As companies look to assess whether employee share-based payment awards will be a component of compensation this fiscal year, modeling assumptions will need to be revisited to consider any impacts from the COVID-19 pandemic on valuation assumptions. The impact of the current uncertain financial climate extends beyond the strike price of awards granted during this year and will continue to impact grants of share-based payment awards for the foreseeable future. This blog will focus on share-based payment awards for employees that are valued using closed form models, such as Black-Scholes-Merton.
In accordance with ASC 718, share-based payment awards are recognized at fair value at the date of grant. The fair value of these awards should mirror the amount at which the award could be transferred in the market by willing participants. Certain input variables are used to calculate the fair value of employee share-based payment awards using closed form models, including:
- Exercise price of the award
- Current price of the share
- Expected term of the award
- Expected volatility of the price of the share during the expected term
- Expected dividend rate for the expected term
- Risk-free interest rate for the expected term
At first glance, it may seem that the COVID-19 pandemic would certainly impact the current share price as well as the exercise price of the award. But, what about the other input variables? Let’s take a closer look at each valuation component.
The fair value of a share-based payment award can fluctuate based on the exercise behavior of the recipient. In general, there is a direct correlation between the value and the length of time an award remains outstanding. The most significant element of the expected term is the underlying potential grant population. This population should be segregated by group based on the expected exercise behavior over the term of the award. Segregation characteristics may include age, position, length of service, or other factors. Characteristics as well as groups should be analyzed often to ensure that expected exercise assumptions remain appropriate. Careful consideration is required as to whether the impacts of the current economic environment may otherwise result in participants holding share-based payment awards for a longer period of time.
There may be circumstances where use of external data may be more appropriate, especially in situations where there is a new share-based payment award program, or the program is modified to include a new class of employees. External data may not be readily available, so it’s important to enlist the assistance of valuation professionals or human resource professionals. The use of external data requires a review of the underlying data to ensure that the group characteristics (age, position, exercise behavior) is what would be expected for the company’s potential grant population.
Note that there is a practical expedient available in ASC 718 for nonpublic entities to calculate the expected term as the midpoint between the exercise date and the contractual term of the award. The is also a practical expedient available for public entities per SEC guidance but there are specific conditions under which it can be applied.
As with other accounting estimates, changes in facts and circumstances should trigger an analysis (and potential refinement) of the methodology used to develop an assumption. Volatility is the rate at which the price of a share changes over a period of time. This assumption usually relies on a lookback approach regarding fluctuations in the price of a share. The lookback term is normally the same length of time as the expected term of the award. An increase in the expected volatility over the term of a share-based payment award will increase the calculated fair value. This is because there is a greater probability that the award could be more valuable to the holder in the future. Depending on the length of the award’s term, volatility could significantly impact fair value.
So, what causes volatility anyway? Change to the value of a share can result from both entity specific factors as well as general economic factors. Entity specific factors may include matters such as acquisitions, divestitures, or a failed takeover bid. An example of general economic factors is the current impacts of the COVID-19 pandemic on share prices. An example of a general economic event that impacted volatility in the past was the financial crisis of 2008. This distinction is important, as it impacts the treatment of the event (and thus the variability in share price during that timeframe) in the volatility assumption. The guidance specifies different approaches depending on whether the volatility was the result of internal or external factors.
As it relates to internal factors, if there were fluctuations in the price of a share during a specific period, management must achieve two factors to exclude the associated time period from the volatility analysis. First, management must demonstrate that the volatility was a direct result of the internal transaction or event. Second, management must determine whether such internal transaction or event is not likely to occur during the term of the share-based payment award. The first consideration is usually a high hurdle for a public company, since it’s often difficult to prove that internal actions directly resulted in market participant behavior. What if the factors above cannot be satisfied, or the volatility of the stock is directly attributable to general market conditions?
If a share price is volatile for an identified period of time and was the result of internal factors, it is possible to exclude the applicable time period from a historical volatility analysis. While this exclusion is not permissible for volatility caused by general economic factors, there are other approaches to explore. For instance, it may be appropriate to place less weight on a specific time period in the calculation. Public companies may wish to extend the length of time analyzed to derive the expected volatility. Management could also calculate implied volatility, but only if there is sufficient trading volume of the underlying awards. These are just some of the examples included in ASC 718 as well as SEC Staff Bulletins. There are extensive considerations to review.
Expected dividend rate
It’s also important to consider whether the current financial landscape will alter the company’s ability or intent to declare and distribute cash dividends to shareholders. Companies may not currently have excess cash flow from operations to return to investors in the form of a dividend. A lower volume of dividends during the expected term of the award will increase the value of the underlying stock during that time period. While ASC 718 does cite that historical experience should generally be the starting point in developing expectations about the future, it’s important to evaluate and incorporate the expected likelihood of dividend activity. This involves regular and ongoing analysis of the forecast as well as discussions with senior management.
Risk-free interest rate
The risk-free interest rate expected to be in place during the term of the share-based payment award may be affected by the current economic environment. In an effort to jumpstart the economy, the government will likely decrease the treasury interest rate. Even though the current treasury interest rate is already low, this assumption should still be analyzed and adjusted based on the best estimate of an effective interest rate during the award term.
So, how would the components highlighted above impact financial reporting for share-based payment awards? As you may recall, existing equity classified awards would not be impacted, as the fair value is measured at the grant date. However, existing liability classified awards as well as newly granted equity classified awards may be impacted if the methodology is modified as a result of considering some of the above valuation components. It is critical to document each component of the valuation methodology in a closed form model, especially when there is a modification.
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