The use of employee stock options as a form of compensation has led to some of the most controversial debates in the business world over the past decade. The practice of backdating grants of options to corporate leaders and other top employees has dominated the news lately, with Apple's (Nasdaq: AAPL ) Steve Jobs among the alleged culprits. The primary reason why the use of employee stock options became so popular in the first place was that companies didn't have to treat them as an expense on their financial statements. When reporting expenses related to stock options became mandatory last year, however, many companies that use employee stock options sought ways to minimize the impact of expensing them on their bottom lines.
On Tuesday, the SEC approved a new method of calculating the appropriate expense figure that a company should use in valuing employee stock options. The method, proposed by Zions Bancorp (Nasdaq: ZION ) , uses an innovative market-based mechanism to put a value on the stock options given to employees. Since this method may result in companies being able to reduce the expense charges they're forced to report, it's certain to be both controversial and popular within corporate America.
Historically, one of the ways in which opponents of options expensing have argued against the practice has been to point out how difficult it is to come up with a valid valuation on which a company can base its chosen expense figure. Unlike the stock options you'll find on public exchanges like the CBOE, employee stock options aren't tradable securities; they are generally issued directly to the employee, and the employee usually can't transfer them to anyone else. As a result, there was no market mechanism available to determine a fair market value for these options.
When companies started having to report options-related expense, most companies used theoretical models to support their figures. In some cases, they supplemented these models with information gathered from other types of options that trade on exchanges. Because these models often resulted in companies having to report higher expenses than they thought were appropriate, many companies that use options extensively argued that a market-based system would provide more accurate results than existing models. Until now, though, the SEC and the Financial Accounting Standards Board typically rejected alternative proposals by companies such as Cisco (Nasdaq: CSCO ) , Genentech (NYSE: DNA ) , and Qualcomm (Nasdaq: QCOM ) that would have reduced options expense costs by 70%.
How the new method works
In contrast to earlier proposals that merely incorporated public trading in underlying shares or exchange-traded options, Zions' approach actually creates a market for the employee options themselves. In order to do this, Zions created a new type of derivative security, which it calls employee stock option appreciation rights or ESOARS. These securities are sold at auction to individuals and institutions that Zions approves for trading.
When investors buy ESOARS, what they are buying is a right to future payments that are linked to the exercise of a company's stock options by that company's employees. For example, say a company has two employees, each of whom is granted options to buy 100 shares of company stock at $20, and also issues 200 ESOARS associated with those options. If one employee exercises the option when the stock is worth $30, then a single buyer of the ESOARS issued will receive $1,000, or the $10 appreciation in the stock price multiplied by the 100 shares purchased through the option exercise. If the other employee exercises at a later time, then the ESOARS will similarly pay an amount based on what the stock is worth at that time.
Notice that these derivative securities are not themselves options. Most notably, ESOARS owners have no control over the exercise of underlying stock options or the timing of when they receive payments. Investors are at the mercy of the decisions made by employees, whether or not they reflect optimal economic behavior. Because these derivative securities have fewer rights than the stock options themselves, it would make sense that they should have a lower value than employee stock options.
A step toward market-based valuation
In its press release, Zions expressed excitement over the SEC's approval of its market-based valuation mechanism. Given that it intends to assist other companies using employee stock options to use this method in the hope of reducing its options expense, Zions clearly hopes that these derivative securities will catch on and lead to substantial business. Because companies that make frequent use of employee stock options have so much at stake, Zions' hope is justified. Whether companies use the Zions method or try to develop another method of their own, you can count on seeing many companies make attempts to expand the SEC's recognition of market-based options valuation methods.
While the Zions method won't stop the ongoing controversy over employee stock options, it may provide a more transparent way for investors to evaluate the actual cost of these options. Because analysts will be able to track the actual payouts made to owners of these securities, they will provide valuable data for continuing research on the best way to value stock options. In the meantime, there's no reason to expect stock options to disappear from the headlines anytime soon.
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Fool contributor Dan Caplinger has never gotten stock options. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy isn't hard to value.