are option grants. As companies consider restricted stock, restricted stock units, performance shares, and long-term cash incentive plans, many look to the few companies that have completely (for now) abandoned options. Microsoft, Amazon, Expedia and others become the new reference point.

The one-for-three number currently is making its rounds as the "right" ratio. This has its roots in several places including the rumored average conversion rate in Microsoft’s restricted stock unit program and the average fortune 500 Black-Scholes value of 33%.

An issue that has not been addressed is the assumption that a full-value grant is equal to its face value. This is because forcing the Black-Scholes valuation (by treating a restricted share as an option with a strike price of $0.00, or $0.000001 to make most models return a value) yields a number equal to face value. But option pricing models, which have an implicit stock price growth assumption, were never intended to value employee stock grants (let alone employee option grants) and their use further distorts the data needed for compensation decisions.

For example, a company with a Black-Scholes value of 60% of face value (the average in the technology sector) might give a 25% "haircut" and thus grant a number of restricted shares equal to 60% x (1-25%) = 45% -- 450 restricted shares in lieu of 1,000 options. But a Black-Scholes value of 60% has an implicit growth rate (over a four-year vesting period) of 12.5% per year. A restricted share will thus grow to 160% of face value at that rate. So, in lieu of an option granted at $10.00 that provides a gain of $6.00, the company is granting .45 restricted shares that grow to a value of $7.20 (.45 * $16.00), a 20% premium over the option gain value. . .with no downside risk. Without the haircut, the premium is even greater.

The FASB Exposure Draft and its endorsement of the binomial model (and implicit avenue for reducing reported option value) is highlighting the inappropriateness of these models for compensation planning. While growth-based models require assumptions as well, the availability of analysts’ growth targets and investors total return expectations provide a more rational basis for assumptions than required by option pricing models.

Responsible compensation planning requires abandoning theoretical option pricing models as a basis for compensation allocation among alternative vehicles under the newly emerging "portfolio" approach to long-term incentives. Not only does the gain model provide a more reliable basis for these decisions, it is a method with greater face validity among Board members, employees, and investors.