Pirates of Stock Based Compensation

Transcription

1 Pirates of Stock Based Compensation A Treasure Hunt to Help Find Hidden Cost Savings in Your Administration of Equity Plans Julia Franke, CEP Aon Hewitt Robert Slaughter, CEP E*TRADE Financial Corporate Services, Inc. Jillian Forusz, CPA, CEP Adobe Systems, Inc.

2 Finding Hidden Treasure in Your Accounting Expense Treasure Map: 1. Options: Valuation Model Selection 2. Post-Vest Holding Restrictions RSUs with Retirement Provisions 3. ESPPs: Valuation when share limit is hit

3 3 HIDDEN TREASURE IN OPTION VALUATIONS

4 Option Valuation Model Under ASC Topic 718, various option pricing models are permitted Black-Scholes Lattice/Binomial Model Monte Carlo Model 4

5 The Black-Scholes Model The formula Fair Value of Call Option = e δt SN d 1 Ke rt N d 2 where d 1 = ln S K + r δ + σ2 2 t σ t d 2 = d 1 σ t S = Share Price at the time of measurement K = Strike or Exercise Price t = expected time of exercise σ = expected volatility of returns r = risk free rate of return δ = dividend yield N = the standard normal cumulative distribution function 5

6 The Binomial/Lattice Model The method Step 1: Create the binomial price tree Step 2: Find Option Value at each final node Probability * 3.125% % % % % 3.125% *Simplification such that there is an equal probability of downward and upward movements. This is generally not the case as the probability of upward and downward movements are governed by the volatility, the dividend yield, and the discount rate. Option Value at Time 5, Node 1 = Stock Price at Time 5, Node 1 Strike Price = $17.50 $10.00 = $7.50 Option Value at Time 5, Node 2 = Stock Price at Time 5, Node 2 Strike Price = $12.50 $10.00 = $2.50 Step 3: Find Option Value at earlier nodes Option Value at Time 4, Node 1 = Stock Price at Time 4, Node 1 Strike Price = $15.00 $10.00 = $5.00 6

7 Aon Hewitt Multiple-Point Model Aon Hewitt s Multiple-Point Option Pricing Model This model assesses the Fair Value of each historical option used in the calculation of the expected life, and outputs the weighted average Fair Value. Due to the convexity of the Black-Scholes model (as seen in the figure below), the inclusion of options with shorter expected lives yield even lower Fair Values. The Fair Value increases more quickly at lower Expected Lives The Fair Value increases more slowly at higher Expected Lives 7

8 Savings in Switching Model Comparison Valuation Assumptions Distribution Analysis Single Point Aon Multiple Point Fair Value Expected Contractual Dividend Risk-Free Standard Company Black-Scholes Black-Scholes Reduction Life Term Volatility Yield Rate Deviation Kurtosis Company A 66.69% 64.19% (3.75%) % 0.00% 1.42% Company B 41.87% 41.31% (1.32%) % 0.00% 1.67% (1.2525) Company C 33.90% 32.56% (3.96%) % 0.00% 1.27% (1.0229) Company D 16.48% 16.12% (2.13%) % 1.71% 1.13% (0.7246) Company E 49.42% 48.17% (2.52%) % 0.00% 2.16% (0.0829) Company F 39.00% 38.27% (1.87%) % 0.00% 1.13% (0.6061) Company G 13.89% 13.38% (3.69%) % 2.51% 1.84% (1.1079) Company H 23.28% 22.81% (2.05%) % 1.30% 1.91% (0.8972) Company I 19.65% 19.21% (2.20%) % 2.00% 1.39% Company J 25.30% 25.06% (0.96%) % 0.00% 1.75% (1.6202) Company K 17.42% 16.79% (3.57%) % 2.12% 1.88% (0.7781) Company L 24.92% 24.39% (2.10%) % 0.00% 1.61% Company M 22.69% 22.31% (1.70%) % 3.00% 2.33% Company N 20.97% 20.29% (3.23%) % 0.82% 1.93% (0.8361) Company O 25.48% 24.94% (2.09%) % 0.00% 1.79% Company P 17.84% 17.41% (2.44%) % 4.13% 1.44% (0.4100) Company Q 60.28% 58.64% (2.73%) % 0.00% 1.55% (1.1772) Company R 21.58% 21.09% (2.27%) % 1.76% 1.43% (0.7818) Company S 27.36% 25.88% (5.39%) % 1.63% 1.96% Company T 22.35% 21.60% (3.37%) % 2.09% 2.21% (0.3064) Average 29.52% 28.72% (2.67%) % 1.15% 1.69% (0.3957) Hidden treasure (savings) range from 1% to over 5% 8

9 HIDDEN TREASURE IN POST VESTING HOLDING RESTRICTION 9

10 Post-Vest Holding Restriction If there is a required Post-Vest hold on any of your granted equity, be sure to take advantage of the discount This mandatory holding requirement can hide in: RSUs / PSUs ESPPs 10

11 Mandatory Post-Vest Holds are Appropriate: RSUs and Performance Awards ESPPs RSUs with Retirement Provisions Most appropriate for executives who tend to have ownership requirements and high net worth. May also be appropriate for those not identified as executive but must be thoughtfully considered. Generally recommend against. These plans are voluntary to participate and are the only equity compensation many of the employees have access to. If holding period is used, short holding periods are best. 11 Acceleration of vesting upon retirement is a benefit to the employee, and results in a lower fair value.

