The valuation of stock options is a complex issue that divorcing parties may face during the determination and division of property. Designed to both reward performance and retain employees, these benefits can be difficult to value, particularly at a random moment for the purpose of marital dissolution.
The American Institute of Certified Public Accountants (“AICPA”) Forensic and Valuation Services Section provides a quick reference guide on valuing stock options, Valuing Stock Options: AICPA’s Financial Instrument Quick Reference Guide (section membership required). We excerpt from the Guide below in order to provide a few highlights.
What is a Stock Option?
A stock option is a contract that allows the owner of the right, but not the obligation, to buy equity in the company that issued the option at a certain price for a certain period of time. In its most basic structure, an option contract consists of:
- The identification of the equity that can be purchased or sold
- The price at which the equity can be purchased or sold
- A discrete time within which the equity can be purchased or sold, and
- A price for the right to own the right to buy or sell equity in the company that issued the option
Valuation models
Valuation models can be as simple or as complex as the derivative they are valuing. Each step in the process requires a thorough technical understanding, as well as professional judgment to identify the model that works best for the particular valuation and ultimately be able to explain and support the resultant conclusions.
Lattice models are used to value derivatives when discrete, or distinct, points in time need to be part of the model (e.g., days, months). Common lattice models are binomial and trinomial models that are easy to use and highly adaptable to different types of options since it allows for changing assumptions between discrete measurements (e.g., volatility). These are structured by discounting a series of cash flows from the time of maturity to the beginning date of the option contract.
The Black-Scholes model is classified as a “close-form” model because it assumes the option is only exercised at the end of the contract term and the underlying assumptions remain constant over the term of the option. This model is useful when trying to value options such as the European options that only have one exercise date. The Black-Scholes model is based on six inputs:
- type of option being priced (e.g., call or put option)
- stock price,
- strike price of the option
- term of the option
- appropriate risk-free rate
- volatility of the underlying stock
The Monte Carlo Model (MC) is considered a stochastic model because this method generates a large number of time-dependent scenarios and estimates the value of the option as a statistical expectation of the outcomes of those simulations. Compared to the Black-Scholes formula, MC allows for much more flexibility, including large changes in the interest rates, volatility and the possibility of major events, such as mergers and acquisitions. Statistics are used to quantify the error in the estimates.
Accounting for Stock Options
There are three main ways to account for stock options. The way these are accounted for depends largely on why and how the options are being issued.
- Fair market value-IRS Revenue Ruling 59-60 defines fair market value as “the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
- Fair value measurement- Accounting Standards Codification (ASC) 820: Fair Value Measurement, is the sole source for authoritative guidance on how entities should measure and disclose fair value in their financial statements under U.S. Generally Accepted Accounting Principles.
- Fair Value Based Measurement- ASC 718 Compensation – Stock Compensation, defines fair value in the context of the employer/employee relationship.
Conclusion
Due to the complexity of valuing stock options, it is critical to consult a financial expert. As we can glean from the AICPA Quick Reference Guide (section membership required), not only must the financial expert apply professional judgment and technical understanding during the process, but he/she must be able to communicate the process and result conclusion(s). If the divorce case includes stock options, hire a financial expert to value these complex financial instruments. The professionals of Mercer Capital can assist in the process. For more information or to discuss an engagement in confidence, please contact us.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Volume 3, No. 1, 2020.
