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BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

The Board spent much time discussing how to measure the fair value of employee share options, including how to take into account common features of employee share options, such as vesting conditions and non-transferability. These discussions focused on measuring fair value at grant date, not only because the Board regarded grant date as the appropriate measurement date for transactions with employees, but also because more measurement issues arise at grant date than at later measurement dates. In reaching its conclusions in ED 2, the Board received assistance from the project’s Advisory Group and from a panel of experts. During its redeliberations of the proposals in ED 2, the Board considered comments by respondents and advice received from valuation experts on the FASB’s Option Valuation Group.

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

Market prices provide the best evidence of the fair value of share options. However, share options with terms and conditions similar to employee share options are seldom traded in the markets. The Board therefore concluded that, if market prices are not available, it will be necessary to apply an option pricing model to estimate the fair value of share options.

The Board decided that it is not necessary or appropriate to prescribe the precise formula or model to be used for option valuation. There is no particular option pricing model that is regarded as theoretically superior to the others, and there is the risk that any model specified might be superseded by improved methodologies in the future. Entities should select whichever model is most appropriate in the circumstances. For example, many employee share options have long lives, are usually exercisable during the period between vesting date and the end of the option’s life, and are often exercised early. These factors should be considered when estimating the grant date fair value of share options.

For many entities, this might preclude the use of the Black-Scholes-Merton formula, which does not take into account the possibility of exercise before the end of the share option’s life and may not adequately reflect the effects of expected early exercise. This is discussed further below (paragraphs BC160–BC162).
All option pricing models take into account the following option features:
● the exercise price of the option
● the current market price of the share
● the expected volatility of the share price
● the dividends expected to be paid on the shares
● the rate of interest available in the market
● the term of the option.

The first two items define the intrinsic value of a share option; the remaining four are relevant to the share option’s time value. Expected volatility, dividends and interest rate are all based on expectations over the option term. Therefore, the option term is an important part of calculating time value, because it affects the other inputs.

One aspect of time value is the value of the right to participate in future gains, if any. The valuation does not attempt to predict what the future gain will be, only the amount that a buyer would pay at the valuation date to obtain the right to participate in any future gains. In other words, option pricing models estimate the value of the share option at the measurement date, not the value of the underlying share at some future date.

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

The Board noted that some argue that any estimate of the fair value of a share option is inherently uncertain, because it is not known what the ultimate outcome will be, eg whether the share option will expire worthless or whether the employee (or other party) will make a large gain on exercise. However, the valuation objective is to measure the fair value of the rights granted, not to predict the outcome of having granted those rights. Hence, irrespective of whether the option expires worthless or the employee makes a large gain on exercise, that outcome does not mean that the grant date estimate of the fair value of the option was unreliable or wrong.

A similar analysis applies to the argument that share options do not have any value until they are in the money, ie the share price is greater than the exercise price. This argument refers to the share option’s intrinsic value only. Share options also have a time value, which is why they are traded in the markets at prices greater than their intrinsic value. The option holder has a valuable right to participate in any future increases in the share price. So even share options that are at the money have a value when granted. The subsequent outcome of that option grant, even if it expires worthless, does not change the fact that the share option had a value at grant date.

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

Application of option pricing models to unlisted and newly listed entities

As explained above, two of the inputs to an option pricing model are the entity’s share price and the expected volatility of its share price. For an unlisted entity, there is no published share price information. The entity would therefore need to estimate the fair value of its shares (eg based on the share price of similar entities that are listed, or on a net assets or earnings basis). It would also need to estimate the expected volatility of that value.

The Board considered whether unlisted entities should be permitted to use the minimum value method instead of a fair value measurement method. The minimum value method is explained earlier, in paragraphs BC80–BC83. Because it excludes the effects of expected volatility, the minimum value method produces a value that is lower, often much lower, than that produced by methods designed to estimate the fair value of an option. Therefore, the Board discussed how an unlisted entity could estimate expected volatility.

An unlisted entity that regularly issues share options or shares to employees (or other parties) might have an internal market for its shares. The volatility of the internal market share prices provides a basis for estimating expected volatility.Alternatively, an entity could use the historical or implied volatility of similar entities that are listed, and for which share price or option price information is available, as the basis for an estimate of expected volatility. This would be appropriate if the entity has estimated the value of its shares by reference to the share prices of these similar listed entities. If the entity has instead used another methodology to value its shares, the entity could derive an estimate of expected volatility consistent with that methodology. For example, the entity might value its shares on the basis of net asset values or earnings, in which case it could use the expected volatility of those net asset values or earnings as a basis for estimating expected share price volatility.