12 Estimated Discount One Year Holding Period The estimated discounts for lack of marketability for a one year holding period produced by the different models, under a range of expected volatility assumptions, are summarized below Expected Volatility Model 20% 40% 60% 80% Chaffe (6.9%) (14.7%) (22.4%) (29.8%) Finnerty (4.6%) (9.1%) (13.3%) (17.3%) Collared Strategy (cost of carry) (2.0%) (2.0%) (2.0%) (2.0%) Regression of Empirical Data 1,2 (7.2%) (9.9%) (12.8%) (15.6%) 1. Based on information available through October 1, Based on a statistical regression analysis of transactions in Rule 144 stock with a one year restriction period, the estimated illiquidity discount equals 4.35% % * Volatility 12

13 Estimated Discount Two Year Holding Period The estimated discounts for lack of marketability for a two year holding period produced by the different models, under a range of expected volatility assumptions, are summarized below Expected Volatility Model 20% 40% 60% 80% Chaffe (9.2%) (19.9%) (30.3%) (40.1%) Finnerty (6.5%) (12.6%) (18.2%) (22.9%) Collared Strategy (cost of carry) (3.9%) (3.9%) (3.9%) (3.9%) Regression of Empirical Data 1,2 (10.9%) (14.8%) (18.8%) (22.7%) 1. Based on information available through October 1, Based on a statistical regression analysis of transactions in Rule 144 stock with a one year restriction period, the estimated illiquidity discount equals 4.35% % * Volatility 13

14 ESPPs Post Vest Hold Savings While we don t recommend mandatory holding requirements on ESPPs, if you already have a holding requirement, take advantage of the savings! ESPP Assumptions and Fair Values No Holding Period 1-year Holding Period Market Price $50.00 $50.00 Illiquidity Discount 0.00% 8.90% Value of Illiquid Share n/a $45.55 Purchase Price $42.50 $42.50 Term to Expire Volatility 40.00% 40.00% Dividend Yield 1.25% 1.25% Risk-Free Interest Rate 1.20% 1.20% Present Value factor of 1 share of stock % 99.38% 15% of a Share of Illiquid Stock X PV factor $7.45 $ % of a Illiquid Call Option $4.75 $ % of a Illiquid Put Option $0.84 $1.18 PV of Interest Foregone ($0.13) ($0.13) Total $12.91 $10.74 As a % of Stock Price 25.82% 21.48% Savings (Hidden Tresure) % 14

15 RSUs Retirement Provision Savings If, for retirement eligible employees, vesting of RSUs accelerates upon employee retirement, and the underlying shares are distributed on the original vest date, this award qualifies for Post-Vest Holding discount The time between retirement eligibility and the original vesting date is considered the period of forced illiquidity 15

16 RSUs Retirement Provision Savings RSUs with 3-year cliff vesting Retirement Eligibility Number of Shares Granted Fair Value on Fully Liquid Basis Estimated Fair Value of Illiquidity Discount Estimated Fair Value on an Illiquid Basis Weighted Average Illiquidity Discount Weighted Average Time to Vest Retirement Eligible at Grant 236,387 $23,638,700 $3,487,702 $20,150, % 0.00 Retirement Eligible During Vesting Period 143,696 $14,369,600 $1,596,116 $12,773, % 1.50 Never Retirement Eligible 624,610 $62,461,000 $0 $62,461, % 3.00 Total 1,004,693 $100,469,300 $5,083,818 $95,385, % 2.08 Actual discount will vary based on duration of holding period and volatility In this example, our hidden treasure was over $5 million! 16

17 17 HIDDEN TREASURE IN ESPP VALUATIONS

18 ESPPs Calculating the Fair Value Fair value generally consists of four components*: Discount capture value of discount Call option capture value of potential stock price appreciation Put option capture value of purchasing additional shares from stock price depreciation (Minus interest foregone) * For ESPPs with a look-back 18

19 ESPPs When a Lower Fair Value is Appropriate Anytime a reduction in stock price would not be beneficial, as the participant would not be able to purchase additional shares. Examples: The entire purchase will be pro-rated due to lack of shares in share pool An individual hits the maximum amount of shares purchased per the ESPP or IRS limits As of the grant date 19

20 ESPPs Calculating the Fair Value ESPP Assumptions and Fair Values Without Limited Shares With Limited Shares Market Price $50.00 $50.00 Purchase Price $42.50 $42.50 Term to Expire Volatility 40.00% 40.00% Dividend Yield 1.25% 1.25% Risk-Free Interest Rate 1.20% 1.20% Present Value factor of 1 share of stock % 99.38% 15% of a Share of Illiquid Stock X PV factor $7.45 $ % of a Illiquid Call Option $4.75 $ % of a Illiquid Put Option $0.84 $0.00 PV of Interest Foregone ($0.13) ($0.13) Total $12.91 $12.07 As a Percentage of Stock Price 25.82% 24.14% Savings (Hidden Tresure) -6.51% 20

21 Questions? 21

22 THE END 22

23 Contact Us Julia Franke, CEP Associate Director Aon Hewitt Phone: Robert Slaughter, CEP E*TRADE Financial Corporate Services Phone: Jillian Forusz, CPA, CEP Adobe Systems, Inc. 23