PRINT THIS PAGE New era for employee stock options27/09/2006. Source: Israel Venture Capital Journal (IVCJ). Udi Savithsky, CPA and Partner at BDO Ziv Haft Consulting Group; Efrat Shust, CPA (Adv.), and Head of Derivatives & Financial Risk Management for BDO 
Valuation issues relating to employee stock options are shaking the high-tech and accounting worlds, says the Israel Venture Capital Journal, and its treatment has attracted a great deal of attention on the part of regulatory bodies. Udi Savithsky, CPA and Partner at BDO Ziv Haft Consulting Group, along with Efrat Shust, CPA (Adv.), and Head of Derivatives & Financial Risk Management for BDO, recommend ways to avoid potential pitfalls when granting options to employees
What do Mercury and Comverse have in common? Up until a number of months ago, the answer would have been that they are both Israeli high-tech companies that have made it big.
They succeeded in attaining world standing in their respective fields by issuing equity in the United States and in demonstrating impressive growth. But today the names Mercury and Comverse will bring up completely different associations for readers of the financial columns. Accounting scandals, executive resignations, SEC investigations and delisting actions have engulfed these two companies, and all because of a failure in accounting for options which were granted to executives.
The saying The bastards changed the rules and didn't tell me, is attributed to former US Vice President Spiro Agnew, who was investigated on suspicion of financial irregularities and tax evasion. In contrast, in this case, no one can claim that. The writing has been on the wall for a long time. The era of the forgiving attitude towards options is over.
This subject is in the spotlight today, and its treatment has attracted a great deal of attention on the part of regulatory bodies, accounting institutes and tax authorities. Employee compensation through company stock options is widespread among high-tech companies. Originally this tool was intended to create a connection between company performance and employee compensation and thus strengthen motivation and increase productivity. Notwithstanding, granting options to hightech employees turned the medium into an instrument for preserving a company's competitive strength in recruiting employees. In fact, in many cases, these options were part of the compensation package that a typical high-tech employee expected.
Options became the most widespread instrument for a number of reasons. Firstly, they did not require companies to expend cash immediately, an important advantage for a young company in the cash burning stage. Secondly, options motivated employees to stay with a company and improve its performance in the long run (several years), since this is the time that generally is a condition for exercising the benefit. The above two advantages apply both to the options incentive and to the stock incentive. Therefore, they alone cannot explain the clear dominance of options over stock. The explanation for this phenomenon is not rooted in cash flow considerations or employee motivation, but rather in an unexpected source financial accounting rules.
Until recently, under certain circumstances, accounting rules allowed that the expense for option grants to employees not be reported in the income statement. The fair value of these options was disclosed only in a note, and thus did not impact financial results and did not attract much attention.
The implication of the matter was that if two identical companies were examined, A, which generously granted options to its employees, and B, which did not grant any options, the financial performance of both companies were apparently identical. The company value for the shareholders of company A was equal to the company value for shareholders of company B. It is clear that this method of measurement is misleading. Company Agranted its employees a benefit at the expense of its shareholders, and thus the economic value remaining in the hands of the shareholders of company Ais less than that remaining in the hands of the shareholders of company B.
This distortion is pronounced relative to other compensation methods that are reflected in the income statement and for which an expense, at the level of the fair value of the compensation, is recorded. As a result, the use of options became a preferred means of compensation for many companies.
This bias in accounting treatment and its implications did not go unnoticed by regulatory authorities and accounting institutes. In December, 2004, after much deliberation, a revised accounting standard, FAS123r, that set new measuring and reporting rules, was published. The main innovation of the standard was the requirement to measure the fair value of the options granted and report it as an expense in the income statement. So, the option benefit was to be reflected in a company's financial results, similar to any other benefit that a company granted to its employees or to others. The subject of options has also attracted the attention of the tax authorities. The US Internal Revenue Service (IRS) recently published proposed regulations that are likely to lead to serious tax consequences for companies, particularly private ones, issuing options to employees.
The regulations proposed by power of Rule 409A state that sanctions will be imposed under circumstances where employees were granted options whose exercise price was lower than the market value of the stock. Recipients of the options would incur a 20 percent penalty in addition to their regular tax liability.
This matter has material implications, especially for a private company. In a large majority of the cases, the value of a share of stock required for the purpose of examination by the tax authorities is not available. Moreover, because of the complicated capital structure typical of high-tech companies, determining this value is not simple and requires the use of one of a number of accepted methodologies.
The new standard and proposed tax regulations signaled a change in the rules of the game. Today, it is clear that treatment of employee options must be determined both by the company itself and by its auditors with the same level of caution with which other financial statement issues (revenues, provisions for losses and the like) are treated. The consequences of failing in the treatment are likely to be heavy, as can be learned from the cases of Mercury and Comverse.
The problem is that the subject's level of complexity requires unique professional qualifications, which often are not found in a company. Measuring the fair value of the options that were granted to employees involves choosing and applying a valuation model and performing estimates and assessments for measuring the value of the options. The valuation methodology must be established and argued in a manner that will be able to withstand examination, both by the auditor and the securities authority, to the extent required. In light of these requirements, the engagement of outside experts for the purpose of evaluation has recently expanded considerably.
Measurement by experts is made with models the binomial model and Monte Carlo simulation that are more appropriate methodologically for employee options than the traditional Black and Scholes model, for example. The results obtained better reflect the value of the options. In most cases, this value will be lower than that derived from the Black and Scholes model and, therefore, the expense that will be recorded by the company will be lower. This factor is another reason that lead companies to turn to experts for the purpose of valuing options.
In light of the lessons of the past and in order to avoid pitfalls in the future, a number of cautionary rules are suggested to managers of companies that routinely grant options to employees:
a. Prior to issuing options, make certain that the exercise price of the option is not lower than the price of an ordinary share of company stock, in order to avoid specific sanctions.
b. Make certain that records pertaining to the options, which were granted fully and accurately, reflect the grants that were made. Particular attention should be given to the day recorded as the time of the grant to ensure that it is the correct date, both in fact and from an accounting perspective.
c. Make certain that the measurement is made by someone with the know-how and appropriate qualifications (generally the CFO or the controller).
d. Make certain that there is a basis and documentation for the valuation details of the appraiser and his or her position, the valuation model, the manner in which the parameters were estimated, and back-up for the assumptions that were made, or the opinion of an outside expert detailing the valuation methodology.
e. Make certain that the valuation model is consistently applied, unless you are convinced that changing the model will improve the measurement. In any case, the model should not be routinely changed.
This article appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com
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