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Tag Archives: Volatility

March 22, 2012

Capped Stock Options: The Next Generation?

I’m not ashamed to admit that I’m not an accounting expert. I have complete and utmost respect for those who are in the trenches of accounting for stock compensation, and even more admiration for those who actually enjoy it. As a result of being an accounting “simpleton”, I appreciate it when an article crosses my desk that explains accounting concepts in interesting and understandable terms. On that note, last week we received an article titled “Using Capped Options to Collar Volatility”, published by Radford and now posted to our Stock Plan Expensing portal, that seemed to highlight a new trend in stock option expensing: the “capped” option.

A Volatile World

One thing I do know about stock option expensing is that the increased volatility of our stock markets has, in many cases, increased stock option valuations. As a result, companies are searching for new ways to conquer a delicate task: minimize stock option expense without impacting the “perceived” value that employees associate with their equity awards. (“It’s worth what I think it’s worth.”)

Capping Maximum Value

One way that some companies have addressed the impact of volatility on their stock option expense is to cap the maximum value that particular stock option can deliver to its recipient upon exercise. For example, a stock option priced at $10 with a cap of 400% would mean that the participant could not receive any additional value once the stock price exceeds $40 (yes, I pulled this example from the article – the terms are simple and easier to understand than any alternative I might make up). Using a cap that seems unattainable – and a 400% return would likely exceed the reasonable expectations of most employees – arguably keeps the employee’s perceived value of the stock option intact, while simultaneously reducing expense. According to the experts who wrote the article, the single act of capping an option – even a seemingly high cap of something like 400% – can have a significant downward impact on stock option expense (assuming other variables in the expense calculation remain constant).

Is this a Trend?

Several companies have jumped on the capped option bandwagon, and there are indicators that more companies are on track to issue capped options. In addition to minimizing the expense component of the stock option, a peripheral benefit seems to be some high marks in the shareholder perception aspect of the equation. Shareholders tend to dislike large windfalls, especially when there are no performance requirements attached to a grant. Capping the maximum value a stock option could deliver certainly would help eliminate the prospect of a windfall. Time will tell in terms of staying power of this new trend. We’ve seen a lot of things emerge in recent years, with staying power (performance grants ring a bell?), so I wouldn’t be surprised if this concept gains some traction.

I’m curious to know who has pursued capped options or is considering doing so. Take our poll below and see how you compare to what other companies are contemplating.

-Jennifer

Online Surveys & Market Research

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January 15, 2009

Volatile Times

Volatility is one of the inputs used to calculate a Black-Scholes model valuation of stock options. As volatility increases, so does the maximum gain that an employee could realize through a future exercise of their option. This, in turn, increases the value of that option, which may be a difficult concept to reconcile when the volatility is increased because of a down market!

With the recent turmoil in the stock markets, companies may find that the volatility they are using to value their stock options is jumping up as their stock price drops. Whether companies are using implied volatility or their own historical volatility, the recent changes in stock price could have impacted those numbers dramatically. There was a thread on this in our NASPP Discussion Forum recently on how to handle these changes, and I’m sure the question on many peoples’ minds right now is “should my company be doing something to deal with this increase in volatility?”

Companies may have created their method of calculating the volatility assumption without anticipating such a sharp downturn in the market. Now, they are looking at their method to see if it is still the best approach. The real intent of calculating volatility is to provide the best estimation of what future volatility will be. Ideally, the period of time the company is using to analyze historical or implied volatility will be long enough to provide an appropriate amount of stability which will accommodate short-term fluctuations. The shorter the period of time being analyzed, the more impact short-term fluctuations have, which may not be a reasonable reflection of what the company’s stock price volatility will look like over the life of the option. On the other hand, won’t options granted during this economic downturn have a higher chance of realizing gain through a dramatic increase in stock price over the life of the grant?

If this is the beginning of the fiscal year for your company, then it is a good time to take a look at how you are coming up with your valuation assumption. This is your opportunity to review your process for estimating volatility to see if it really is the most appropriate. Keep in mind, however, that FAS 123(R) clearly states that the method for determining the estimates should not only be “reasonable and supportable” (Paragraph 16), but also be “determined in a consistent manner from period to period” (Paragraph 23). So, if you are considering a change, such as an increase in length of time included in the calculation or a change to the way you weigh different periods, you will need to make sure that it is a change your company can not only justify to your auditors now, but also sustain as a valid method going forward.

For more information on your valuation assumptions, check out this article from Towers Perrin, Granting Stock Options in Turbulent Times: Take Care When Choosing Valuation Assumptions, in our Stock Plan Expensing portal. Also, get an idea of how your method for determining volatility measures up against other companies by taking our Compliance-O-Meter quiz on Volatility. We’ve got one for private companies and one for public companies.

-Rachel

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