Are estate planners shortchanging their clients by applying obsolete and inappropriate valuation rules that overvalue transferred stock options?

Regardless of how you feel about the ability of older valuation methods to produce accurate estimates of fair market value in the past, as market realities have changed, the valuation methods specified in Rev. Proc. 98-34 and Rev. Proc. 2002-45 have become obsolete.

For many clients, the old methods produce option prices far in excess of fair market value.  And, with option grant plans from 4,000 companies covering more than 9 million plan members as of 2006 1 – and with more and more plans allowing inter-family transfers – the stakes for calculating accurate valuations are high.

The relevant revenue procedures are based on the valuation rules of Statement of Financial Accounting Standards No. 123, which the Financial Accounting Standards Board’s (FASB) revised in December 2004 (SFAS 123R).  The financial accounting standard prescribes valuation methods based on standard option-pricing models, adjusted for the historical experience of the issuing entity with early-exercise behavior.  However, SFAS 123R also says that “the best evidence of fair value for employee stock options is observable market prices of identical or similar instruments in active markets.”  There is a tension between the prescribed methods and the market-based context of the financial accounting standard.  However, for the relevant revenue procedures, the tension is even greater, as the definition of fair market value is much more explicitly market-based.

Because they lack the liquidity of the publicly traded options the valuation models were designed to price, employee stock options are worth significantly less.  So what’s the best methodology for valuing stock options, and how can the most-accurate valuation methods be reconciled with the rules and procedures of tax valuation practice?

Tax Valuations vs. Accounting Valuations

First, start with an understanding of what SFAS 123R allows, and the recognition that different valuation methods serve different purposes.

Statement 123R establishes acceptable valuation methods for determining the compensation expenses associated with the reporting company’s employee stock option grants, so the methods allowed are not designed for valuing options for tax purposes.   Further complicating valuations, the standard of value in financial accounting is “fair value” while the standard of value in tax cases is “fair market value”
The most important difference between an SFAS 123R valuation and the true fair market value of illiquid options is that SFAS 123R does not allow discounts for illiquidity.  Instead, SFAS 123R requires that companies estimate the time-to-exercise of options granted, based as much as possible on actual early-exercise behavior of plan participants.2

SFAS 123R allows the use of closed-form models, such as the Black-Scholes method, and methods such as binomial/trinomial trees and Monte-Carlo simulation.  Black-Scholes may provide accurate values for short-term publicly traded options, but it overvalues stock options that are not publicly traded.  The Black-Scholes formula, in its simplest form, is as follows:

, where

, and

The model relies on these assumptions:3

1. The stock price follows a constant Brownian motion (with µ and σ constant).
2. Short selling with full use of proceeds is permitted.
3. There are no transaction costs or taxes and all securities are perfectly divisible.
4. There are no dividends during the life of the option or warrant.
5. There are no riskless arbitrage opportunities.
6. Security trading is continuous for both the option and the stock.
7. The risk-free rate of return is constant and the same for all maturities.

While none of these assumptions holds perfectly in real-world situations, they hold well enough to make Black-Scholes the most commonly used model among options traders valuing fully liquid stock options on actively traded stocks.  Known biases in the model are minor and trading software compensates for them automatically. 

With non-tradable options and warrants, though, the Black-Scholes model overstates prices, often by a wide margin.  Black-Scholes and other SFAS 123R methodologies are inaccurate, even for financial accounting purposes, because the financial accounting standard rejects the application of a liquidity discount.  The alternative method of shortening the options’ expected average lives cannot accurately account for the discount an arm’s-length investor would apply to illiquid options due to their lack of tradability.  For one, early-exercise behavior is highly individual and, further, even the “average” plan participant in very large option grant plans will tend to exhibit highly variable early exercise behavior over time.4  Estimating expected terms at grant is often almost impossible, especially for young firms with limited option plan histories.  Such estimates tend to be conservative and overestimate the expected term.  As we shall also see later in this article, even if we could shorten the term accurately, these methods would still overvalue the average illiquid stock option. 

The illiquidity discount for non-tradable options and warrants varies significantly, depending on how far in the money the option or warrant is.  That’s partly because the holder of the option or warrant can often immediately realize its intrinsic value by exercising it early.  However, liquidity has value in and of itself, and illiquidity discounts apply to all non-tradable securities, separate from the possibility (in the case of options) of early exercise.

The “safe harbor” revenue procedures of the IRS – Rev. Proc. 98-34 and Rev. Proc. 2002-45 – are equally problematic.  They generally require use of the Black-Scholes or binomial models, do not allow illiquidity discounts, and place limitations on specification of the inputs to the models.

Rev. Proc. 98-34, which applies to valuation of stock options for calculating gift, estate and generation-skipping transfer taxes, allows the use of any valuation method that takes into account each of the following:

• Exercise price of the option
• Expected life of the option
• Current price of the underlying stock
• Expected volatility of the underlying stock
• Expected dividends on the underlying stock
• Risk-free interest rate for the expected term of the option

The volatility of the underlying stock must be based on the volatility disclosed in the financial statement for the fiscal year in which the valuation is made.  Likewise for dividends used in the valuation.  In determining the factor for the risk-free interest rate, you must use the yield to maturity of zero-coupon U.S. Treasury bonds as of the valuation date with a remaining term nearest to the expected life of the option.
To calculate the expected life of the option, you can use either the “maximum remaining term” of the option, which is the number of years remaining from the valuation date rounded to the nearest tenth of a year, or the “computed expected life,” which is calculated by multiplying the maximum remaining term by the quotient of the weighted-average expected life, divided by the number of years from the date the option was granted.  However, the maximum remaining term must be used in many cases, including when:

• The transferor of the option (or the decedent) is not the person initially granted the option.
• The person transferring the option is not an employee or director of the company that granted the option as of the valuation date (except when the transfer takes place at death).
• The option being valued does not terminate within six months after employment or service as a director ends (except when the transfer takes place upon the owner’s death or disability).
• The terms of the option being valued permit the option to be transferred to a charity or to someone other than “the natural objects of the transferor’s bounty.”
• The option being valued has an exercise price that is not fixed on the valuation date (except when the transfer takes place at death). 
• The option being valued has terms and conditions such that if all of the options granted in the fiscal year of the company that includes the valuation date had the same terms and conditions, the weighted-average expected life for the year would be more than 120% of the weighted average expected life reported for the year.
• The company is not required by FAS 123 to disclose an expected life of the options granted in the fiscal year of the company that includes the valuation date.
  
  1. www.nceo.org/reference/index.html.

  2. The FASB’s position is based on empirical research of early exercise patterns.

  3. Hull, J. (2006) Options, Futures, and Other Derivatives, 6th ed. Pearson Prentice Hall. pp 290-291.

  4. For example, early-exercise behavior changes with changing employee demographics and with something as unpredictable as the changing fortunes of the company’s stock in the market.