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

The Board acknowledged that these approaches for estimating the expected volatility of an unlisted entity’s shares are somewhat subjective. However, the Board thought it likely that, in practice, the application of these approaches would result in underestimates of expected volatility, rather than overestimates, because entities were likely to exercise caution in making such estimates, to ensure that the resulting option values are not overstated. Therefore, estimating expected volatility is likely to produce a more reliable measure of the fair value of share options granted by unlisted entities than an alternative valuation method, such as the minimum value method.

Newly listed entities would not need to estimate their share price. However, like unlisted entities, newly listed entities could have difficulties in estimating expected volatility when valuing share options, because they might not have sufficient historical share price information upon which to base an estimate of expected volatility.

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

The Board concluded that, in general, unlisted and newly listed entities should not be exempt from a requirement to apply fair value measurement and that the IFRS should include implementation guidance on estimating expected volatility for the purposes of applying an option pricing model to share options granted by unlisted and newly listed entities.

However, the Board acknowledged that there might be some instances in which an entity—such as (but not limited to) an unlisted or newly listed entity—cannot estimate reliably the grant date fair value of share options granted. In this situation, the Board concluded that the entity should measure the share option at its intrinsic value, initially at the date the entity obtains the goods or the counterparty renders service and subsequently at each reporting date until the final settlement of the share-based payment arrangement, with the effects of the remeasurement recognised in profit or loss. For a grant of share options, the share-based payment arrangement is finally settled when the options are exercised, forfeited (eg upon cessation of employment) or lapse (eg at the end of the option’s life). For a grant of shares, the share-based payment arrangement is finally settled when the shares vest or are forfeited.

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

Application of option pricing models to employee share options

Option pricing models are widely used in, and accepted by, the financial markets. However, there are differences between employee share options and traded share options. The Board considered the valuation implications of these
differences, with assistance from its Advisory Group and other experts, including experts in the FASB’s Option Valuation Group, and comments made by respondents to ED 2. Employee share options usually differ from traded options in the following ways, which are discussed further below:
(a) there is a vesting period, during which time the share options are not exercisable;
(b) the options are non-transferable;
(c) there are conditions attached to vesting which, if not satisfied, cause the options to be forfeited; and
(d) the option term is significantly longer.

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

Inability to exercise during the vesting period

Typically, employee share options have a vesting period, during which the options cannot be exercised. For example, a share option might be granted with a ten-year life and a vesting period of three years, so the option is not exercisable for the first three years and can then be exercised at any time during the remaining seven years. Employee share options cannot be exercised during the vesting period because the employees must first ‘pay’ for the options, by providing the necessary services. Furthermore, there might be other specified periods during which an employee share option cannot be exercised (eg during a closed period).

In the finance literature, employee share options are sometimes called Bermudian options, being partly European and partly American. An American share option can be exercised at any time during the option’s life, whereas a European share option can be exercised only at the end of the option’s life. An American share option is more valuable than a European share option, although the difference in value is not usually significant.

Therefore, other things being equal, an employee share option would have a higher value than a European share option and a lower value than an American share option, but the difference between the three values is unlikely to be significant.

If the entity uses the Black-Scholes-Merton formula, or another option pricing model that values European share options, there is no need to adjust the model for the inability to exercise an option in the vesting period (or any other period), because the model already assumes that the option cannot be exercised during that period.

If the entity uses an option pricing model that values American share options, such as the binomial model, the inability to exercise an option during the vesting period can be taken into account in applying such a model.

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

Although the inability to exercise the share option during the vesting period does not, in itself, have a significant effect on the value of the option, there is still the question whether this restriction has an effect when combined with non-transferability. This is discussed in the following section.

The Board therefore concluded that:
(a) if the entity uses an option pricing model that values European share options, such as the Black-Scholes-Merton formula, no adjustment is required for the inability to exercise the options during the vesting period, because the model already assumes that they cannot be exercised during that period.
(b) if the entity uses an option pricing model that values American share options, such as a binomial model, the application of the model should take account of the inability to exercise the options during the vesting period.

BASIS FOR CONCLUSIONS ON IFRS 2 FAIR VALUE OF EMPLOYEE SHARE OPTIONS

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